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The likelihood of rolling over a retirement account at least once during one’s working years is fairly high. That’s why it’s important to learn the best transfer strategies based on your financial situation. Following are a few tips to clear the confusion behind rolling over your company retirement funds into another account:

How to dodge a hefty tax withholding penalty

If you leave your current job—whether or not it’s by choice—take it as an opportunity to promptly rollover your 401(k) into an IRA account. Your money has a higher potential for growth there, as an IRA provides many more investment options than would be available in your former 401(k) or in a new employer’s retirement plan.

At your request, your former company will gladly issue you a check for the full vested balance of your account. Be careful, however, because if the check is made out to you, it is required to withhold 20% for federal income tax. That could be a serious chunk of money, considering you may also have to pay a 10% federal penalty on the withdrawal if you are under age 55. You also won’t recover that 20% until you file taxes the following year.

Here’s what to do to avoid the 20% withholding tax: schedule a “direct” rollover, also known as a “trustee-to-trustee” rollover. This means you request the distribution check from your former retirement plan to be made out in the name of the trustee or financial institution of the new IRA account where you wish to rollover the funds.

Check with the bank or brokerage firm that will act as your IRA trustee or custodian for exact instructions for how the check should be made out to avoid any confusion or errors.

Next, you should make sure your former employer’s retirement plan is aware you are making a direct rollover. You will most likely be asked to complete a form where you will describe how your distribution check should be written. When you receive the check, make sure you deposit it in your new IRA within 60 days.

If you’re worried about accidentally missing that 60-day window, you may instead be able to request a direct rollover via a wire transfer from your former company’s plan account to your new IRA.

When an IRA rollover isn’t the best option 

If your former company’s retirement plan holds some appreciated employer stock, it may be in your best interest to withdraw the shares and hold them in a taxable account in lieu of rolling them into an IRA.

If all your company retirement accounts are completely liquidated in the same year and you receive those shares as part of a lump-sum distribution, then you’ll only owe taxes on the sum your company paid for the stock. Remember, if the stock has been appreciating, this could be a small portion of its current market value.

The benefit is the net unrealized appreciation (difference between the market value on the distribution date and the plan’s cost for the shares) when you receive the shares will mean you’ll have lower tax rates on long-term capital gains. You also won’t have to pay that tax until you sell the shares. Any additional appreciation is also eligible for lower long-term capital gains rates if you keep the shares more than a year.

Rule for tax-free rollovers: cash to cash, stock to stock

If you withdraw cash from a retirement plan account, to avoid penalties, you must roll over that same amount of cash into your IRA. It’s the same case if you’re transferring funds from one IRA to another. Don’t make the mistake of withdrawing cash from an IRA or 401(k), buying stocks with those funds, and then trying to roll them back into your account. That type of transfer is prohibited and you’ll promptly be taxed on the withdrawal. If you’re younger than 59 1/2, you will additionally owe the 10% “premature withdrawal” penalty tax.

To avoid this situation, first transfer the cash from your retirement plan account into your IRA and then purchase your desired stocks. The same goes for withdrawing stock from a retirement plan or IRA account: you can’t sell the shares and then transfer over an equal amount of cash. You’re also prohibited from rolling over different shares of equal value.

IRA-to-IRA transfers

If you are simply rolling over funds from one IRA to another, you won’t be responsible for paying that dreaded 20% federal income tax. The check from one IRA can be made out in your name with no penalty as long as you transfer the funds into the other account with 60 days and you have not made any other IRA rollovers in the past year.

The bottom line: the rules behind rolling over IRAs can get tricky, so it’s best to double check with a financial professional before completing your transaction to make sure you do it right.

Author Ron L. Brown, CFP®

Ron is a CERTIFIED FINANCIAL PLANNER™ and President of R.L. Brown Wealth Management. He specializes in retirement, estate, and business planning for professionals and entrepreneurs. Ron assists his clients with creating a financial plan to ensure they are able to live their ideal lifestyle during retirement and leave a strong legacy for their family. Ron has been featured in The Wall Street Journal, US News, Yahoo Finance, Investopedia, and numerous other high profile financial publications.

More posts by Ron L. Brown, CFP®
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