A 401(k) Financial Advisor’s Guide Indirect Rollovers

Moving to a new job presents several options for handling your 401(k). Each brings a unique set of pros and cons, so it is helpful to know your options. The most common and preferred tactic is to perform a direct rollover. A direct rollover seamlessly transfers funds from the old 401(k) account to a new retirement account.

The direct 401(k) rollover is typically preferred because it ensures that your balance isn’t subject to early-withdrawal penalties or taxes. However, certain situations exist where you may want to do a 401(k) indirect rollover. If you need money that someone will reimburse within 60 days, you could benefit from an indirect rollover. In this 401(k) financial advisor guide to indirect rollovers, we will cover the following topics:

• Performing a 401(k) indirect rollover
• Pros and cons of a 401(k) indirect rollover
• Tax considerations for a 401(k) indirect rollover

Performing a 401(k) Indirect Rollover

To initiate a 401(k) indirect rollover (also known as a 60-day rollover), inform the plan administrator of your intent to execute the indirect rollover. The administrator will then liquidate the account and provide you with a check for the total amount, less a mandatory 20% withholding tax which will be retained and sent to the IRS on your behalf. 

Once you receive the check, a 60-calendar-day deadline begins. You must contribute the total disbursement amount, plus additional funds equaling the 20% tax withheld, to an eligible retirement account before the deadline passes. You will receive a tax credit equal to the 20% if you successfully complete the indirect rollover. If the 60-day period elapses and the total amount is not rolled into a qualified retirement account, the outstanding amount is taxed as ordinary income.

You also run the risk of facing an early-withdrawal fee if you are under the age of 59 ½ at the time you received the funds. The 60-day deadline is strict. And to reiterate, you will need to provide the 20% withholding tax from your own funds. If you are considering performing an indirect 401(k) rollover, planning is vital. 

You must be aware of how much additional money you will be responsible for providing. You will recoup the 20% withholding tax as a tax credit for the year the distribution occurred, provided you satisfy the contribution obligations within 60 days. If circumstances arise that are out of your control, the IRS may waive the 60-day deadline. We highly recommend consulting with a 401(k) financial advisor before attempting an indirect 401(k) rollover. 

Pros and Cons of a 401(k) Indirect Rollover

The primary reason for electing to perform a 401(k) indirect rollover is to have immediate access to the funds. As long as the full distribution amount, plus the 20% withholding tax, is rolled over into an eligible retirement account within 60 days, there are no restrictions on how you can use the money. This strategy is typically employed when a person needs cash that someone will reimbursed within 60 days.

An indirect 401(k) rollover is much riskier than a direct rollover. It exposes you to potential ordinary income tax and a 10% early-distribution tax if you are younger than 59 ½ at the time of disbursement. It is also important to remember that you must include the 20% withholding tax when rolling over into the retirement account. If you do not have disposable funds to cover the 20% withholding tax, it will be taxed as ordinary income. 

Due to the significant risks of a 401(k) indirect rollover, it would be advantageous to talk to a financial advisor that is well-versed in the process. A 401(k) financial advisor may also provide alternative solutions to avoid doing an indirect rollover altogether.

How to Report an Indirect Rollover on Tax Return

Accurately reporting an indirect rollover on your tax return is crucial for recouping the 20% withholding tax and staying in good graces with the IRS. To report an indirect rollover on your tax return, you will need to fill out form 1099-R. 

Full Rollover Within 60 Days: If you successfully rolled over the full amount, including the 20% withheld, do not enter capital gains into box 3 or net unrealized appreciation in box 6 of form 1099-R. You must also enter the distribution amount on form 1040, line 5a (Pensions and annuities). Report $0 as the taxable amount on line 5b

Partial or No Rollover Within 60 Days: If the total distribution amount, including the 20% withheld, was not rolled over into an eligible retirement account within the 60-day window, capital gains on the outstanding amount will need to be reported. You may also be subject to the early-withdrawal penalty. To report the early withdrawal, enter distribution code 1 into box 7 on the 1099-R.

Avoid Unnecessary Taxes and Penalties with the Help of a 401(k) Financial Advisor

Indirect 401(k) rollovers are not for everyone. If 60 days pass before you re-deposit the total distribution into another retirement account, you can no longer defer taxes. If you are under 59 ½ years old at the time of distribution, a 10% early-withdrawal penalty may apply. Rolling over too much into an account could also leave you vulnerable to a 6% excess contribution penalty.

A lot is at stake when you perform an indirect rollover, especially if your retirement account has a high balance. Working with a trusted 401(k) financial advisor helps you avoid costly taxes and penalties while preparing for your eventual retirement. If you have a 401(k) from an old job, consider consulting with a Morgan Rosel Wealth Management 401(k) financial advisor.