Retirement > 401(k)s & IRAs
The basics on rollovers
January 4, 2001: 10:58 a.m. ET

Here is the lowdown on rolling over your 401(k) to an IRA
By Ed Slott
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NEW YORK (CNNfn) - You're leaving your job at the end of the month, or you're finally ready to retire and enjoy life. Either way, before you go, you're going to need to decide whether to leave your 401(k) or take it with you.

I think it's always better to do a rollover IRA because you'll have more investing options and more protection from taxes. It will also allow you to preserve more of your money for your heirs. And here's what you need to know to get the job done.

A rollover is when you receive assets from one retirement plan and transfer them to another.

graphicIt can be from one IRA to another IRA or from your company retirement account to your IRA. But transferring money from your 401(k) or other company plan to your IRA is the most common and that is where the most costly mistakes are made.

The idea is to transfer your company plan funds to your IRA account without triggering a tax. However, if this transfer is done with a rollover there is a chance that your retirement funds will be hit by early taxes and penalties. This can make some or all of your nest egg ineligible to go into an IRA.

There are really only two ways to move company retirement plan money to an IRA. A rollover and a "direct trustee-to trustee transfer."

Rollover basics

A rollover is when your company distributes your plan assets to you. You actually receive a check or stock certificates. Then it is up to you to transfer those assets to your IRA (or to another company's plan) within 60 days after you receive the distribution from your plan.

If you miss the 60-day deadline, you're out of luck. You must report the entire distribution as income. You'll pay income tax on the entire distribution and if you have not yet reached 59-1/2 years old, you will also pay a 10 percent penalty.

You can only do one 60-day rollover per year, but the year is actually any 12-month period and not necessarily a calendar year. For example, if your receive your distribution on June 1, 2001, it does not mean that you can do another rollover as soon as the New Year begins in January 2002. You must wait a full year until June 1, 2002 to do another rollover of the same money. The rule applies separately to each IRA you own.

Read Ed Slott's columns on the three most important decisions you'll make with your IRA: Choosing a beneficiary, picking a life expectancy and picking a distribution method.

If you choose the rollover method to move your company pension money to your IRA, you'll be subject to mandatory 20 percent withholding tax. This means that you will only receive 80 percent of your pension money and the rest will be sent to Uncle Sam to pay any tax owed on the transfer. The problem is that you should not owe any tax. But now, because of the 20 percent withholding tax rule, you'll only have 80 percent of your company retirement money to roll to your IRA.

If you only roll over 80 percent, then you'll pay tax and be subject to the 10 percent penalty on the 20 percent that was not rolled over. The only way out of this predicament is if you have other, non-pension or non-IRA funds available to make up the 20 percent shortage. If you don't, you'll be stuck paying tax and a possible 10 percent penalty on the 20 percent that was not rolled over.

This is why you should not use the rollover method to transfer funds from your company pan to your IRA. Be smart and use the direct trustee-to-trustee transfer method and save yourself a bundle of tax headaches.

Direct trustee-to-trustee transfer method

This is, as the name implies a direct transfer of funds from your company retirement plan to your IRA.

This is not technically a rollover, because a rollover means that the funds were first distributed to you. The direct trustee-to-trustee transfer is better because you cannot trigger an unexpected tax since you never touch the money. It goes directly from your company plan to your IRA.

Trustee-to-trustee transfers are not subject to any tax withholding and are exempt from the one-per-year 60-day rollover rule.

You must inform your company that you want a direct transfer and tell them not to make the check out to you. It should be transferred directly to an IRA that you will set up to receive the assets directly from your company plan graphic

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