What Is an Eligible Rollover Distribution?
Understand how to move retirement savings to a new account. Following specific rules for your distribution is key to avoiding tax withholding and penalties.
An eligible rollover distribution is a payment from a qualified retirement plan that can be moved to another retirement account, like an IRA or a new employer’s plan, without being immediately taxed. This process allows for the continued tax-deferred growth of retirement savings. Properly handling a distribution when changing jobs or retiring ensures that the tax benefits of the account are preserved.
Defining an Eligible Rollover Distribution
The Internal Revenue Service (IRS) defines an eligible rollover distribution by what it is not. Any distribution from a qualified plan, such as a 401(k) or 403(b), is eligible for rollover unless it is a specifically excluded payment. These exceptions cover situations where a rollover would conflict with other tax rules.
Required Minimum Distributions
One of the primary exclusions is the Required Minimum Distribution (RMD). The law mandates that individuals begin taking distributions from their retirement accounts starting at age 73. This age is scheduled to increase to 75 in 2033. These RMDs are not eligible to be rolled over because their purpose is to ensure taxes are eventually paid on the funds. Any amount withdrawn that exceeds the annual RMD may be considered an eligible rollover distribution.
Substantially Equal Periodic Payments
Distributions that are part of a series of substantially equal periodic payments (SEPPs) are also not eligible for rollover. These payment schedules are set up to last for the individual’s life expectancy or for a specified period of ten years or more. Because these payments are structured as a long-term income stream, they are treated as regular income and cannot be moved back into a tax-deferred retirement account.
Hardship Distributions
A hardship distribution, which is a withdrawal from a retirement plan due to an immediate and heavy financial need, cannot be rolled over. The logic behind this exclusion is that these funds are intended for immediate use to alleviate a financial hardship, not for continued retirement savings.
Loans Treated as Distributions
If a participant takes a loan from their retirement plan and defaults on it, the outstanding loan balance is treated as a taxable distribution. This “deemed distribution” is not an eligible rollover distribution. The only exception is a “qualified plan loan offset amount,” where the loan is offset against the account balance at termination of employment; this specific type of offset may be eligible for rollover.
Corrective Distributions
Corrective distributions are also ineligible for rollover. These occur when a plan returns funds to a participant to correct an error, such as contributions that exceeded legal limits. Since the purpose of these distributions is to bring the plan back into compliance, the funds cannot be rolled back into a retirement account.
Other Excluded Payments
A few other specific payment types are not considered eligible rollover distributions. Dividends paid on employer stock held within an Employee Stock Ownership Plan (ESOP) are not eligible if they are passed through to the participant. Additionally, the value of life insurance coverage purchased within the plan is considered a current benefit, and its cost cannot be rolled over.
Tax Withholding Rules for Eligible Rollover Distributions
An eligible rollover distribution paid directly to an individual is subject to a mandatory 20% federal income tax withholding. This rule encourages keeping retirement savings within the retirement system. This withholding is not a penalty but a prepayment of federal income taxes that may be due on the distribution.
The withholding applies automatically if the funds are made payable to the account holder. For instance, if your eligible distribution is $20,000 and you choose to receive a check in your name, the plan administrator is required to send $4,000 directly to the IRS. You would receive a check for the remaining $16,000.
To complete a full rollover of the original $20,000, you must deposit that entire amount, which requires using $4,000 of personal funds to make up for the amount that was withheld for taxes. The only way to completely avoid this mandatory withholding is to elect a direct rollover.
Executing a Rollover of an Eligible Distribution
There are two methods for moving an eligible rollover distribution to another retirement account: a direct rollover and an indirect rollover. The choice between these methods has different consequences for taxation and complexity.
Direct Rollover
A direct rollover, often called a trustee-to-trustee transfer, is the most straightforward method. In this process, you instruct your former plan administrator to send the funds directly to the custodian of your new retirement plan or IRA. The payment is made payable to the receiving institution, not to you. Because the money is transferred directly between financial institutions, there is no mandatory 20% tax withholding. This method ensures the entire eligible distribution amount is moved to the new account, preserving its tax-deferred status.
Indirect Rollover
An indirect rollover, also known as a 60-day rollover, is a more complex process. With this method, the plan administrator issues a check payable directly to you, after withholding the mandatory 20% for federal taxes. You then have 60 days from the date you receive the funds to deposit the money into a new eligible retirement plan or IRA.
To avoid any tax liability on the distribution, you must deposit the entire original amount of the distribution into the new account. Using the previous example, if your distribution was $20,000 and $4,000 was withheld, you must deposit $20,000, which requires you to come up with the $4,000 from other sources. If you only roll over the $16,000 you received, the $4,000 withheld will be considered a taxable distribution and may be subject to a 10% early withdrawal penalty if you are under age 59½.