If you have recently changed jobs or retired, you are entitled to rollover your existing 401k or other employer sponsored plan to an individual retirement account, or IRA. It is important to know the IRA rollover rules in order to avoid the negative tax implications which can eat away at your investments.
There are a number of options for investors who are looking to rollover their retirement accounts, and each comes with its own benefits and drawbacks, and each should be weighed carefully against your investment objective.
If you are unsure which option is best for you, consult with a financial adviser, such as the retirement and IRA rollover specialists at ETrade, to find out which avenue is best for your situation.
IRA Rollover Rules: Cash Distributions
You can elect to receive a cash distribution from your 401k or IRA, and then the check will be made payable directly to you. These direct distributions are subject to state and federal income taxes. There is a required 20% withheld from your payment by your employer, as a prepayment of your estimated taxes.
You could owe more or less than the 20% withheld depending on your tax bracket when your file your personal income taxes. In addition, if you are under the age of 59½, you could also be subject to a premature withdrawal penalty of 10%.
A cash distribution from your individual retirement account is by far the most heavily taxed and penalized option that you can take if you are under the age of 59½. It is advised to utilize this option only when absolutely necessary, otherwise, IRA rollover rules make it relatively simple to convert your retirement funds to an IRA.
IRA Rollover Rules: Indirect Rollover
An indirect rollover allows you to take a cash distribution from your former retirement account and the deposit the funds into your individual retirement account within 60 days. There will still be a required 20% withholding for prepayment of federal income taxes.
In order to avoid penalties and taxes, the entire distribution plus the 20% that was withheld for taxes must be deposited into your new individual retirement account. If there is any amount not rolled over within this time period, including the 20% withholding, then that amount will be subject to penalties and taxes.
IRA Rollover Rules: Direct Rollover
A direct rollover authorizes your employer to pay the new custodian of your IRA directly, this is sometimes referred to as trustee-to-trustee transfer. With a direct rollover, the check is made payable directly to the new custodian and this option carries no penalties or taxes, and are not subject to mandatory withholdings.
IRA rollover rules make direct rollovers most likely your best option as your funds continue to grow tax-deferred, and you incur no hefty tax penalties or fees.
There is a lot to consider when rolling over your existing retirement account to an IRA. It can be helpful to discuss your situation with a rollover specialist, like the trained financial advisers at ETrade, to assess which option is best for you.