401(k) Rollover Mistakes to Avoid

Whether you’ve lost your job or plan on changing jobs in the near future, there are common 401(k) rollover mistakes you need to be aware of.

Ignore these, and a rollover could take a chunk out of your retirement savings, trigger a big tax bill, and impact the quality of your retirement.

Keep reading for the top 401(k) rollover mistakes and how to avoid them.

401(k) Options When Leaving a Job

Here are the options on what you can do with your 401(k) when you leave a job:

  1. Leave the money behind in your former employer’s 401(k) plan. You don’t have to, but you can (and we’d advise against this option unless you qualify for the 55 and Separated from Service Rule).
  2. Roll over your 401(k) into an individual retirement account (IRA). This option has many advantages, including consolidating more than one 401(k) account into an IRA. This works well for those with a string of old 401(k) accounts.
  3. Roll over the old 401(k) to your new 401(k), if permitted by your new employer. If you have at least $5,000 saved in your old 401(k), most companies allow you to roll it over.
  4. Cash out your 401(k). This is a costly option we advise against because you will face penalties and pay taxes for cashing out before age 59½.

Costly Rollover Mistakes

What seems like a simple misunderstanding could possibly turn into a costly 401(k) mistake that could take a chunk out of your retirement savings.

This costly mistake lies in understanding the 2 types of rollovers.

Direct Rollover – With a 401(k) direct rollover, the transaction occurs directly between the custodian of your old 401(k) plan and the custodian of your new 401(k), IRA, Roth IRA, or annuity. There are no penalties or taxes that have to be paid with a direct 401(k) rollover because it’s a trustee-to-trustee transfer.

Indirect Rollover – 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 within a 60-day period. If you don’t, it’s treated as a distribution, and you will pay taxes on the amount.

Indirect rollovers may be a huge mistake if you don’t follow the rules.

But, it’s just one of many.

Keep reading for the most common mistakes so you can avoid them at all costs.

#1 Doing an Indirect Rollover Incorrectly

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 deposit the funds into the new retirement plan.

Unlike the direct rollover, 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 IRS mandates that your 401(k) custodian withhold this amount – so you get a check mailed to you, minus the 20% taxes.

After you receive the check, you are required to put those funds—along with the missing 20% – in a new retirement account within 60 days.

You will be able to recover the withheld taxes when you file your tax return, but to complete the rollover, you need to produce 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 if you are under the age of 59½.

This means, if you miss the 60-day deadline or decide to cash the check, you may be forced to pay a 10% penalty in addition to the 20% tax.

Here’s how costly this could get: Let’s say you do an indirect rollover of your $10,000 total 401(k) balance before age 59½ – and you miss the 60-day deadline to roll over your funds. You will have 20% withheld in taxes along with a 10% penalty for early withdrawal.

This means that you might only keep $7,000 of your original $10,000 401(k) balance – depending on your tax bracket.

See how quickly this could eat away at your hard-earned savings?

#2 Leaving Your Old 401(k) Behind

Leaving behind 401(k)s with past employers happens more often than it should.

According to Capitalize, “The number of forgotten 401(k)s increased by over 20% since May 2021 driven by a period of heightened job switching (“The Great Resignation”) with 3.8 million and 4.4 million accounts left behind in 2021 and 2022 respectively.”¹

Based on their findings, this equates to 1 in 5 job changers leaving a 401(k) account behind when changing jobs

It may seem easy and safe, but that’s not always the case.

It is your money – not your former employer’s.

And that means your past employer cannot manage your old 401(k) for you.

Leaving behind an old 401(k) means your account will remain subject to plan rules and you will continue to have limited investment options.

This often results in your retirement funds not suiting your risk tolerance and may lead you to miss out on potential gains or avoiding losses.

Bottom line: When you aren’t engaged with your 401(k), your money won’t work for you like it should.

[Related Read: The Danger of Forgetting to Roll Over Old 401(k)s]

#3 Rolling Over Your 401(k) Too Early

There is an IRS rule that – if you qualify – may help you have more money and avoid penalties that could eat into your retirement income.

It’s called the 55 and Separated from Service Rule. It’s also called the Rule of 55, or 55 Rule.

This IRS provision allows you to take penalty-free distributions on 401(k)s if you leave your job during or after the calendar year you turn 55.

If you want to retire early or lose your job and need cash flow to cover daily expenses while you look for another job, this rule allows you to take distributions sooner than is typically allowed.

You will still owe ordinary income tax on the amount you withdraw, but you can avoid the 10% IRS early withdrawal penalty.

[Related Read: When It May Not Make Sense to Roll Over Your 401(k)]

#4 Taking Company Stock with You

Does your 401(k) contain shares of your former employer’s stock?

If so, be careful!

Rolling over stock that has appreciated over the years may wind up costing you.

A special rule, the Net Unrealized Appreciation (NUA) rule, applies when you receive a tax distribution of employer stock from your plan.

According to this rule, you only pay ordinary income tax on the cost basis of the stock, which is the stock price at the time the plan purchased it for you.

Any appreciation in the stock will receive more favorable long-term capital gains treatment.

However, this rule does not apply if you roll over the stock to an IRA.

The NUA rules must be utilized as part of a full and final rollover from an employer plan.

Before You Roll Over Your 401(k)

Understanding all your rollover options before you make a move is crucial, and seeking professional help before you make your move is advisable.

Each investor’s situation is unique, and speaking with someone may help you avoid costly 401(k) rollover mistakes and may help 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.

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