401(k) Rollovers: The Tax Implications

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401(k) Rollovers: The Tax Implications

Employees who enroll in their company’s 401(k) plans have a few alternatives when they depart. The tax effects are determined by the choice they choose. The laws governing this sort of transaction may be complicated and, in some situations, prohibitive. It is critical to grasp these guidelines in order to prevent expensive tax mistakes that may significantly upset your retirement plan.

Key Takeaways

  • If you cash out your 401(k) after leaving your job, you may be exposed to taxes and early withdrawal penalties.
  • If you leave your assets in your old employer’s 401(k), you will not pay taxes or fees, but you will no longer be able to contribute to the plan.
  • To minimize possible taxes and penalties, if you roll over your savings into an IRA or a 401(k) plan offered by your new company, you should do it straight from one plan to the other.

3 Options

When members in a 401(k) plan quit their employment, they generally have three options. Each option has its own set of tax laws.

Cash Out

The cheque from the plan is either made payable directly to the plan owner or is placed into the owner’s bank or retail investment account, which is likely the most basic option when it comes to withdrawing money out of a 401(k) or other retirement plan.

This is also the most costly option since the member will be taxed at standard income rates on the withdrawn sum. Participants under the age of 5912 will risk an extra 10% penalty for withdrawing early. When state taxes are included in, the overall tax burden might easily approach 45% or greater, depending on the participant’s tax rate.

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The true cost of this option is the loss of the possibility for that money to grow tax-free or tax-deferred, which may diminish the participant’s nest egg by thousands of dollars in their later years.

Leave It Alone

The member does nothing and leaves their 401(k) money with the previous employer’s plan custodian under this option. This choice has no tax consequences, but you cannot continue to contribute to the plan.

Roll It Over

This is most likely the most popular option among previous plan members. Those who go this option will instruct the plan custodian to transfer their funds to another 401(k)—if they are hired by a firm that has a plan that allows rollovers from other plans—or to an individual retirement account (IRA).

You cannot conduct another indirect rollover after 12 months after completing one.

If the rollover monies are sent to the participant in the form of a check, it will be made payable to the next plan or account custodian rather than the participant. After then, the participant has 60 days to deposit the funds with the custodian. If the participant fails to do so, the Internal Revenue Service (IRS) will consider the full amount of the check to be a distribution and liable to relevant taxes and penalties.

Those who want to avoid this potential fee might choose for a direct rollover, in which the money is transferred straight into the new plan or account without a check being written to the member. Direct rollovers are preferred by most financial advisors and retirement plan professionals over indirect rollovers.

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In addition, members may only perform an indirect 401(k) plan rollover once every 12 months. If they repeat this before a year has passed, the full balance of the second rollover will be considered a distribution. Between each indirect rollover, this time restriction must be satisfied.


Although the majority of withdrawals from 401(k) or other eligible plans by members under the age of 5912 are subject to the 10% early withdrawal penalty, there are five exceptions. Withdrawals are permitted without penalty in the following circumstances:

  • Withdrawals to pay back IRS taxes
  • After-death distributions to the participant’s estate
  • Distributions to a participant who has suffered a permanent disability
  • Unreimbursed medical expenditure distributions that exceed 10% of the participant’s adjusted gross income for the year
  • Distributions made as part of an IRS-approved sequence of substantially equal recurring payments

The NUA Rule

Employees who acquired shares of their company’s stock via their 401(k) plan may be eligible for preferential tax treatment when they roll over the remainder of their plan balances if certain conditions are fulfilled.

If you have publicly traded stock in the firm for which you work, you may take it from your 401(k) and place it in a taxable brokerage account for better tax treatment. The difference between the stock’s purchase price and its current value, known as net unrealized appreciation (NUA), is thus taxed as capital gains rather than income tax.

This regulation has the potential to reduce the total tax payment for workers who have amassed a substantial number of shares in their company plan over time.

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The Bottom Line

The tax requirements for 401(k) rollovers might be simple for people who choose to receive cash distributions or leave their plan assets alone. The requirements for people who want to keep their plan balances tax-advantaged might be complicated, but choosing for a straight rollover will typically keep the participant out of any possible tax issues. Visit the IRS website for further information. It’s also a good idea to speak with a retirement plan custodian or a financial adviser.

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