Choosing a Direct IRA Rollover Avoids 20% Withholding on Plan Distributions | Ed Slott and Company, LLC

Choosing a Direct IRA Rollover Avoids 20% Withholding on Plan Distributions

By Joe Cicchinelli, IRA Technical Expert

Follow Me on Twitter: @JoeCiccEdSlott

If you're receiving a distribution from your employer's retirement plan, such as a 401(k) or 403(b) plan, you have the choice to roll over those funds tax-free to an IRA. There are two ways to do that: 1) by doing a direct rollover or 2) by an indirect (or 60-day) rollover. Generally, if you intend to roll over all of your company retirement plan balance to an IRA, the better way to do that is by using a direct rollover.

In a direct rollover, also known as a direct transfer, the funds are sent directly from your company retirement plan to your IRA. You have no control or use of the money in a direct rollover. Even if a direct rollover check is mailed to you, the check will be made payable to your IRA custodian for the benefit of your IRA (i.e., it’s not made payable to you personally). The direct rollover advantage is that the 20% withholding rules do not apply so your entire plan balance can easily be rolled over.

If you instead choose to have the company plan balance paid to you personally, then 20% will be withheld for federal income taxes. You can still roll over your entire plan balance, including the 20% that was withheld, within 60 days. This is known as an indirect or 60-day rollover. But the problem is if you want to roll over your entire company plan balance to your IRA, you’ll have to come up with the 20% that was withheld for income taxes from your own personal funds. That might be difficult especially if that amount is a lot of money. If you don’t roll over the 20% that was withheld, you’ll be taxed on it because you didn’t roll over that amount to your IRA. In hindsight, it would have been easier to simply have chosen a direct rollover to avoid the 20% withholding issue completely. You will recover the 20% withheld amount when you file your tax return.
 

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