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401(k) Rollovers

A 401(k) rollover is the moving of a 401(k) plan from its current custodian (the company holding it) to another. The following requirements must be met so that the 401(k) may keep its tax-deferral:

The new 401(k) plan must accept rollovers.
If you prefer (or if the new 401[k] does not accept rollovers), your original 401(k) funds can be rolled over into a traditional IRA. (Beginning in 2008, rollovers into Roth IRAs will also be allowed in some circumstances.)
The full amount from the original account must be placed into the new 401(k) (or IRA) within 60 days. If a lesser amount is rolled over, penalty taxes will be applied.

You can move the funds via a direct rollover (trustee-to-trustee transfer), in which the funds are transferred from the old custodian to a new one without you touching them. This is usually the smoothest method because it doesn?t incur tax penalties or withholding by the IRS.

A direct rollover doesn?t incur tax penalties or withholding by the IRS.

You can also remove the money from the old account and put it into the new account yourself. However, with this method, the IRS requires that 20% of the funds be withheld for tax purposes, even if you intend to roll the money over to a new 401(k) or IRA. You will then have to deposit the full rollover amount in order to avoid an early withdrawal penalty. This means you will need to come up with an amount equal to the 20% that was withheld. Once you have done so, however, the withheld 20% will be returned to you.

Non-spouse beneficiaries now enjoy a benefit they did not have prior to 2006: the ability to transfer inherited 401(k) and other qualified plan and IRA accounts into a new IRA. The transfer (though similar, this is technically not a "rollover") must be by a direct trustee-to-trustee transfer. In the case of funds from a qualified plan, that plan must allow such transfers. The new IRA must be titled as an inherited IRA—something like "John Doe IRA, deceased, for the benefit of Junior Doe." The non-spouse beneficiary's (Junior?s) Social Security number will be used, however. This arrangement allows the non-spouse beneficiary to stretch payments over his or her life expectancy to increase the deferral of taxes. The non-spouse beneficiary (say, Junior) may name his own beneficiary, but this new beneficiary must continue to take distributions over Junior?s life expectancy.

It should be noted that a Roth 401(k) can be rolled over tax-free into another Roth 401(k). A traditional 401(k) cannot be rolled tax-free into a Roth, however. (Otherwise, those rolled-over dollars would totally escape taxation.) Instead, a tax-free rollover from a 401(k) or other qualified plan can be made into a traditional IRA, followed by a taxable conversion to a Roth IRA. To make any conversion to a Roth, one must qualify under the Roth IRA conversion rules and income limitations.

Beginning in 2008, however, subject to those same conversion rules and limitations, direct rollovers will be allowed from 401(k) and other qualified plans directly into a Roth IRA. (In other words, there will be no need to create a traditional IRA as a conduit in this process.)