Do I Have to Pay Taxes If I Transfer My 401k to an IRA?
Rolling your 401(k) funds over to an IRA allows the IRS to view them as transfer contributions instead of distributions, thus keeping more of your retirement savings tax-deferred and benefitting from compound interest.
However, you could take an alternative route and choose to withdraw funds in cash and pay taxes and any applicable penalties (if under age 59 1/2). Here are the advantages and disadvantages of each approach.
Taxes
An easy and straightforward way to convert your 401(k) distribution is to roll it over into an individual retirement account (IRA). This can be accomplished either directly, trustee-to-trustee transfer or an in-kind transfer – meaning the money moves directly between custodians without receiving checks in return.
Financial institutions sometimes provide low-cost or free IRAs for new customers. This may include FDIC-insured savings accounts and money market funds with modest annual returns, while self-directed or brokerage IRAs allow greater investment flexibility and can even include multiple asset classes.
IRS taxes IRA contributions and earnings only when they’re withdrawn during retirement, so early withdrawals incur both taxes and a 10% penalty unless exempt. A Roth IRA allows you to avoid taxes on after-tax contributions as well as withdrawals during retirement; it’s especially suitable for people who anticipate landing themselves in a higher tax bracket in retirement.
Withdrawals
If you’re moving money from an old employer’s retirement plan into an Individual Retirement Account (IRA), there are various methods you can take. A direct rollover may be the safest method – meaning the check from your former employer would be made out directly to your IRA provider rather than you.
Importantly, the IRS mandates that 20% be withheld for federal taxes when withdrawing your money; without sufficient funds available to pay these withholdings you could owe significant taxes and early withdrawal penalties.
Your former employer could also send a check payable directly to your new IRA provider; this counts as direct rollover but requires some more steps and should be deposited within 60 days from receipt to avoid tax penalties and cash distributions, which tend to be more expensive options.
Rollovers
Your former employer’s 401(k) funds may be eligible to be moved (or “rolled over”) into an individual retirement account (IRA), which provides more investment options and often lower fees compared to its counterpart and greater withdrawal flexibility.
However, before making any rollover decisions it’s crucial to understand their tax repercussions. If you opt to move funds into a Roth IRA for instance, for instance, taxes will be due immediately but could save money in future by eliminating future liabilities.
When taking a distribution from your former employer’s plan, the IRS requires that 20% be withheld for taxes. If your other income doesn’t cover this bill, any shortfall must be covered through other sources – otherwise your withdrawal would be considered taxable and you could face an early withdrawal penalty of 10%. A direct rollover allows you to bypass withholding and thus sidestep this issue altogether.
Fees
Some 401(k) plans charge their participants fees for investments and administrative services that eat into investment returns over time, making an IRA a better way of controlling those fees.
Rollover to an IRA could provide additional tax benefits, including being able to invest in Roth accounts that allow your contributions to remain even after retirement. Speak with a financial professional about this option for your specific circumstances.
If you choose an indirect rollover, funds will first be sent directly to you in the form of a check, with 60 days for deposit into an IRA or you could face taxes and penalties. Keep in mind that only one indirect rollover per 12-month period can take place.
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