by Jason Topp
Since the downturn in the economy, a lot of folks have lost jobs, been laid off, or have started their retirement journeys early. Perhaps you left on your own terms, or you are looking for a new career path.
Any way you slice it, thousands of Americans are contemplating a 401k rollover. A rollover can be accomplished in one of two ways: directly or indirectly, and it's extremely important to know the difference between the two.
A direct rollover simply transfers funds from your former company (or rather the one administering the plan for your company - known as the trustee) to a new trustee. This could be a company that is acting as a custodian for your IRA. It could be a new company you're working for that has a 401k plan.
The key here is that the funds are never paid to the individual, but rather checks are payable to a company as trustee. Once the funds are rolled over, they become governed by the rules of the new plan.
Example of a Direct Rollover
Joe retires from his company after 35 years of service. He has a 401k worth $400,000 and decides he'd like to roll over his money to an IRA.
Joe calls his former trustee and asks for a direct rollover to a new IRA he established. After a week, Joe receives a check for $400,000. Frantically, Joe calls his IRA custodian because he thought if he received a check he'd have to pay taxes on all that money.
The custodian asks Joe to whom the check is made payable. Joe responds with, "XYZ Financial as Custodian for the Joe Example IRA."
The custodian explains that as along as the check is made payable to the trustee, then there is nothing to worry about, even if the check was sent directly to Joe.
An indirect rollover is just the opposite. Funds are distributed to an individual who then must deposit those funds with a new trustee.
At first glance, this sounds like a nice option; however, the trick is that the individual receiving the funds has 60 calendar days to deposit funds into a new plan. If the distribution is not deposited into a new IRA or 401k plan within 60 days, then it will be considered a taxable distribution and taxes plus any applicable penalties will be assessed by the IRS.
Another catch is that folks who take an indirect rollover need to know that a mandatory 20% will be withheld from the distribution by the current trustee. (The 20% withholding rule only applies to qualifed plan rollovers (think 401k), not rollovers or transfers from IRAs). The withholding will be considered federal tax due, and will be assessed even if the individual plans to deposit money into a new IRA or 401k plan within the 60 day period! Ouch!
The IRS requires that the full amount of the withdrawal, including the 20%, be deposited into the new IRA or 401k plan. If an individual does not make up that 20% that was withheld, then Uncle Sam considers it a distribution and the applicable taxes and penalties will be assessed. Double ouch!
Example of a Indirect Rollover
John left his job and decided to take his $100,000 401k with him. He told his employer to just send him a check. John's former employer withholds $20,000 (mandatory 20%), so John actually received a check $80,000.
Upset that he received less than the full value of his 401k, he called his former custodian who informed him that if he wanted to roll over the entire $100,000 so as to avoid paying income tax on that distribution, he would need to come up with $20,000 from another source to add to the $80,000 he actually received. If John rolls over only $80,000, he must include the $20,000 that did not get rolled over as reportable income for the year.
Although there a few exceptions to the 10% penalty rule for 401k or IRA withdrawals, if John is under age 59 1/2, he may also be subject to the 10% premature distribution penalty tax.
Choose Your Rollover Wisely
Understanding the difference between a direct and indirect rollover will help you make an informed decision on which is more appropriate for you in your situation. You cannot change your mind once a decision is made, so it's important to choose wisely.
Jason Topp is a 10-year financial services vet who gets his writing fix at Redeeming Riches, where he loves to talk about saving money and true wealth.