The best way to rollover your 401(k) to an IRA

I have a 401(k) account with a former employer and would like to roll it over into an IRA account. What is the best way to do this?

In general, the best way to roll over your 401(k) account to an IRA is to do it without any tax consequences or penalties. If an IRA rollover is not completed properly, the IRS may consider the rollover as a distribution/withdrawal rather than a transfer. If the funds are distributed or withdrawn it may be subject to income taxes and early withdrawal penalties (if the distribution occurs before you are age 59.5).

Here’s what you need to do to accomplish a tax-free, penalty-free rollover. The first thing to do it make sure that your former employer’s 401(k) plan allows you to roll over the assets in your account to an IRA. You can do this by contacting your former employer’s Human Resources department or the administrator of your former employer’s 401(k) plan. Most 401(k) plans allow it but if your former employer’s plan does not, find out what options are available to you. If the plan does allow it, you have two general ways to do it – as a direct rollover or as an indirect rollover.

Doing a direct rollover is generally the best method. A direct rollover is one where the administrator of the 401(k) plan transfers the assets or funds in your 401(k) plan directly to the trustee of your IRA account. This method prevents you from taking possession of the funds and minimizes the possibility of failing to deposit the funds into your account. The 401(k) administrator can either send the funds from your account to you in the form of a check or directly to the IRA trustee. In either case, the check for your funds should be made out to the IRA trustee for your benefit. The check should not be made out to you. If the check is made out to the IRA trustee for your benefit and it is deposited into your IRA account, it will be considered a direct rollover and you should not incur any income taxes or penalties for the rollover.

If the check is made out to you, you can do an indirect rollover. However, the 401(k) administrator will be required to withhold income taxes at 20% before issuing the check to you. When you deposit that check into your IRA account (which needs to be done within the 60-day deadline), you will need to deposit the full amount rolled over from your 401(k). In other words, you need to deposit the check sent to you plus come out-of-pocket to make up the difference between the full amount rolled over and the amount of the check you received. If you fail to deposit the full rollover amount within 60 days, the IRS will treat the un-deposited amount as a withdrawal and you may be subject to income taxes and early withdrawal penalties. If the indirect rollover is completed properly, you will receive the withheld taxes back when you file your income tax return for that year.

To minimize any tax consequences, early distribution penalties, out-of-pocket costs, and potential missed deadlines, it is almost always better to do a direct rollover if available when doing an IRA rollover.