Tax-Free IRA Rollover Done Correctly – Here’s How

by Neal Frankle, CFP ®

You can easily do a tax-free IRA rollover. Don’t be intimidated. You only have to remember a few IRA rollover rules to save a boatload of money. The reality is, in order to avoid the big landmines, all you have to really do is understand a little vocabulary.

First, just keep in mind that the word rollover only pertains to moving money out of a 401k, 457 or 403b. You can even do a rollover to a Roth 401k. You “roll” the money out of an employer-sponsored plan into a traditional IRA without paying taxes. That’s why they call it a rollover. Usually these rollovers occur when you separate from service either by retiring or leaving the employer and finding another job. The rollover is actually done by your former employer.

When you move money from one IRA to another IRA, that’s called a transfer. Different rules apply to rollovers, and other rules apply to transfers even though both tactics are tax-free. But if you keep the definitions straight in your mind, you’ll be miles ahead of the game. Vernacular is especially important when it comes to IRA beneficiary rules.

When you leave your employer, you may or may not want to roll the retirement plan into an IRA. Most people do because 401k plans don’t offer the best retirement investments possible. Other people keep the money in the 401k. They think it’s easier to borrow money from a 401k and don’t know how to borrow from an IRA. Personally, I don’t think borrowing from retirement funds is a great idea either way, so I think the IRA rollover is a good move. If you decide to roll the retirement plan to your IRA, make sure you request a DIRECT ROLLOVER and not an INDIRECT ROLLOVER.

Direct Rollover

A direct rollover means your employer makes the check out to the firm that is going to be the custodian for your new IRA. They may actually send the check to you, but that doesn’t matter. It will probably be made out to “ABC Custodian, FBO (for the benefit of) Mary Johnson.” Don’t worry if they send you the check. They do this because they want to make sure you know what’s happening with your money. As long as the check isn’t made out to you, you’re OK.

Indirect Rollover

If you request an indirect rollover, the check will be made payable to you and you’ll have 60 days to get it into an IRA account. This is a terrible idea because the government sets you up to sock it to you. The employer will withhold 20% of the money before they send you the check. But you’re still responsible to roll over the entire amount. If you don’t, you’ll be slapped with a tax on any amount you didn’t roll over, PLUS you may be subject to a 10% penalty if you are under 59 ½. Nobody likes to owe money to the IRS, so please don’t do this. It’s completely avoidable.

Other Options

You can take the rollover and deposit it into an IRA, but that’s not your only choice. You can also roll the money over to a 403b or 457 plan as long as your new employer allows it. Keep in mind that the government allows for this, but your employer doesn’t have to accept the rollover.

Keep in mind that if you die, your spouse can also elect to roll the money over to his employer-sponsored plan or his IRA (just like you could if you simply found a new job). But if anyone other than a spouse is the beneficiary (like your children), they can’t do a rollover. (Read IRA beneficiary rules.)

 

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