Tax Implications

Tax Implications of Retirement Account Rollovers

Understanding the tax consequences of rollovers helps you avoid costly mistakes and make informed decisions. The tax treatment depends on the type of accounts involved and how you execute the transfer.

Direct Rollovers: Usually Tax-Free

When funds move directly between qualified accounts (traditional to traditional, Roth to Roth), no taxable event occurs:

• Traditional 401(k) to Traditional IRA: Tax-deferred, no current tax
• Roth 401(k) to Roth IRA: Tax-free transfer
• Traditional 401(k) to new employer’s 401(k): Tax-deferred

The key is ensuring funds never pass through your hands. The check should be payable to the receiving institution.

Taxable Rollover Scenarios

These situations create taxable income:

• Pre-tax to Roth conversion: Converting traditional IRA or 401(k) funds to a Roth IRA triggers income tax on the converted amount.
• After-tax 401(k) to Roth IRA: The earnings portion is taxable; your contributions are not.
• Missed 60-day deadline: Indirect rollovers not completed within 60 days become taxable distributions.

The 20% Withholding Trap

If you receive a distribution check made payable to you (not a direct rollover), your employer must withhold 20% for federal taxes. To complete the rollover, you must deposit the full original amount within 60 days—including replacing the 20% from other funds. Otherwise, the withheld amount is treated as a taxable distribution.

Example: You receive a $100,000 distribution. Your employer withholds $20,000. You receive $80,000. To avoid taxes, you must deposit $100,000 into an IRA within 60 days. If you only deposit the $80,000 you received, the $20,000 withheld becomes taxable income (plus potential early withdrawal penalty).

State Tax Considerations

Some states offer tax advantages for retirement account rollovers:

• Several states don’t tax retirement income at all
• Some states offer exclusions for pension income
• Military retirement pay may have special treatment

Consider state taxes when planning conversions, especially if you might relocate in retirement.