So the question is do you pay taxes on a 401k rollover? It depends on how you roll it over.  The rule of thumb is if you touch the money yourself, meaning you get a check from your retirement fund to deposit into a new account or you cash out completely, you are going to pay taxes.  If you transfer it from plan to plan, also known as a direct rollover, you will not be taxed.  They do this because if you have the cash in your hand, they treat it as new income.  Having cash in hand from your 401k defeats the purpose of a retirement plan and to deter you from cashing out early, they hit you with taxes and penalties.

If you take the money out of your previous employers retirement account you have 60 days to deposit that money into a new retirement account to avoid paying income taxes.  You will however be hit with an automatic 20% mandatory withholding for federal taxes which you want to pay back.  Whatever portion that you do not rollover will not only be hit with income tax, you could be subject to another 10% additional penalty due to early distribution. There are certain circumstances when this will not apply but essentially it means if you take the money prior to turning 59 ½ you may be liable for this 10% additional tax.

Whenever possible, you want to do a direct rollover to avoid paying a lot of money in taxes.  If you do decide to take a check and roll it over yourself, make sure you take care of it within 60 days. Remember, you have a retirement account for a reason.  You want to avoid dipping into this account unless necessary.  My next article will be about a few other 401k rollover questions, like what the exceptions are to the 10% additional penalty and when it’s ok to borrow from your 401k. The second part is going to be very short!

If you leave a company and decide to physically receive a part of or all of your 401k assets, this is considered a cash distribution. You may think, “This is my money so I will take it and run”, and the truth is, yes, you can take the money and run but not without paying some hefty taxes first.  State and federal income taxes will take a portion out of your distribution.  When you made the contributions to your 401k you probably did so with pre-taxed dollars.  Your employer contributions were also tax deferred.  When you go with a cash distribution you pay income tax on all pre-taxed earnings. Then there is a mandatory withholding of taxes of 20%.  Yep, you read that right, 20%. So if you had $50,000 in your retirement account and you cashed out your distributions you would pay $10,000 in taxes that your previous employer must pay to the IRS.  If you are still considering this, you also may have to pay a 10% penalty called a premature distribution for withdrawing from the account if you are under the age of 59 1/2 at the time you decided to leave the company.  Essentially if you had $50,000 you would have to pay $5,000 for penalties.  So if you add all the taxes you will pay your $50,000 is now $35,000 or less all because you cashed out early [ReviewAZON asin="1413310311" display="inlinepost"]

Unfortunately, the only benefit to this option is that you have hard cash in your hands now, rather than later.  So if you are in a financial crisis, and by crisis I mean serious medical injuries or tying to save your home, not buy a new wardrobe, then this would be a good option for you to take if you are willing to take the big financial hit.  We all know the tax man is going to get any money he can from us but this is also to deter you from withdrawing early.  The point of a retirement savings account is so that it can continue to grow and earn you money so you can one day retire.  If you withdraw early you have now taken a big chunk of that money and thrown it away.  Please think about your options and look into the 401k rollover options available whether it’s a 401k rollover to IRA or 401k rollover into your new employer’s retirement plan.  A cash distribution option is not something to take lightly. The money in hand seems nice but you will miss it greatly when you are retired! You may need to seek the advice of a tax adviser if you are still unsure about taking a cash out or if you need a third party to help you decide whether this is your best financial option.

Summary:

• Cash Distributions are only a good idea if you are in a financial crisis and need the money.  Speak with a tax advisor or 401k professional to determine if this is your best option.
• You will get dinged quite a bit by the tax man for cashing out early
• If you are unsure of what to do with your money, leave it in your current 401k plan until you have done some research or consulted with a professional regarding your next move

The option I am going to talk about now is leaving your retirement investment with your previous employer.  I am going to discuss this first, rather than a 401k rollover or cash out option because when you leave your job you may not know exactly what you want to do yet.  I want you to know it is OK to leave your current investments where they are and what the rules are for doing so.  Take some time and do some research.

Depending on your companies rules (I suggest getting a copy), to keep your retirement savings in your previous employer’s retirement savings plan usually means you must have a balance of $5,000 or more. Some companies may only require that your balance was over $5,000 at any given time. The good news with this option is your money will continue to accrue tax-deferred, you still maintain control over how the money is invested among the companies’ investment options, you will continue to receive quarterly statements and if in the future you want to do a  rollover 401k to a new employer who has a qualified plan or to an IRA you can do so without penalty. However, the drawbacks are future contributions may not be allowed or will be restricted, you may have limited access and your money is in the hands of your former employer. With some companies if you are over the plans designated retirement age or are 62 years of age or older, your previous employer may insist you take a payout.  Companies tend to do this to decrease the administrative costs.  If this situation does occur, do not fret as you still have other choices.  Unfortunately you just don’t have the luxury of leaving your money where it is at while you figure out your next move.

Leaving your money in your previous employer’s retirement savings plan is a good choice if you are unsure whether you want to cash out or participate in a 401k rollover and need some time to figure it out.  Another good reason to leave your retirement investments where they are is if you are quitting your job to start your own business.  Leaving the money in its current retirement plan could protect your retirement assets from any creditors if for some unforeseen circumstances your new business does not succeed.  Just make sure you don’t get in a habit of having a trail of old 401ks laying around with multiple previous employers.  Not only does this make it harder for you to keep track but it can also get really complicated when you do retire. If you are unsure of how to proceed with your options or still have questions it is a good idea to call a tax adviser prior to choosing your distribution option.