The Heartbreak of Withholding From Indirect Rollover

Taking early withdrawals from your retirement plans is rarely a good idea, and should only be considered when it’s the last possible option available to you.  But this article is more about the pain you could experience if you don’t handle a rollover correctly – bypassing the trustee-to-trustee transfer option and going with an indirect rollover.

Withholding Rule For Indirect Rollovers

In general, if you take an early withdrawal (pre-age 59½) from a Qualified Retirement Plan (QRP) that includes pre-tax money, the custodian of the account is required to withhold and pay to the IRS 20% of the pre-tax amount withdrawn.  This can still be a tax-free transaction if you finish the indirect rollover process correctly and place the entire amount of the distribution in an IRA or other QRP (like a 401k) within 60 days.  However, if you don’t complete the indirect rollover, with the whole amount of the distribution, you’re likely to get a tax surprise…

A transaction like this is called an “indirect rollover”, as opposed to a direct or a trustee-to-trustee rollover.  In the event that you complete the indirect rollover within 60 days, you will need to come up with the 20% that was withheld in order to have a full rollover – otherwise you’ll have to pay tax and a penalty on the amount that was not rolled over. (It is important to note that this mandatory withholding is only for employer plans – 401k, 403b and the like. There is no mandatory withholding on an IRA distribution.)

An Example

For example, let’s say you’re 50 years of age, and you have a 401(k) from a former employer that you’d like to roll over into your IRA account.  The 401(k) is worth $50,000.  For whatever reason, you opted to have the 401(k) custodian send you a check for the amount, which you then plan on sending to the IRA custodian for deposit (within the allowable 60 day period, as an indirect rollover).

Lo and behold, when the check arrives, it’s only made out for $40,000!  This is because the custodian was required to withhold 20%… and now, since you don’t have any savings to speak of, you can only send the $40,000 over to the IRA custodian.  Guess what?  Come tax time, you will have to include that “missing” $10,000 as income, plus you’ll get to pay a 10% early withdrawal penalty as well.  So if you’re in the 25% tax bracket, you get to pay $3,500 in tax and penalties (25% times $10,000 plus 10% times $10,000).

Now, the original 401(k) that was worth $50,000 is reduced to an IRA worth $40,000 and a tax refund of $6,500 (since $10,000 was withheld and your tax and penalties were only $3,500).  This swift little maneuver has cost you 7% of your retirement plan!  Plus, you’ve lost tax-deferral on $10,000…

ALWAYS Do the Direct Rollover

It is for this reason that, whenever possible, you always should do a direct, or trustee-to-trustee transfer when rolling over IRA and QRP funds to a new account.  When you do a trustee-to-trustee rollover, no withholding applies, so you don’t have to make up any difference, and your tax-deferred amount remains intact.

It’s important to note that in our example above, if you had the $10,000 available to you in savings or elsewhere to make up the difference for the withholding, you could still complete the indirect rollover without tax or penalty by sending a total of $50,000 to the IRA custodian within 60 days.  Then when you file your taxes for the year, that $10,000 withheld would amount to either a refund to you or a reduction in the amount of tax that you had to pay for the year.