You can though postpone any income tax on this withdrawal by completing a 401k rollover to an IRA. A rollover is really just a movement of assets from one retirement plan into a second retirement plan.
The IRS allows you to make this tax-free 401k rollover into another employer qualified retirement plan or into your Individual Retirement Account (IRA).
The IRS has instituted very important and very exact rules as to how this tax-free rollover must take place. It is imperative that you understand these rules and your options.
Net Unrealized Appreciation (NUA)
If your 401k assets consist of appreciated company stock of your employer, you have what is known as Net Unrealized Appreciation (NUA). Generally, for tax puposes it is better to rollover this stock into an IRA or other retirement plan. Net Unrealized Appreciation is very complex and there can be circumstances where it may be better to currently pay income taxes on the taxable cost portion of the stock. You should definitely receive competent tax and investment advice for NUA issues -- it is in your best interest.
401k Rollovers
If you withdraw cash or other assets such as capital stock from a 401K plan (known as a 401k cash out), a taxable event generally has occurred, because your 401k salary deferrals were not subject to income tax.
How a 401k Rollover To an IRA Will Save IRS Taxes and Penalties
401k IRA Rollover
Helping you to save your retirement.
A 401k Rollover Will Protect Your 401k Retirement Assets
When you retire or when you leave a job and you don't want to leave your 401k assets in your former employer's 401k plan, you basically have three options:
■ You may setup an IRA account to which you can rollover your 401k assets. Generally, most 401k rollovers are made to an IRA.
■ You may be able to make a 401k rollover to your new employer's retirement plan, which could be another 401k plan, profit sharing plan, etc.
■ You may elect to receive your 401k assets without making a rollover. This is known as a "cash-out" of your 401k. Your employer is required to withhold 20% of the amount of your 401k withdrawal for Federal Income Taxes. The bad part of a cash-out is that you will have to pay income taxes on the entire taxable portion of the 401k distribution. You additionally may be subject to an IRS 10% penalty, if you are under the age of 59½ at the time of the distribution.
If you choose to do a 401k rollover, you can have the assets directly transferred to your new IRA or retirement plan. In this way, you never receive or take control of the assets. The IRS does not require any income tax to be withheld on a direct rollover.
401k Taxes and Penalties
Some people wrongly assume that the 20% tax withheld is the entire amount that they will owe Uncle Sam; and that they will not have to pay any more taxes when they file their income tax return. That is a gigantic mistake that you don't want to make. The total tax bill will depend upon your other income and your tax bracket. The combined income taxes and the 10% penalty in 2009 can easily be 35% and as much as 45% of your 401k withdrawal. So, if your 401k cash out was $200,000 and the tax and penalty was 45%, you would be paying $90,000 to Uncle Sam. That's a big chunk out of your retirement cash and it is gone forever. Plus, since you only had 20% withheld or $40,000, you will have to pay an additional $50,000 to the IRS when you file your tax return.
Other Small Business Retirement Plans
The general consensus lately has been to refer to all retirement plans as either a 401k plan or an Individual Retirement Account (IRA). Though in recent years the 401k salary deferral plan has become the most popular employee retirement plan, there are other types of plans. These plans include:
Even though the information on this web site will provide you with valuable information about 401K plans, IRA plans, and other retirement plans, the information is general in nature and not intended to be personal advice. The information on this web site is not offerred as legal, investment or tax advice. These plans and the rollover process can be complicated. See IRS Publication 590 for more details. You are also encouraged to seek competent professional retirement planning advice from other sources.
There are potential severe income tax pitfalls if you don't understand the rollover rules and fail to correctly follow them. You could unintentionally lose a large portion of your retirement nest egg to income taxes and penalties. Please see the below example of how you can lose a large chunk of your 401k to income taxes and penalties.
You can be put into this rollover decision if you leave your job through retirement or any other termination of employment. You sometimes have the option of leaving your retirement assets in your former employer's retirement plan. In most cases, it makes more sense to not leave it in your old retirement plan but to use a rollover to transfer it either to your new employer's retirement plan or to your IRA.
However, if the assets are distributed to you, the IRS requires that 20% will be generally withheld for income taxes. You then will have 60 days in which to rollover the distribution. You must rollover 100% of the distribution and not just the 80% you received after the income tax withholding. In other words, you'll have to come up with the other 20% from other funds. And, if you cannot put together the missing 20%, you could be in jepoardy for a big tax and penalty hit. That's why it is usually better to make a direct rollover to avoid the 20% withholding requirement.
