Don’t Make This Costly 401(k) Mistake If You’ve Recently Switched Jobs

Don’t Make This Costly 401(k) Mistake If You’ve Recently Switched Jobs

As you move through your career, there’s a good chance you’ll have multiple jobs before you retire. With multiple jobs can come multiple 401(k) accounts to keep up with. Instead of having accounts across different platforms and providers, you can roll over past accounts into your current 401(k), combining them into one.

However, if you decide to do so, make sure you watch out for this costly mistake.

Direct versus indirect rollover

If you decide you want to roll over a 401(k), you have two options: direct or indirect.

Image source: Getty Images.

With a direct rollover, your previous plan provider(s) sends your money directly to your new plan provider without you ever touching it. In some cases, if a plan-to-plan transfer can’t be made, your old plan provider(s) will write out a check in your new plan provider’s name and give it to you to deposit into the new account. Although you physically had the check, it wasn’t in your name, so it’s still considered a direct rollover.

During an indirect rollover, your old plan(s) sends you the money (in your name), and it’s your responsibility to deposit it into your new account.

Don’t forget the 60-day rule for indirect rollovers

If you decide to do an indirect rollover, the one thing you must be aware of is the 60-day rule. The 60-day rule states that you have 60 days from the date you receive the money from your old plan(s) to deposit it into your new plan or redeposit it back into your old plan(s).

If you don’t deposit the money within 60 days, the IRS will treat it as a withdrawal, and you’ll have to pay income taxes on the full amount. If you’re younger than 59 1/2, you’ll also face a 10% early withdrawal penalty.

Imagine you’re converting $100,000 from past 401(k) accounts to your current account. A 10% early withdrawal penalty by itself would cost you $10,000. Add in the income taxes you’ll owe — especially since the $100,000 will likely push you up one or two tax brackets — and you could easily lose more than one-third of the rolled-over amount. Not following the 60-day rule is expensive.

Dealing with withheld taxes

If you’re doing an indirect rollover, your old plan provider(s) will typically withhold 20% of the total amount you’re rolling over for tax purposes. So, if you’re rolling over $100,000, you might only receive $80,000. To make matters a bit worse: You’ll be responsible for replacing the withheld amount when you deposit the funds into your new 401(k) account.

There are three scenarios when doing an indirect rollover:

  1. You replace the withheld amount, and everything is good to go. In this case, you find $20,000 from somewhere and deposit the full $100,000.
  2. If you deposit the $80,000 and not the withheld $20,000, the $80,000 will be nontaxable, but you’ll owe taxes on the $20,000, as well as a possible 10% early withdrawal fee.
  3. If you don’t deposit any of the $100,000 within 60 days, the full $100,000 will be counted as taxable income, and the $20,000 withheld will count as taxes paid.

In case you haven’t noticed, the one common theme in finances is taxes; they’re virtually inescapable. So, at the very minimum, you want to be aware of the tax implications of your moves. Doing an indirect rollover not knowing how the taxes work can be an honest, yet costly, mistake.

Don’t take unnecessary chances

In most scenarios, it’s much easier to just go with a direct rollover. You don’t have to worry about taxes, the 60-day rule, or anything else. You let your plan providers do the work. Not only can the withheld amount be costly to replace before the rollover, but being on a timer (60 days) can also make some people anxious, and they’d rather avoid it altogether.

There are situations where someone may need to access the funds they’re rolling over during that 60-day grace period, but those should be few and far between. There’s nothing inherently wrong with doing an indirect 401(k) rollover; just make sure you’re aware of the implications.

10 stocks we like better than Walmart

When our award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

They just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

See the 10 stocks

Stock Advisor returns as of 2/14/21

The Motley Fool has a disclosure policy.