As a financial advisor, I help clients navigate rolling over old 401(k)s to IRAs all the time. But what about people who don’t have a financial expert to rely on? They’ll most likely look to the internet for advice.
I noticed something recently though. The articles and blogs online only give guidance on the first step of a rollover, which is how to initiate one.
I couldn’t find an article that explained what happens after the rollover takes place, which is when some of the most important work actually begins.
That’s because rolling over a retirement plan to another retirement plan is considered a tax-free event. However, if you don’t report the rollover properly, you could be surprised with a tax deficiency letter from the IRS and possibly many hours spent resolving the issue.
Fear not! This is your complete rollover guide — from start to finish — so you’ll never miss a step in the process.
Before Starting a Rollover
Before actually beginning the rollover process, you’ll need to decide where you want your money to go.
If you have an old employer retirement plan — like a 401(k), 403(b), etc. — there aren’t very many reasons you’d want to leave it there.
Having multiple accounts at different custodians (the financial institution that holds your money) makes it really difficult to keep track of your finances. By simply rolling over an old retirement plan to another one you will greatly simplify your account structure.
Does your new employer retirement plan accept rollovers? If so, are you comfortable with putting your money there? If you already have an Individual Retirement Account (IRA), would you rather put it there?
Here is a nifty guidethe IRS provides that can help you choose which type of retirement plan you can roll in to.
Rollover Initiated
Once you’ve decided where the money will be going, you’re going to begin the actual rollover process.
There are a few ways I usually see rollovers initiated:
- With a rollover form that the old custodian will give you
- With a phone call to the old custodian
- With transfer paperwork from your new custodian
It’s at this point that your first major decision takes place because you’ll have two ways the money can be delivered.
Option 1. Have the money sent directly to your new custodian. This is the simplest type of rollover since the money goes from one account to the other, with no involvement or responsibility on your part. This is known as a direct rollover, or trustee-to-trustee transfer.
Option 2. Have the money sent to you and then you forward that money to the new custodian. This is known as an indirect rollover.
With an indirect rollover, the day you take possession of the money you have 60 days to turn around and put that money into another retirement account. Even if you’re one day late, the entire distribution will become subject to income taxes and the 10% early withdrawal penalty if you’re under the age of 59 1/2.
Outside of some advanced planning strategies, I would generally avoid indirect rollover at all costs because they can be difficult to manage.
After the Rollover Occurs
Okay, the money is in your retirement account but you’re not done yet!
Even though you aren’t required to pay tax on this type of activity, you still must report it to the Internal Revenue Service.
At the end of the year — or early the following year — that your rollover took place, you will receive a Form 1099-R from the custodian who sent the money. The IRS will also be receiving one. That’s because your rollover is reported as a distribution, even when it’s rolled into another eligible retirement account.
It’s up to you to properly report the rollover on your tax return to avoid paying taxes. To do this, you’ll need to write in the amount shown on the 1099-R on line 4a and a zero on the taxable amount on line 4b. Write “rollover” or “R/O” in the blank space beside it. This will explain to the IRS why the distribution amount shown on line 4a is more than the taxable amount shown on line 4b.
And thats it! After your taxes are filed and the rollover has been reported, you are finally done!
Incorrect Reporting
Keep in mind that when a rollover isn’t reported properly, you’ll receive Notice CP2000 from the IRS asking for the taxes you owe them. I know because it’s happened to me!
If the rollover went into your IRA, you’ll receive Form 5498 from your custodian that can be used to substantiate your case. Make sure you keep these in your tax file.
If the money is sent to an employer retirement plan (401k, 403b, etc.) you won’t receive Form 5498 and it will require a little more work on your end to show the IRS that it was, in fact, a rollover.