Retirement Rollover Rules: A Not-So-Scary Primer

We’ve already talked about required minimum distributions, or RMDs, here on the blog. But before we worry about taking money out of our retirement accounts, we have to make sure we’re putting cash into them — and abiding by the IRS’s swath of retirement rollover rules along the way.

After all, you may hold a number of different retirement accounts: employee-sponsored plans, like a 401(k) or 403(b), or a self-directed Roth or traditional IRA. And whether you’re in the process of sharpening your retirement strategy, nearing retirement age, or simply undergoing a career change, there are a lot of retirement rollover rules to consider when you’re deciding whether (and how) to move your money from one retirement account to another.

Retirement Rollover vs. Direct Transfer: What’s the Difference?

Let’s say you’ve been working for several years at a job with a solid, employer-matched 401(k) plan. You’ve been making contributions at every pay period, and have amassed a nice sum: $200,000.

But maybe a new opportunity caught your eye, or your spouse’s suddenly-landed dream job has the two of you skipping town for a new destination. Maybe you’re even being laid off — hey, life happens!

Either way, you’ve got to figure out what to do with that nice fat retirement stash you’ve been nursing.

Cashing in your 401(k) means you’ll pay both income tax and, if you’re under the age of 59.5, a 10% early withdrawal penalty… which is not a very savvy financial strategy, even if it would put about $180,000 into your pocket.

But you know saving for the golden years is important, so you decide to keep the funds invested in some sort of retirement plan. You have two different options: you can transfer the money, moving it into to a new 401(k) plan, or roll it over into a different type of eligible retirement account.

But that’s the key word: eligible.

Not every type of retirement account is rollover compatible, and each different kind of account has its own rules and regulations.

For example, a Roth 401(k) can be rolled over to a Roth IRA, but it doesn’t work in the other direction. (More on these specific rules just a little bit later!)

To add one more layer of complication to the story, there are two different types of rollovers: direct and indirect.

A Direct Rollover

Sometimes known as a custodian-to-custodian transfer, means your money is transferred directly between the two retirement accounts — and is thus impervious to penalties and taxes. The custodian or administrator of the plan will either send the money straight to the new account, or write a check made out to the new account “in the benefit” of you, the investor. Either way, you can’t actually touch the money, and so no penalties are assessed and no taxes are withheld.

An Indirect Rollover

With this option, you basically cash out the retirement account and reinvest the funds manually. In this case, the custodian writes a check to you, personally, for you to re-allocate as you see fit. (This check is called a rollover distribution.)

However, you won’t be getting a check for the full amount that was in your original retirement account. The account administrator is required by the IRS to withhold 20% of the total to cover taxes. Furthermore, if you’re under the age of 59.5 (and you haven’t retired yet), you’ll likely be subject to an additional 10% tax penalty.

Fortunately, there is a way to avoid those charges: You simply have to reinvest the funds in a new retirement account within 60 days. However, the IRS rules state that you must reinvest the exact same amount that was in your original retirement plan — and that check you got was for 20% less, remember? That means you’ll need to cough up some of your own dough to cover the difference. Then, you’ll be reimbursed for that gap in the form of a tax credit.

Specific Retirement Rollover Rules By Plan

Given all the tax hoops and hoopla that go into indirect rollovers, direct rollovers are preferable in the vast majority of cases. But unfortunately, not every type of retirement account is eligible to be rolled over into every other.

For example, a traditional 401(k), as a qualified plan, can be rolled over into a traditional or Roth IRA — or just about any other retirement plan out there, as a matter of fact.

But if you have a Roth IRA, those funds are ineligible to be rolled over into anything other than another Roth IRA, and even then, you’re only allowed one rollover per year.

Here’s another great example, which really drives home just how specific these regulations can get. A governmental 457(b) can be rolled over into just about any other retirement plan you can imagine… while a non-governmental, tax-exempt 457(b) can only be rolled over into a Roth IRA or transferred directly into another 457 (b) of the same type.

You can find the IRS’s full list of retirement rollover rules here, which will help you get a better sense of where you might be able to move your money. Of course, from a strategic standpoint, myriad factors go into this decision: for instance, if you retire before the age of 59.5, you may be able to take penalty-free distributions from a 401(k), but not from an IRA plan!

As with all things money, your specific retirement needs are just that: specific, unique to your personal values and situation. If you’re trying to figure out how best to reallocate your retirement funds, we’re happy to help.

Get in touch and we’ll arrange a time to create a custom retirement strategy for you.

investing for retirement ebook ipad - McClain Lovejoy
investing for retirement ebook ipad - McClain Lovejoy
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