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If you have a 401(k) plan (or any Qualified Retirement Plan (QRP) such as a 403(b) plan), when you leave employment at that job you can rollover the plan funds to an IRA or another QRP at a new job. Listed below are 2 very good reasons that you should use a Direct rollover (also known as a trustee-to-trustee transfer) instead of the 60-day rollover.
A 60-day rollover is where the former plan distributes the funds from your account to you, and in order to make the rollover complete you must deposit the entire distributed amount into the new plan or IRA within 60 days.
Reasons to Use a Direct Rollover
- You must complete the rollover to the new account or IRA within 60 days. There is little if any leeway on this 60-day period – and though it seems as if this is a simple task to accomplish, there are many cases where well-intentioned individuals missed the bus on this one. All it takes is a lost letter in the mail, or the check falling through the cracks, or any of myriad ways to miss the deadline.
- When funds are distributed from a QRP to an individual, the plan administrator is required to withhold 20% of the distribution for income tax. This presents a problem if you were planning to rollover the full amount of the QRP distribution into your new plan or IRA, since you’ll now need to come up with the missing 20% from other sources. Granted, if all things remain the same you should get the withheld 20% back from the IRS when you file your taxes, but that could be a long wait if you don’t have a lot of excess cash lying around.
Using the direct rollover eliminates both of the issues listed above. When then QRP administrator enacts a direct rollover for you, most often the distribution is directly to the administrator or custodian of the new plan or IRA. Sometimes the QRP administrator will send a check to you, the plan participant, made out to the new administrator or custodian, so you’ll still need to make sure that the check gets to the new plan. You’re in a much better position to get around the 60-day window if the check is made out to the new custodian, since technically the 60-day rollover requires that you have the funds at your disposal (for use or deposit in another account).
In addition, using a direct rollover eliminates the 20% withholding requirement altogether. There’s no amount to make up later.
Sterling Raskie, MSFS, CFP®, ChFC®
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Both reasons are right, and the 20% one deserves a worked number because people underestimate how it compounds. On a $100,000 60-day rollover the plan sends you $80,000; to complete the rollover you must deposit $100,000 within 60 days, so you need $20,000 of your own cash in the meantime. If you only redeposit the $80,000 you received, the missing $20,000 is treated as a distribution — taxed as ordinary income and, if you’re under 59½, hit with the 10% penalty on top — and the $20,000 withheld doesn’t come back until the following year’s refund. That’s the trap: the withholding looks like a cash-flow inconvenience but it becomes a permanent tax bill for anyone who can’t front the difference. Two additions. First, the 20% is a floor, not a choice — it’s mandatory on eligible rollover distributions paid to the participant, and a W-4R can raise it but not lower it, which is different from IRA distributions where you can elect out entirely. Second, the once-per-12-months rule on 60-day rollovers applies to IRA-to-IRA moves, not to 401(k)-to-IRA, so that particular limit isn’t the issue here; the issue is purely the deadline and the withholding. The practical tip I’d add for the “check made out to the new custodian but mailed to you” case: ask the old plan to write it as “[Custodian] FBO [your name]” and photograph both sides before you forward it, because if it’s lost the plan will need to stop payment and reissue, and that clock is still running.