An indirect 401k rollover is a process of transferring funds from a 401k retirement account to another retirement account, like a traditional IRA or a Roth IRA. This can be particularly useful if you have a 401k plan and an IRA.
Direct vs. Indirect 401k Rollover
You might be wondering what the difference is between a 401k direct rollover vs. an indirect rollover. The main difference is how the transfer is completed. With a direct rollover distribution, you have no direct access to the funds being transferred.
In this circumstance, you receive a distribution from your 401k retirement plan and your employer’s plan administrator directly transfers these funds to another retirement plan on your behalf.
An indirect rollover from a 401k works differently. In this instance, you receive the distribution from your 401k. However, your employer would withhold a part of your distribution to cover the taxes due for this pending transaction, as Investopedia explains. The funds for taxes withheld from you will be returned to you as a tax credit for the year when the 401k indirect rollover is completed.
What Are the 401k Indirect Rollover Rules?
As with many tax procedures and processes, there are 401k indirect rollover rules that must be followed.
A 401k indirect rollover is also called a 60-day rollover because the full distribution amount must be paid within 60 days. If you receive a distribution of $15,000 and your employer withholds $3,000 for taxes (i.e. the 20% withholding tax), then you will receive $12,000. To complete the rollover, you will need to deposit the money, the full $15,000, into your tax-deferred account.
This means you will need to provide the funds withheld by your employer for taxes. If you are unable to do so by the 60-day deadline for 401k indirect rollovers, the $3,000 that was not paid would be considered a distribution. This means you will need to pay income taxes on that amount.
This is one of the main 401k indirect rollover rules that must be followed to avoid paying taxes and penalties. The 60-day rollover rule is always something to keep in mind if you choose to complete a 401k indirect rollover.
Another 401k indirect rollover rule to keep in mind is the limit. You are only permitted to make one 401k indirect rollover every 12 months. If you take more than one distribution from your 401k plan before the 12-month period ends, then you will need to pay an early distribution tax.
However, there is an exception to this rule with 401k indirect rollovers. If you are transferring from one qualified retirement plan to another, you can make more than one rollover. This would mean that a 401k indirect rollover to another 401k will be exempted from this rule, for example.
It is also important to know that a 401k indirect rollover can’t be split into multiple accounts. If you try to split an indirect rollover from a 401k plan into two accounts, then it will be considered two rollovers.
This would exceed the number of permitted rollovers in the 12-month period. In addition to the early distribution tax you will have to pay, you can face an excess contribution tax on one of the two accounts as long as the account exists.
When or Why Should I Complete a 401k Indirect Rollover?
An indirect 401k rollover allows you to diversify your investment portfolio. By rolling over funds to an IRA, the account owner can choose from a wider range of investment options than are typically available within the 401k plan.
While this can be accomplished with a direct rollover, a 401k indirect rollover allows you to use the distribution if you have a sudden expense. This is one major advantage of indirect 401k rollovers, as it allows you to take a zero-interest loan. All you need to do is pay back the full amount within 60 days to avoid penalties.
An indirect 401k rollover can also be beneficial if you switch jobs. This way, your previous employer transfers your distribution to your new employer's 401k plan for you. You may also consider using a 401k indirect rollover if you are moving from being employed to being self-employed. This way you are rolling over your distribution from a 401k to an IRA.
You should consider a 401k indirect rollover when you have guidance from a trusted financial advisor. While an indirect rollover can be beneficial, the potential penalties and tax burdens can leave you with a hefty tax bill if you aren’t careful.
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Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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