Taxes seem to be a common question when it comes to our 401k accounts. When you invest, that money is tax deferred, but we all know we’re going to get taxed at some point. It’s inevitable. The saying is “nothing is certain but death and taxes”. Isn’t that the truth? Well, we can’t do much about the death part, but we can educate ourselves about our tax responsibilities on the money we are investing.
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!