The #1 401(k) Rollover Mistake – Avoid This at All Costs
If you’re one of the millions of people who recently left a job, there’s one thing that’s worse than leaving behind your 401(k) with a past employer – and that is making a very costly 401(k) rollover mistake.
More than 4 million people have left their jobs each month in the U.S. so far in 2022. And, data shows, this trend still isn’t letting up.¹
A report from McKinsey and Co. published in July 2022, found about 40% of workers are considering quitting their current jobs in the next 3 to 6 months.²
Whether you left behind an old 401(k) in the past or you plan on leaving your employer that offers a 401(k), you may not want to leave it behind.
If you do decide to roll it over, it’s critical you understand your rollover options and plan your decision wisely. If not, taxes and penalties may take a huge bite out of your retirement funds.
Keep reading to find out more about this #1 401(k) rollover mistake and how to avoid it.
2 Types of Rollovers
First thing you need to understand are the 2 types of rollovers: direct and indirect.
A 401(k) direct rollover is exactly as it sounds – the transaction occurs directly between the custodian of your old 401(k) plan and the custodian of your new 401(k) or IRA.
You never actually receive the funds or have control of them, so a trustee-to-trustee transfer is not treated as a taxable distribution.
There are no penalties or taxes that have to be paid with a direct 401(k) rollover. You can roll over your old 401(k) directly into your new 401(k), IRA, Roth Ira, or annuity.
Indirect rollovers are where the mistakes may be made – mistakes that are very costly.
With an indirect 401(k) rollover, you receive a distribution check from your 401(k) plan, and, then, to complete the rollover transaction, you must make a deposit into the new retirement plan that you want to receive the funds.
20% taxes are withheld from every indirect rollover – whether you plan to roll over the funds or use the money to pay off debt or make a purchase. The money for taxes is always withheld.
This is because the IRS mandates that your 401(k) custodian withhold this amount – so you get a check mailed to you, less the 20% taxes.
When you get the check in the mail, you are required to put those funds in a new retirement account within 60 days.
If you want to roll over your entire distribution, you’ll need to come up with that extra 20% from your other funds to complete the rollover. You will be able to recover the withheld taxes when you file your tax return, but to complete the rollover, you need to come up with that extra cash.
If you fail to do so by the 60-day deadline, your distribution will be taxed as ordinary income and subject to a 10% early withdrawal penalty – unless you are age 59½ or another exception applies.
This is where the #1 401(k) rollover mistake occurs.
Should you miss the 60-day deadline or decide you need to cash the check to pay for a new roof, to pay down debt, or go on vacation – you will owe taxes plus penalties.
That is, unless you are 59½ because the IRS states this is when you can withdraw penalty-free. However, you will still have to pay taxes as ordinary income on the money.
The True Cost of This 401(k) Rollover Mistake
It’s probably clear at this point how costly making an indirect rollover can be – even more so if you are under age 59½.
To further our point, let’s say you’re 45 years old and in the 20% tax bracket and you have a $10,000 balance with your old 401(k).
Whether you missed the 60-day deadline to roll over your funds or you decided to cash it out – If you cashed in your 401(k) and you’re under age 59½, this is considered a distribution. Now you are taxed 20%, plus you’ll pay a 10% penalty for early withdrawal.
That means 30% of your hard-earned retirement savings will go to the government!
And you’ll only get to keep $7,000. That’s $3,000 of hard-earned savings gone down the drain.
Aside from the money lost, there are long-term implications to missing the 60-day deadline and being forced to cash out your 401(k).
You’re putting a dent in your future retirement income. Your money won’t be working for you, and you will miss out on compounded earnings, as well as tax-deferred growth.
Before You Roll Over Your Old 401(k)
It’s important to understand all your rollover options before you make a move, and seek professional help.
Each investor’s situation is unique, and speaking with someone who can navigate the rollover process helps you make the best decision possible for your financial future.
Have questions about rolling over your 401(k)? Book a complimentary 15-minute 401(k) Strategy Session with one of our advisors.