401k Indirect Rollover

In contrast to a 401k direct rollover, a 401k indirect rollover does not automatically preserve the tax benefits associated with your 401k account. Because you’re being given the distribution amount directly instead of the transfer being handled by account trustees, the IRS places additional strictures on indirect rollovers to try to ensure you re-invest your retirement savings in another qualified 401k or IRA plan.

The first penalty is an automatic 20% withholding of the account balance that’s designed to pay a portion of the taxes that would be due should you elect not to re-invest the funds in another IRA or 401k account. Although the taxes due if you decide to keep the funds would likely be more than 20%, this insures the IRS that they’ll get at least a portion of the taxes that become due on the distribution.

The second penalty is a 10% early withdrawal fee. Because it can’t be guaranteed that you’ll actually execute the 401k indirect rollover, the IRS also preemptively assesses this penalty based on the assumption that you won’t.

To have these withholding fees credit to your new 401k or IRA account, you must open a qualified IRA or 401k account within sixty days of receiving the distribution check and make a deposit in the amount of the entire original distribution (including the amounts that were deducted in fees and withholding). To recoup the withholding, you must then file the amounts as a credit on the distribution year’s tax return.

As a quick example, let’s assume that you have $30,000 in a 401k account and you decide on an indirect rollover:

Account value: $30,000
Tax withholding: 20% of $30,000 or $6,000
Early withdrawal fee: 10% or $30,000 or $3,000
Total distribution: $30,000 – $6,000 – $3,000 or $21,000

To recoup the $9,000 in fees and penalties, within sixty days you must deposit into a qualifying IRA or 401k account the amount of $30,000. You’ll eventually be credited the $9,000 when you file your tax return but, in the short term, you must come up with that $9,000 on your own.

As you can see, the 401k indirect rollover isn’t the preferred method the IRS wants you to use to rollover your 401k account. It’s designed to place substantial penalties on your retirement funds to help ensure that you’ll actually follow through on rolling over the money into another qualified IRA or 401k account.

(The above is not intended as investment or financial advice and is presented for educational purposes only. Consult a qualified tax or financial professional before you make any decisions about your 401k indirect rollover.)