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

Jane recently left her job and wondered if she should roll her 401k over to an IRA or not. She was frustrated by her former employer’s limited investment choices and limitations. She was right on both counts.  What really seemed silly were the trading rules at the 401k plan;  if she traded out of a fund she couldn’t go back in for 90 days.  Because of those wacky limits and very sparse menu of investment choices, she wanted to roll her account but wasn’t exactly sure how to do it.

If you are in the same boat as Jane, don’t be intimidated. You only have to remember a few IRA rollover rules to save a boatload of money, have more investment choices and get free of dumb trading rules.  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 to your IRA.  You “roll” the money out of an employer-sponsored plan into a traditional IRA without paying taxes.  If you decide to go this route your first order of business is to open your IRA account at the right custodian.  Your next move is to contact your former employer and complete their paperwork.  In no time at all the money will be rolled over.  It’s just that simple.

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. 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 new custodian for your 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 new 401k, 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.  There are pros and cons to this which we’ll talk about later.  But most people like to roll their accounts to an IRA because they enjoy the added flexibility and expanded investment menu.

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.)

Have you ever rolled an old 401k over?  What was your experience?  Are you happy you did so?  Why or why not?