The 20% Withholding Problem with Certain Rollovers From Company Retirement Plans

When you retire or switch jobs, you will be entitled to receive the funds from your company retirement plan. At that point you will be notified of your options on what to do with that money. The basic options you have are to receive the funds personally or do a direct rollover (sometimes called a direct transfer) of the funds to an IRA. If you want to do a rollover to your IRA, there are problems if you choose to have the money distributed to you personally.

When you choose to have your company retirement plan money distributed to you personally, you can still roll over those funds to your IRA within 60 days. However, you will have to deal with the mandatory 20% withholding rules. Those rules say that when a rollover eligible company plan distribution is paid to you personally, versus doing a direct rollover to your IRA, that amount is subject to automatic 20% federal income tax withholding.

Let’s assume you switch jobs at age 50 with $50,000 in your former employer’s 401(k) plan. All of the $50,000 is rollover eligible. You plan to roll over the money to an IRA but you choose to have the $50,000 paid to you personally. You then receive a check for only $40,000. What happened to the other $10,000? It was sent to IRS as federal income tax withholding. Specifically, the plan administrator had to withhold 20% ($50,000 X 20% = $10,000).

The good news is you’re allowed to roll over the entire $50,000, but the bad news is you only have $40,000. If you can come up with the $10,000 from your own personal funds, you can roll over the entire $50,000 tax-free within 60 days to your IRA. You’ll get back the $10,000 that was withheld when you file your tax return for the year (either as an income tax-refund or as a credit to use if you owe taxes to IRS).

If you only roll over the $40,000 you received, the $10,000 you didn’t roll over will be taxable and subject to a 10% early distribution penalty, if applicable. The reason for that is because $50,000 is rollover eligible and you’re only rolling over $40,000.

In hindsight, it would have been better if you had simply chosen to do a direct rollover to your IRA in the first place. The direct rollover avoids the 20% mandatory withholding rules, so all $50,000 would have been transferred directly into your IRA tax-free. If you intend to rollover over your company plan funds to your IRA, the direct rollover is the better choice.

– By Joe Cicchinelli and Jared Trexler