Here's the right way to avoid tax pitfalls and roll your 401(k) assets to an IRA

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It's not uncommon to want to move money from a workplace savings plan to an individual retirement account when you leave the company.

Yet if you're not careful while doing that rollover, you can make costly errors or lock yourself into something that can't be easily undone. The key is to avoid any tax pitfalls.

"People think it's straightforward: they retired, or they left their job, so they think they should do a rollover," said certified financial planner Marguerita Cheng, CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland.

"But there are mistakes that can happen," Cheng said.

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Both 401(k) plans and IRAs have the common purpose of letting you put away tax-advantaged savings for retirement. However, there are some rules that differ between the two. Even the rollover process itself can come with snags if you're not careful.

Here are some other things to be aware of before initiating a rollover. These generally apply to traditional 401(k) plans and IRAs, whose contributions are generally made pre-tax.

The transfer process

Once you've decided to move your retirement savings to an IRA, it's best to avoid receiving a check made out directly to you from the 401(k) plan, even if it is sent to you.

Assuming you have the rollover account set up and ready to receive the funds from the 401(k), the check should be made out to the IRA custodian — i.e., say Schwab, Fidelity Investments or another investment manager — for the benefit of you. In this case, there is no tax withholding.

If the check is payable to you, though, it is initially considered a distribution. That means your 401(k) plan is required to withhold 20% for taxes. 

For example: Say your 401(k) balance is $50,000. You inadvertently have the rollover check made out to you, so it's for $40,000 (the $10,000 reduction is the mandatory 20% tax withholding).

You then deposit the check into your rollover IRA. However, if your intent was to put the whole $50,000 in the IRA, you would have to come up with that $10,000 if you want the whole event to be non-taxable.

Otherwise, that withheld amount is considered a distribution, potentially subject to an early-withdrawal penalty if you are younger than age 59½. 

"Make sure you're specifying that you want to do a direct rollover," Cheng said.

The rule of 55

If you leave your job in or after the year you turn 55 but before age 59½, you can take penalty-free distributions from your 401(k) (although they will still be taxable). If you move the money to an IRA, you lose that ability to tap the money early.

"Someone might lose their job and want to roll over their 401(k) to an IRA, but they underestimate how long they're going to be unemployed," said CFP Melissa Brennan, a financial planner with ARS Private Wealth in Houston.

In that case, if they already have rolled over the money to an IRA and needed to access it, they would end up paying the 10% penalty unless they can qualify under another reason for an early withdrawal.

If someone wants to move money to an IRA — maybe the investment options are greater or the costs are lower — and is in that 55-to-59½ age range, one option may be to do a partial rollover if your 401(k) plan allows it.

That way, you at least leave some money in the 401(k) in case you need to take distributions before the minimum age of penalty-free withdrawals.

Spouses, take note

If you are the spouse of someone who plans to roll over their 401(k) balance to an IRA, be aware that would you lose the right to be the sole heir of that money. With the workplace plan, the beneficiary must be you, the spouse, unless you sign a waiver so it can be someone else.

Once the money lands in the rollover IRA, the account owner can name any beneficiary they want without their spouse's consent.

Here's another potential misstep: Making a withdrawal from your 401(k) to give to your ex-spouse as dictated in a divorce agreement. That won't work — the money will be considered a distribution to you, subject to taxation, as well as potentially a penalty if you're under age 59½. 

In a divorce, retirement assets that are awarded to the ex-spouse can only be distributed penalty-free via a qualified domestic relations order, or QDRO. That document is separate from the divorce decree and must be approved by a judge.

Tread carefully with company stock

Some retirement savers hold company stock in their 401(k) alongside their other investments. In that situation, if you roll over all your 401(k) assets to an IRA, you lose the potential to get a more favorable tax treatment on any growth those shares had while in your 401(k).

It gets a bit confusing, but the idea is that if the company stock has unrealized gains, you transfer it to a brokerage account instead of rolling it over to the IRA along with your other 401(k) assets. Upon transferring, you are taxed on the cost basis (the value of the stock when you first acquired it in your 401(k).

It's a complex transaction, and if done incorrectly, the strategy loses its tax advantage.

Melisssa Brennan

Financial planner with ARS Private Wealth

However, when you then sell the shares from your brokerage account — whether immediately or down the road — any growth the stock experienced inside the 401(k) would be taxed at long-term capital gains rates (0%, 15% or 20%, depending on the rest of your income). This could be less than the ordinary-income tax treatment you'd face if the stock went into a rollover IRA and then were withdrawn.

Here's an example: If the cost basis of your company stock is $10,000 and the gains on it were $20,000, you would pay ordinary taxes on the $10,000 when you transfer the shares to a brokerage account.

The $20,000 in gains, however, would be taxed at long-term rates once the stock is sold. Any further growth from the point of transfer to sale would be taxed as either short- or long-term gains, depending on how long you held it before selling.

"It's a complex transaction, and if done incorrectly, the strategy loses its tax advantage," Brennan said.

In other words, professional guidance would likely be useful in this situation.

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