What Does Conversion Out Mean on a 401k?

Understanding Fund Movements from a 401(k)

The phrase “conversion out” is not a standard financial term but commonly refers to moving funds from a 401(k) plan. These movements allow individuals to manage their retirement assets by transferring them to different types of retirement accounts or, in some cases, taking distributions. Several distinct processes exist, each with unique characteristics.

A direct rollover moves funds directly from your 401(k) to another qualified retirement account, such as a new employer’s 401(k) or an Individual Retirement Arrangement (IRA). In this process, the funds are never physically in your possession, maintaining their tax-deferred status.

An indirect rollover, also known as a 60-day rollover, involves funds distributed to you directly. You then have 60 days to deposit them into another qualified retirement account. Your plan administrator will typically withhold 20% for federal income tax. To complete the rollover and avoid taxation, you must deposit the full amount of the distribution, including the withheld portion, into the new account within the 60-day timeframe.

Some 401(k) plans may permit an in-service non-hardship distribution, allowing withdrawals while still employed and before reaching retirement age. These distributions are not tied to a financial hardship and are typically available for certain account balances, such as amounts contributed after a specific age or employer contributions that have been in the plan for a certain period. The specific 401(k) plan determines their availability and rules.

A Roth conversion moves pre-tax funds from a traditional 401(k) into a Roth IRA or an in-plan Roth 401(k) account. This process changes the tax treatment of the funds, converting them from tax-deferred to tax-free upon qualified withdrawal in retirement. The pre-tax amounts converted become taxable income in the year of conversion.

A cash distribution, or withdrawal, is when you simply take the funds out of your 401(k) as spendable cash. Unlike rollovers or conversions, this action is typically not intended to move the funds into another retirement account. Such distributions are usually subject to immediate taxation and may incur additional penalties, depending on your age and the reason for the withdrawal.

Tax Consequences of 401(k) Fund Movements

The tax implications of moving funds from a 401(k) vary significantly depending on the method chosen.

Direct rollovers are generally tax-free events. Since the funds are transferred directly between financial institutions, they are not considered a taxable distribution to you, maintaining their tax-deferred status.

Indirect rollovers involve a temporary withholding of 20% for federal income tax by the plan administrator. For example, if you receive a $10,000 distribution, only $8,000 might be sent to you, with $2,000 withheld for taxes. To complete the rollover and avoid the distribution being taxed, you must deposit the full $10,000 into the new retirement account within 60 days. If the full amount is not rolled over, the unrolled portion becomes a taxable distribution, potentially subject to income tax and an early withdrawal penalty.

A Roth conversion from a traditional 401(k) is a taxable event for the pre-tax portion of the converted amount. When you convert pre-tax funds to a Roth account, these amounts are included in your gross income for the year of the conversion. This conversion triggers immediate taxation but allows for tax-free withdrawals in retirement if conditions like the five-year rule and age 59½ are met.

Cash distributions are fully taxable as ordinary income in the year they are received. If you are under age 59½, these distributions are subject to an additional 10% early withdrawal penalty. However, there are specific exceptions, such as distributions made due to disability or qualified unreimbursed medical expenses.

In-service distributions are taxed based on whether the contributions were pre-tax or Roth. Pre-tax contributions and earnings are taxable as ordinary income and may be subject to the 10% early withdrawal penalty if you are under age 59½. Distributions from Roth contributions are generally tax-free and penalty-free if qualified, typically after five years and age 59½ or older, disabled, or deceased.

Initiating a 401(k) Fund Movement

To begin the process of moving funds from your 401(k), contact your plan administrator or the recordkeeper. This entity manages your 401(k) and is the primary point of contact for all distribution and rollover requests.

Upon contact, you will specify the type of fund movement you wish to initiate, such as a direct rollover to an IRA, an indirect rollover, or a Roth conversion. The plan administrator will then provide the specific forms required for your request, asking for details like your personal information, the amount to move, and destination account information.

For direct rollovers, the plan administrator will send the funds directly to the new financial institution via electronic transfer or a check made payable to the new account. This direct transfer ensures the funds bypass your personal possession.

In the case of an indirect rollover, the plan administrator will issue funds directly to you, typically with the mandatory 20% federal income tax withholding applied. You are responsible for depositing these funds into your new retirement account within 60 calendar days from the date you received the distribution. You must roll over the entire amount, including the 20% withheld, to avoid it being considered a taxable withdrawal.

The timeline for these processes can vary, but direct rollovers typically take one to three weeks once all required forms are submitted. Indirect rollovers place the responsibility of timely deposit on the individual within the 60-day window. Following up with your plan administrator and the receiving institution is advisable to ensure accurate and prompt processing.

Tax Reporting for 401(k) Distributions and Rollovers

Any distribution or rollover from a 401(k) will be reported to you and the Internal Revenue Service (IRS) on Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” Your 401(k) plan administrator issues this form by January 31st of the year following the distribution. Form 1099-R details the gross distribution, taxable amount, and any federal income tax withheld.

Form 1099-R’s Box 7 contains a distribution code indicating the transaction’s nature. For instance, a code G signifies a direct rollover to another qualified plan or IRA, while code H indicates a direct rollover to a Roth IRA. These codes are essential for accurate tax reporting.

When reporting rollovers, if you completed a direct rollover, you report the gross distribution from Form 1099-R, indicating the entire amount was rolled over to avoid taxation. For an indirect rollover, you report the gross distribution, including any withheld amount, and show the full amount was rolled over within the 60-day period to avoid taxation.

For Roth conversions, the pre-tax amount converted is reported as ordinary income on your tax return. Form 1099-R typically shows the gross distribution and taxable amount in Boxes 1 and 2a, with a distribution code indicating the Roth rollover. This taxable amount increases your adjusted gross income.

Taxable withdrawals, such as cash distributions not rolled over, are reported as ordinary income on your tax return. The “taxable amount” on Form 1099-R (Box 2a) is included in your income. If an early withdrawal penalty applies for being under age 59½, this 10% penalty is calculated on the taxable amount and reported on your tax return, typically on Schedule 1 (Form 1040), line 8.