Direct and Indirect 401(k) Rollovers: What’s the Difference?

direct and indirect 401(k) rollovers

Rolling over a 401(k) after you’ve left a job may not be your top priority – but it should be. Because leaving behind a 401(k) with a past employer is costing you more in retirement savings than you think.

Before you make a move, it’s important to understand the difference between direct and indirect 401(k) rollovers.

Knowing the difference and the tax implications (and possible penalties) for direct and indirect 401(k) rollovers will help you make the best financial decision for your future.

Why You Shouldn’t Leave Behind a 401(k)

According to a 2021 Capitalize white paper titled The True Cost of Forgotten 401(k) Accounts, by the end of 2020, Americans had over $6.7 trillion in 401(k) accounts.

Out of that 6.7 trillion, “There are “$1.35 trillion of assets and more than 24 million forgotten 401(k)s in 2021.”

Yes, you read that correctly: 24 million forgotten 401(k) accounts.

As people frequently move jobs, it’s easy to leave a 401(k) behind with a past employer – especially if you think your past employer is taking care of your 401(k) for you.

Here’s the thing: your employer is NOT handling your 401(k) for you. Legally, they can’t.

It’s your money and your responsibility to manage your retirement savings.

Changing jobs is also a busy time for people, and the last thing they’re thinking about is rolling over their 401(k).

However, the data shows it’s costing 401(k) investors more money than they realize.

In the same Capitalize report, “Individuals could miss out on nearly $700,000 in retirement savings throughout their lives due to the risk of a forgotten 401(k) being in a higher-fee plan and poorly allocated investments.”

Obviously, how much you may be missing out on depends on the account balance of your old 401(k).

The point here is, by leaving behind a 401(k), you are not maximizing your retirement savings like you probably want to.

Before you make the decision to hurry and roll over your 401(k), it’s important to understand the difference between direct and indirect 401(k) rollovers.

Knowing the types – and the tax implications of each – will help you better protect your hard-earned savings.

Direct 401(k) Rollovers

A 401(k) direct rollover occurs directly between the trustee, or custodian, of your old retirement plan and the trustee of your new plan.

You never actually receive the funds or have control of them, so a trustee-to-trustee transfer is not treated as a distribution.

Trustee-to-trustee transfers avoid both the danger of missing the 60-day deadline with indirect rollovers and, for employer plans, the 20% withholding problem.

With employer retirement plans, a trustee-to-trustee transfer is usually referred to as a direct rollover.

If you receive a distribution from your employer’s plan that’s eligible for rollover, your employer must give you the option of making a direct rollover to another employer plan or an IRA.

A trustee-to-trustee transfer (direct rollover) is generally the safest, most efficient way to move retirement funds.

Taking a distribution yourself and rolling it over makes sense only if you need to use the funds temporarily, and are certain you can roll over the full amount within 60 days.

When it comes to direct 401(k) rollovers, you have a few options:

#1 Roll Over Your Traditional 401(k) to a Traditional IRA

If you have a traditional 401(k), the transfer to a traditional IRA is simple, since those contributions were also made pre-tax. So, no new taxes are due when the money is rolled over. New earnings will accumulate in your IRA tax-deferred.

Required minimum distributions for traditional IRAs must start at age 72 – bumped up from age 70 ½ thanks to the SECURE Act, which was passed into law December 2019.

#2 Roll Over Your Traditional 401(k) to a Roth IRA

If your traditional 401(k) allows direct rollovers to a Roth IRA, you can roll over to a new or existing Roth IRA.

If you roll over a traditional 401(k) into a Roth IRA, you’ll have to pay taxes on the rollover amount.

Earnings that accumulate after the rollover will be eligible for tax-free withdrawal when you are at least 59½ and the Roth IRA has been open at least 5 years.

Required minimum distributions for Roth IRAs are the same as traditional. You must take RMDs starting at age 72.

NOTE: If you have both a traditional 401(k) and the Roth 401(k) provision, then you will need to set up two separate IRAs: a traditional IRA and a Roth IRA.

#3 Roll Over Your Roth 401(k) to a Roth IRA

If you have a Roth 401(k) provision, you can roll over to a new or existing Roth IRA. No taxes are due when you convert accounts, and any new earnings accumulate tax-deferred.

Earnings that accumulate after the rollover will be eligible for tax-free withdrawal when you are at least 59½ and the Roth IRA has been open for at least 5 years.

#4 Rolling Over a 401(k) to an Annuity

Many financial advisors often recommend annuities because your investment grows tax-deferred and you pay no income tax on your gains until they are withdrawn.

However, rolling over your 401(k) to an annuity offers no additional tax benefits, as your money is already tax-deferred inside your 401(k).

Annuities are attractive because they guarantee income for life, but some may also come with hefty fees. This is why it’s critical to read and understand the fine print, should you decide to roll over to an annuity.

In addition, some annuity plans have the option of paying you for life and then transferring the remainder of the contract to your spouse if you die first. Others do not allow you to pass on the remainder to your beneficiaries.

Indirect 401(k) Rollovers

With this type of 401(k) rollover, you actually receive a distribution from your retirement plan, and, then, to complete the rollover transaction, you make a deposit into the new retirement plan that you want to receive the funds.

You can make a rollover at any age, but there are specific rules that must be followed.

Most importantly, you must generally complete the rollover within 60 days of the date the funds are paid from the distributing plan.

If properly completed, indirect rollovers aren’t subject to income tax.

But, if you fail to complete the rollover or miss the 60-day deadline, all or part of your distribution may be taxed and subject to a 10% early distribution penalty (unless you are age 59½ or another exception applies).

Further, if you receive a distribution from an employer retirement plan, your employer must withhold 20% of the payment for income taxes. After taxes are taken out, you will be sent the funds via check.

This means that, if you want to roll over your entire distribution, you’ll need to come up with that extra 20% from your other funds (you’ll be able to recover the withheld taxes when you file your tax return).

Note that the IRS only allows for one indirect rollover per 12-month period.

Direct and Indirect 401(k) Rollovers: Buyer Beware

If you are close to retirement, be on guard. There are financial marketing programs that specifically target investors based on their age because marketers have the data that shows who has a 401(k) and is near retirement.

They will reach out and try to get you to roll over your 401(k).

There’s nothing wrong with this except that, to some advisors on the other end of the line, you are nothing more than a transaction.

And, if you aren’t fully aware of your 401(k) rollover options AND the implications of each, you may make a decision that hurts your retirement future.

If you’re close to retirement, make it a point to watch this video.

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