This IRA Rollover Mistake Could Trigger a Massive Tax Bill

Many workers who leave a job take their 401(k) account with them and roll the money into an IRA. However, if you mishandle this transition, you could put your financial fitness at stake.

Before you roll a 401(k) or existing IRA into a separate IRA account, make sure you understand the 60-day rule so you don't trigger a massive tax bill.

Why do people use IRA rollovers?

Workers who leave a job and have a 401(k) account often want to keep their retirement money growing for many years into the future. An IRA rollover helps you achieve that goal.

This option allows you to move money from the 401(k) and into an IRA so you keep the funds growing tax-deferred. Other potential advantages of a rollover include:

• Lower fees
• A broader range of investment options
• The ability to consolidate various retirement accounts into a single account

There are other situations where people use an IRA rollover, such as rolling over an existing IRA into a separate IRA.

What is the danger of rolling money into an IRA?

If you do a rollover correctly, a rollover generally avoids current taxes and penalties. The new IRA account functions much like your 401(k) plan did.

However, if you make a mistake in the rollover process, expect it to be costly. In some cases, you might owe taxes and other fees. You could also end up losing the advantage of keeping the money growing tax-deferred.

Here are some questions to ask yourself before undertaking a rollover.

What is the 60-day rollover rule?

A worker who is leaving a company may have the money in their 401(k) account directly paid to them. This is sometimes referred to as an "indirect rollover."

When you receive money as part of an indirect rollover, you generally have 60 calendar days to roll the money into an IRA or another retirement plan.

What happens if you mess up the rule?

If you fail to roll over the money within the 60-day window, it is treated as a taxable distribution. That means that instead of the money continuing to grow tax-deferred, you instead face a tax bill during the year of the rollover.

In addition, it's possible to pay additional taxes if you have not reached the age of 59.5. In other words, failing to understand the 60-day rollover rule could lead to a situation that triggers a big tax bill that could run up to tens of thousands of dollars.

The precise amount you owe in taxes depends on the size of the distribution and your tax bracket.

What is the withholding trap?

If funds from a retirement plan are distributed straight to you, they are subject to 20% in mandatory withholding. This is true even if your plan is to eventually roll the money into an IRA.

If an IRA distribution is paid out directly to you, many are subject to a 10% withholding unless you opt out of withholding.

What happens if you fall into this trap?

The IRS offers an example on its website that illustrates the danger of falling into the withholding trap. If a worker receives a direct distribution of $10,000 from a 401(k) plan, the worker's employer is required to withhold $2,000 from the distribution.

When the worker finally decides to roll over the remaining $8,000, the $2,000 that was withheld is treated as taxable income. A worker in this situation who wants to roll over the full $10,000 and avoid taxes would be required to come up with an additional $2,000 from other savings to make that happen.

What is the 'once per year' rule?

You are allowed to make a single rollover from one IRA to another IRA over a 12-month period. This rule applies even if you have multiple IRA accounts.

However, it does not apply when rolling a retirement plan into an IRA. There is no limit on such rollovers.

What happens if you violate this rule?

If you violate the once-per-year rule, you must include the distribution amounts in your gross income at tax time. In addition, you may be on the hook for a 10% early withdrawal tax on these amounts.

In addition, until you fix things by moving the money back out of the IRA, the cash could be subject to 6% taxes per year for as long as it is in the IRA.

What is the best way to avoid making a mistake with an IRA rollover?

All of this probably sounds like a massive financial headache. Fortunately, there is a way to avoid the negative consequences.

Requesting a direct rollover of the money from a 401(k) plan or IRA to a separate IRA helps you steer clear of all taxes and penalties.

Talk to your plan's administrator and request that instead of paying the money to you, they make a payment directly to the IRA. In many cases, the administrator cuts a check that is made out to the new account.

Taxes are not withheld on any of the amount transferred.

If you are rolling one IRA into another IRA, ask the financial firm that has your IRA to make the payment directly to the second IRA. In this case, too, no taxes are withheld.

Bottom line

In some cases, you might be eligible for a waiver if you receive your retirement funds directly and miss the 60-day deadline. This might apply in cases of a mistake by your financial institution, a natural disaster, or a hardship in your life.

However, you should not count on such exceptions to bail you out. Instead, request a direct rollover. Most companies see employees come and go all the time, so your 401(k) plan administrator should be familiar with how to execute your request or a direct rollover.

By requesting a direct rollover, you eliminate the risk of surprise taxes on your retirement savings and stay on track for retirement.

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