Avoid These 3 Fatal Mistakes While Passing a 401(k) | Smart Change: Personal Finance

(Steven Walters)

Nowadays, it is not unusual to see someone sticking to the same job throughout their career. If you find yourself in a situation where you get a new job — and a new 401(k) plan — but don’t want to deal with multiple 401(k) plans in different places, you have the option of passing on your 401(k).

Rolling over a 401(k) has its benefits, but it can also have its drawbacks if you’re not fully aware of how it works. Here are three critical mistakes to avoid when doing a 401(k) stretch.

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1. Doing an indirect extension without reason

When you decide to do a 401(k) rollover, you have two primary options: direct rollover and indirect rollover. With an indirect rollover, the funds are paid to you, after which it is up to you to take it and put it into your rolling IRA during the required period as shown below.

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With direct revolving, the money being revolved does not touch; It moves from your old plan to your new plan. In some cases, your old plan may write a check to your new plan provider for the renewed amount, and you’ll be responsible for forwarding it, but it’s still considered a direct extension because the check was written to the new plan and not to you.

Doing a live rollover can take some effort in transferring funds. If you don’t need to access the money you’re renewing, you can save yourself some effort by choosing to do a direct extension.

2. Not following the 60-day rule

If you decide to do an indirect rollover, you absolutely need to be aware of the 60-day rule, which states that you have 60 days from the date you received the money from your old plan to deposit it into your new plan or re-deposit it back into your old plan. If, for whatever reason, you don’t deposit the money within 60 days, the IRS will treat it as a withdrawal, and you’ll have to pay income taxes on the full amount. If you are under 59 1/2, you will also face a 10% early withdrawal penalty.

Not following the 60-day rule can be a costly mistake.

3. Not knowing the tax implications

If you decide to do an indirect extension, the IRS requires that your old plan provider automatically withhold 20% of the total amount you renew. So, if you are transferring $200,000, you will only receive $160,000. To make matters worse, you will be responsible for making up the amount withheld when you deposit funds into your new plan. Here are the three tax implications you can face when doing an indirect rollover:

  1. You will not owe any taxes if you add $40,000 to the $160,000 you received and deposit the entire $200,000 into your new account.
  2. If you deposit $160,000 and not the $40,000 withheld, the $160,000 will be non-taxable, but you will owe taxes on the $40,000 and may face a 10% early withdrawal penalty.
  3. If you do not re-deposit any of $200,000 within the 60-day grace period, you will have to report $200,000 in taxable income and $40,000 withheld as taxes paid.

Not knowing the tax implications of indirect rollover could result in a costly tax bill that you weren’t expecting.

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