The 401(k) rollover mistake that can trigger a surprise tax bill

A laid-off worker who asks for 401(k) money the wrong way can see 20% skimmed off for federal tax withholding before the cash ever reaches an IRA, according to MarketWatch columnist Dan Moisand.

Moisand, a financial planner at Moisand Fitzgerald Tamayo in Orlando, Fla., addressed the issue in a MarketWatch retirement Q&A after a reader described a man who said his former employer withheld money from a 401(k) payout even though he later put the money into an IRA.

His answer: yes, that can happen. The key is whether the worker used a direct rollover or an indirect rollover.

The clean route: direct rollover

Moisand said the safer way to move retirement money after leaving a job is a direct rollover, also known as a trustee-to-trustee transfer.

In that setup, the old workplace plan sends the money straight to the new retirement account, such as another 401(k) or an IRA. In some cases, a check may be handed to the former employee, but Moisand said it should be made payable to the new account provider for the benefit of the worker’s IRA, rather than to the worker personally.

That distinction matters. According to Moisand, a direct rollover does not create immediate tax consequences, does not require tax withholding and is not covered by the rule limiting certain rollovers to one per 12-month period.

He said people can make direct rollovers as often as they want.

The costly route: indirect rollover

The trouble starts when the money is paid directly to the former employee. Moisand said that is known as an indirect rollover, or a 60-day rollover.

Under that method, the former worker receives the distribution and then has 60 days to deposit it into another 401(k) plan or IRA. If that does not happen in time, Moisand said taxes are due.

There is another catch: because the check is payable to the worker and treated as a distribution, the former employer must withhold 20% for taxes, according to Moisand. He said the employer does not have discretion to skip that withholding.

For example, Moisand said a worker trying to move $100,000 from a 401(k) to an IRA through an indirect rollover would receive only $80,000. The missing $20,000 would have gone to withholding.

If the worker fails to put the money into an IRA within 60 days, or has already made another indirect rollover during the previous 12 months, Moisand said the full $100,000 would be treated as a distribution taxed as ordinary income.

Even if the worker deposits the $80,000 into an IRA within the 60-day window, the tax math can still sting. Moisand said the original distribution was $100,000, but only $80,000 was rolled over, leaving $20,000 as taxable income.

Workers younger than 59½ may face another hit. Moisand said distributions can also trigger a 10% premature distribution penalty, in addition to income taxes.

His bottom line for anyone moving money from one tax-deferred retirement account to another: use a direct rollover.

This story draws on original reporting from MarketWatch.