401k and IRA Rollovers - Direct IRA Rollover Rules - 20% IRA Withholding Law
What is a Direct IRA Rollover?
A Direct IRA Rollover is when your 401k retirement savings (or 401k distributions) are transferred directly from your old employer's account to your own Individual Retirement Account through a trustee-to-trustee transfer. This means the money never actually reaches your hands, it is wired from your old 401k administrator to your new one. With this method, no taxes are withheld and you will NOT have to pay any penalties
If you own your employer's company stock as part of your retirement savings portfolio, you have 2 options available:
What if i Take a 401k Cash Distribution and do NOT Rollover into IRA?
If you take the cash from your old employer administered 401k plan instead of rolling it over to a Rollover IRA, you will have to pay early withdrawal penalties (10%) and a 20% tax withholding fee. For example, consider this scenario:
* The above example assumes the 401k retiree is less than 59 and 1/2 years old and has to pay the 10% Early-Withdrawal Penalty fee. However, if you are older than 59 and 1/2, this 10% early-withdrawal penalty fee does NOT apply to you. The above example also assumes a Local State Tax rate of 7% (varies from state to state) and a Federal Tax Rate of 30% (20% Withholding Tax + 10% Federal Income Tax)
20% IRA Withholding Law
If you change your job or officially retire, the total 401k Retirement Savings you receive could be less than you expect. This is because companies by law are required to withhold 20% of your entire 401k savings account for tax purposes. This applies only to qualified retirement plans and includes 401k plans, 403b plans and other profit sharing plans.
This law is implemented to discourage retirees from withdrawing money from their plans early on and let it earn the power of compounding interest. This 20% IRA Withholding law can be overridden by doing a 100% Direct IRA Rollover to your own Individual Retirement Account (IRA).
The 20% Withholding Law does NOT apply to:
Your Age and IRA Withdrawals
- If you quit your current job with no intention of returning (aka "Separation from Service") during or after the age of 55, you are allowed to make withdrawals from your retirement savings account without paying the 10% early withdrawal penalty. Read your 401k Summary document to determine whether you are allowed to make any withdrawals in the course of your employment contract. Most employers do not allow employees to withdraw money from their 401k plans during their working life.