Moving your money from an old employer-sponsored retirement plan – like a 401k or a 403b – to an IRA can be a smart move financially, as these accounts typically offer a wider range of investment opportunity and higher returns overall. However, if you aren’t careful, you could wind up on the hook for a serious IRA tax penalty. Let’s look more closely at how you can avoid this situation.

Transferring Funds out of an old Retirement Plan

The first step in understanding how to avoid the IRA rollover tax is to become familiar with the options available to you for moving your retirement funds out of an old employer’s account. Typically, you have three options:

1. Cash out your old account. When you close your old employer-sponsored account, you do have the option to take your invested funds as cash. However, this choice comes with some pretty stiff tax implications – plan to pay at least ordinary income taxes plus early withdrawal penalties unless you deposit your funds into a new IRA within 60 days.
2. Move the funds to your new employer’s retirement account. in most cases, this doesn’t make much sense – remember; you’re moving your funds out of the old 401k or 403b to take advantage of new opportunities and higher rates of return. Simply rolling your funds into a new employer account offers neither of these benefits.
3. Transfer your balance directly into an IRA. in this scenario, you instruct your current account holder to move the money directly into your new account. you never see the money and you’re never subject to IRA rollover taxes.

Understanding the IRA Tax Implications of these Options

For the purposes of this article, let’s assume that you plan to transfer your funds to an IRA account and look at the advantages and disadvantages of the first and third scenarios from an IRA tax standpoint.

In scenario one, you take a cash distribution of the entire balance of your old 401k or 403b account. if you want, you can simply keep the cash, although this is rarely a smart move. At a minimum, you’ll pay income tax on the money, plus the mandatory 20% withholding tax your employer is required to withdraw and any other IRA rollover tax penalties that may apply. After all is said and done, you could be out as much as 50% of the balance of your former account.

Of course, if you do take the cash distribution, you can avoid some of these IRA rollover taxes by depositing the funds into a new IRA account within 60 days. However, even if you plan to go this route, your former employer is still required to withhold the mandatory 20% IRA tax. if you want to defer tax on the total taxable portion of the transfer, you’ll need to add funds of your own to the IRA to make up for this 20%.

For this reason, the third scenario is almost always the best choice for avoiding IRA rollover tax penalties. When the funds are transferred directly from one retirement account to another, no IRA taxes are withheld and you aren’t required to pay ordinary income tax on the account balance. your funds are able to continue to grow and enjoy the benefits of an IRA, without suffering any losses during the transfer process.

Avoid IRA Rollover Tax with Direct Transfer | IRA Rollover Tax