The Biggest Mistakes People Make With IRA Rollovers

These mistakes can be costly, potentially amounting to tens of thousands of dollars, since the funds in a workplace retirement plan like a 401(k) often represent one of the largest payouts an individual receives.

Rolling these funds directly into a traditional IRA offers flexibility and control without paying immediate taxes, along with the ability to select from a variety of investment options—such as stocks, bonds, mutual funds, exchange-traded funds, certificates of deposit and annuities. With a company plan, you are likely to have a limited number of choices, perhaps only a half-dozen or so.

“We’ve seen an increased frequency of rollovers recently,” says Sarah Brenner, director of retirement education at Ed Slott & Co., a tax consulting firm in Rockville Centre, N.Y. “And we’ve seen a lot of questions about how to avoid mistakes in these rollovers.”

Here are some of those mistakes.

1) Taking a lump-sum distribution of the 401(k) funds instead of moving them directly to the IRA custodian. In such cases, called indirect rollovers, you have only 60 days to deposit them in the IRA. If you miss the deadline, the amount is considered a distribution that will likely need to be included in your gross income for tax purposes. If you are younger than 59½, you also could be charged a 10% early-withdrawal penalty on the money received.

There is an exception, however, for employees who have highly appreciated stock of the company they are leaving in their 401(k). It’s called the net unrealized appreciation, or NUA, strategy.

Those employees can take the lump-sum distribution and will have to pay tax at the ordinary income-tax rate—but only on the cost basis, or the adjusted original value, of that stock. The difference between the cost basis and the current market value is the NUA, and they can defer the tax on that difference until they sell the stock.

For example, if you paid $30,000 for company stock and it is now worth $90,000, the NUA is $60,000. Even when it comes time to pay, the tax on this $60,000 appreciation will be at the long-term capital-gains rate.

2) Not realizing that when you do an indirect rollover, your workplace plan administrator will usually withhold 20% of your account and send it to the Internal Revenue Service as prepayment of federal-income tax on the distribution. This happens even if you plan to immediately deposit the money in an IRA. (When you file your tax return in April, you will get a refund from the IRS if too much tax was withheld.) So if you want to contribute the same amount that was in your 401(k) to your IRA, you must provide funds from other sources to make up for the amount withheld.

3) Rolling over funds from a 401(k) to an IRA before taking a required minimum distribution, or RMD. This mistake affects those who are required to take an RMD for the year that they are receiving the distribution from the 401(k)—individuals age 72 or older. Doing so would result in an excess contribution, which is subject to an annual 6% penalty until it is corrected.

4) Not realizing that rolling over funds from a 401(k) to a Roth IRA is considered a conversion and you must pay the tax immediately. However, if there are after-tax dollars in your 401(k) plan, you can make a tax-free distribution of those funds to a Roth IRA. You must hold funds in a Roth IRA account for at least five years before withdrawing any earnings or those earnings will be taxable and potentially subject to penalty. 

5) Not knowing there are limits when moving funds from one IRA to another IRA if you do a 60-day rollover. Generally, you are allowed to roll over just one distribution from an IRA to another IRA within a 12-month period, regardless of how many IRAs you have. If you make more than one distribution, it is considered taxable income. And if you are under 59½, there is an additional 10% penalty.

According to the IRS, “The limit will apply by aggregating all of an individual’s IRAs, including SEP and Simple IRAs, as well as traditional and Roth IRAs, effectively treating them as one IRA for purposes of the limit.”

To ensure a successful rollover, it may be useful to make a direct trustee-to-trustee transfer marked “for the benefit of” the IRA owner, rather than an indirect one. Then there will be no 60-day rule or once-a-year rule to worry about.

Mr. Sloane is a writer in New York. He can be reached at [email protected].