Do I Pay Taxes on a 401(k) to 401(k) Rollover?

Moving funds from an old 401(k) to a new one is a common financial step when changing jobs. A 401(k) to 401(k) rollover is not a taxable event, meaning you will not owe income taxes on the money being moved. However, you must follow specific IRS regulations to preserve the tax-deferred status of your retirement savings. The method you choose for the transfer is important, as it determines whether you face immediate tax consequences.

Direct vs Indirect Rollovers

The simplest way to move retirement funds without tax implications is through a direct rollover. In this method, the administrator of your old 401(k) plan sends the money directly to the administrator of your new 401(k) plan. The funds are transferred electronically or via a check made payable to the new plan, not to you. Because you never take possession of the money, the IRS does not consider it a distribution, and no taxes are withheld.

An alternative is the indirect rollover. Your old plan administrator sends you a check for your account’s value, but the law requires them to withhold a mandatory 20% for federal income taxes. For example, if your account balance is $50,000, you will receive a check for $40,000, with $10,000 sent to the IRS. You then have 60 days from receiving the funds to deposit the full amount, including the 20% that was withheld, into your new 401(k). To complete the rollover of the original $50,000, you must use $10,000 of your own money to make up for the withheld amount, which you can claim as a credit when you file your annual tax return.

Tax Consequences of an Incomplete Rollover

Failing to follow the rules for an indirect rollover can lead to tax penalties. The primary regulation is the 60-day rule, which requires the entire distribution to be deposited into a new retirement account within 60 days of receipt. If you miss this deadline, the IRS treats the amount you received as a taxable distribution. The funds become part of your gross income for that year and are taxed at your ordinary income tax rate.

The financial consequences are more severe if you are younger than 59½. In addition to income tax, you will be subject to a 10% early withdrawal penalty. For instance, if you are under 59½ and fail to roll over a $50,000 distribution, the entire amount becomes taxable income. If your federal tax rate is 22%, you would owe $11,000 in income tax plus a $5,000 early withdrawal penalty, for a total of $16,000.

An exception known as the “Rule of 55” may allow you to avoid the 10% penalty. If you leave your job during or after the calendar year you turn 55, you can take distributions from that specific 401(k) without the penalty, though they are still subject to ordinary income tax. This rule applies only to the 401(k) of the employer you are leaving and does not extend to funds in IRAs or 401(k)s from previous jobs.

These tax consequences apply to any portion of the distribution not rolled over. For example, if you only deposit the $40,000 check from an indirect rollover and fail to add the $10,000 that was withheld, that $10,000 is considered a taxable distribution. It would be subject to both income tax and the early withdrawal penalty if you are under 59½.

The Rollover Process

To ensure a smooth rollover, it is best to prepare before initiating the process. You will need to gather specific information from both your old and new 401(k) plans, including the account number for your old 401(k) and contact information for its plan administrator. From your new employer’s plan, you will need the new account number and their instructions for accepting a rollover, such as a mailing address or electronic transfer details.

The process begins by contacting the plan administrator of your old 401(k) to request their rollover distribution paperwork. On this form, you will provide the information for your new plan and state whether you are requesting a direct or indirect rollover. For a direct rollover, you will provide the new plan’s details so the check can be made payable to that institution.

Some new plans may require a “letter of acceptance” to confirm they will accept the funds, which you can generate during the new plan’s rollover setup process. You should also confirm if any special requirements, like a notarized signature, are needed to complete the paperwork.

Special Considerations for Roth 401(k) Rollovers

A direct rollover from a Roth 401(k) to another Roth 401(k) is a tax-free event because both accounts are funded with after-tax dollars. The primary consideration for this type of rollover relates to the five-year rule for qualified distributions.

For a distribution from a Roth account to be tax-free, the account must have been open for at least five years, and you must be at least 59½ years old. When you roll over a Roth 401(k), the five-year holding period from your original account carries over to the new plan. For example, if you contributed to your first Roth 401(k) for three years, you will only need to wait two more years to meet the requirement in the new plan.

This is different from a Roth conversion, which involves moving funds from a traditional 401(k) to a Roth 401(k). A conversion is a taxable event, and you must pay income tax on the entire amount being moved in the year the transaction occurs. This tax is due because you are moving pre-tax money into an after-tax account.