Here's How to Do a 401(k) Rollover Right, According to a Financial Planner

As a Certified Financial Planner® who spent nearly a year studying for the certification exam, I know better than most how many complicated rules retirement accounts can have. Not only is that frustrating to users, but it also opens the door to costly mistakes people don't even realize they're making.

This happens a lot with 401(k) rollovers. While cashing out your account might seem like the quickest and easiest option, it often creates more headaches than it's worth. Fortunately, there is a way to sidestep problems with the IRS, and it's easier than you think.

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Why you'll regret cashing out your old 401(k)

Cashing out your old 401(k) -- requesting that the plan administrator cut you a check for the balance -- can trigger tax penalties because the government may consider it a distribution. This could force you to pay ordinary income taxes on the balance, plus a 10% early withdrawal penalty if you're under age 59 1/2 at the time.

You can avoid these tax consequences by depositing the funds into a new 401(k) or IRA within 60 days of cashing out your old account. But that's trickier than it sounds, too. When you cash out your old account, your plan administrator must withhold 20% for taxes by law. But you still need to deposit that 20% into your new account, or else it'll be considered a distribution.

That means if you cash out a 401(k) with $10,000, you'll only receive a check for $8,000, and you'll have to come up with the remaining $2,000 on your own. If you can do this, you'll get the withheld $2,000 back with your tax refund. If not, that money goes toward covering your tax liability for the distribution.

Save yourself the headache by doing a direct rollover

Doing a direct rollover, whereby you direct your old 401(k) plan administrator to send your funds straight to your new plan, is a much better strategy if you want to avoid immediate tax consequences. Once you have the new account set up and ready to accept funds, all you have to do is share the details with your old plan administrator. Your new plan provider may be able to help you figure out what information you need to provide.

There's usually a small, one-time transfer fee associated with this. But the money comes directly out of your account, so you don't receive a bill.

If you do it correctly, the IRS won't tax you on any of the money in the year of the transfer, unless you're moving money from a traditional 401(k) to a Roth IRA. That would be a Roth IRA conversion.

If you have any questions about the possible tax consequences of your 401(k) move, check with an accountant for personalized advice. Do this before you begin your rollover to make sure you know exactly what to expect.

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