401(k) 411

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In this post:

This is a series that I posted to the Facebook group a while back.   I’ve aggregated those posts and pasted them all below, to make them easier to find and review. The formatting isn’t great, because it’s just a copy/paste from the Facebook group.  I’ll probably come back and clean it all up a bit, down the road, but for now…

 

The 401(k) 411 – Introduction

Do you have access to a 401(k)? Do you use it? Do you have any questions about how to get the most out of your 401(k)? I’m putting together a series of posts about 401(k)s and similar retirement plans like 403(b)s. Let me know if there’s anything you’d like to see covered!

What is a 401(k)? A 401(k) is a tax-advantaged, employer-sponsored retirement account named after the subsection of the Internal Revenue code that defines it. There are other very similar employer-provided retirement accounts such as the 403(b), which can be thought of as a special 401(k) for employees of public schools and nonprofits. There are a few differences between these various types of employer-provided retirement accounts, but for the purposes of this series of posts, we’re just going to use the term 401(k) as a catch-all.

Here are a few important defining characteristics of 401(k)s to get us started and maybe generate some questions:
  • Provided by employers – Not every employer will choose to provide a 401(k). Employers that do provide them can set eligibility criteria for their employees. Folks who are are self-employed and have no employees (other than a spouse) can choose to set up a solo401(k) in which they act as their own employer.
  • Tax-deferral – The portion of your income you choose to contribute to a 401(k) is not taxed at the time of contribution. This can provide a significant reduction to your tax bill in the year that you make the contribution. However, it is not tax-free. When you eventually withdraw funds from a 401(k) in retirement, those withdrawals are taxed at the regular income tax rates for the entire amount of the withdrawal, not just the gains.
  • Contribution limits – Federal law limits contributions to 401(k)s. In 2021, that limit is $19,500 for employees under 50 years of age. Those over 50 can contribute up to $26,000 per year.
  • Employer contributions – Employers may also contribute to these accounts on behalf of their employees, often in the form a matching contribution.
  • After-tax contributions – Some plans allow employees to contribute additional funds above the $19,500 limit. These contributions are called “after-tax” because they are paid with regular taxable income. In other words, you don’t get the initial tax deduction for these types of contributions.
  • Combined limits – The total combined yearly contribution limits, including employee contribution, employer contribution, and after-tax contributions, is currently $58,000, or 100% of your income if your total income is lower. For those 50 and over, the limit goes up to $64,500.
  • ROTH 401(k) – Some 401(k) plans allow for “Roth” contributions. This is an alternative option of tax savings that you may choose if you expect that your taxes in retirement will be higher than your current taxes. Instead of taking a tax deduction on this year’s contributions and then paying regular income tax on the withdrawals, a Roth 401(k) is funded with after-tax dollars, and future withdrawals in retirement are 100% tax-free.
  • Early withdrawal penalties – The 401(k) is set up to encourage saving for retirement. In order to prevent people from using it as a tax shelter for income they plan on using before retirement, there is a penalty charged for withdrawals taken before a defined retirement age. Currently that age is 59 and a half, and the penalty is an additional 10% on top of the regular income tax that you’ll have to pay.
  • Required minimum distributions – Because 401(k)s are intended as retirement savings vehicles and not as a means of generating a perpetual stream of tax-sheltered wealth for heirs, there are rules that require you to eventually withdraw (ie “distribute”) your funds. The current age at which this happens is 72, and the amount you have to withdraw comes from actuarial tables define by the IRS.

 

401(k) 411 – EMPLOYER MATCH

An employer matching contribution to your 401(k) is the easiest, safest free money most people will ever have access to. It’s a guaranteed return on your investment that can be up to 100%. And yet you might be surprised to find out that 20% of people with access to an employer match don’t take advantage of it!
Does your employer offer a match? What’s the structure of it? Many employers offer something like a 50% match up to 8% of your pay. Others may offer a 100% match, often up to a lower percentage of your income. My last employer gave a 6% contribution even if the employee contributed nothing!
If you’re not sure about your employer’s match, or whether you’re taking full advantage of it, contact your employer and find out! The immediate and guaranteed return provided by an employer match is so powerful that even folks with thousands of dollars in high-interest credit card debt should consider taking full advantage of their employers match before paying down that debt! (As long as they’re able to make the minimum payment on the debt.)

Self-employed/Solo 401(k)

Since 401(k)s are employer provided, does that mean that self-employed folks are out of luck? No!
If you have your own business and have no full-time employees (other than a spouse), then you can set up your own 401(k) for your business! There are plenty of account providers out there and you can open an account with them pretty much as easily as any other investment account. The cool thing about Solo 401(k)s is that you get to make the employee and the employer contributions! That means you have a much higher effective contribution limit each year. Just like with a regular 401(k), employees in 2021 can contribute up to $19,500 each year (or 100% of their earnings, whichever is lower). Then, as the employer, you also get to make a “company match” contribution up to 25% of your yearly pay, to a maximum combined employee/employer total of $58,000. And those limits are even higher if you’re 50 years old or more.
If you’re self-employed, then I highly recommend setting up a solo 401(k). But before you do, make sure you’re definitely eligible! Aside from having no full-time employees, your business has to be engaged in “active” production of goods or services. Income that the IRS defines as “passive” does not count. So, unfortunately, income from rentals, royalties, or other K-1 distributions is excluded.

Tax deferral vs Roth Contributions

The primary benefit of a 401(k) (other than any employer match you may receive) is that it allows for tax-deferred growth of a portion of your income. You don’t pay income tax on any contributions that you make in a given year. Instead, you defer that tax until retirement, when you withdraw the funds. Additionally, you don’t pay any taxes on dividends or capital gains that occur while the money is in the 401(k). Instead, those gains are simply included in the income tax that you pay when you withdraw the funds. This deferral of taxes allows you to potentially invest more money than you would have been able to if you had to pay income tax on your full income. It also allows your earnings to take full advantage of compound interest, without being lessened by capital gains/dividend taxes.
And perhaps most importantly, most people expect to be in a lower tax bracket during retirement. So, when the time comes to make withdrawals from your 401(k) and finally pay your deferred income taxes, the hope is that you will be paying a lower rate during retirement than you are paying now.
Not everyone is as hopeful about what tax rates will look like in the future, though. Maybe you believe that taxes will go up significantly before you retire. Maybe you have passive income from rentals and royalties that will keep you in a higher tax bracket during retirement. Or maybe you are simply saving so much now that when you retire you plan on spending as much or more money each year than you currently do. In any of those cases, you may want to consider looking into a Roth 401(k).
Roth 401(k)s are typically offered right alongside traditional 401(k)s. You simply tell your employer how much of your contribution should go into the traditional 401(k), and how much should go into the Roth 401(k). Unlike traditional 401(k) contributions, the portion of your income that you put in a Roth 401(k) comes from after-tax dollars. Your taxable income does not decrease and you pay full income tax rates on the amount that gets contributed, as if you were paid that amount directly. However, once the money is in the Roth account, it will now grow tax-free and will remain tax-free when you withdraw it in retirement.
What this means is that you get to make a choice: Pay taxes now, or pay taxes later. Which one makes the most sense for you will depend on your current tax bracket and how much you expect to be taxed when you retire.

After-tax, non-Roth contributions

Last time we explored the difference between traditional and Roth 401(k) options. Those are by far the most common ways people choose contribute to their 401(k)s.
However, there is one more type of contribution you can make to a 401(k) that gets a bit more complicated: After-tax contributions to a traditional 401(k). This works a bit like a combination of traditional and Roth: The after-tax funds that you contribute will grow without taxes on the earnings until you make a withdrawal. When you withdraw that money, you don’t pay tax on after-tax contribution that you make (after all, you already paid tax on that before you contributed it!) and you do pay ordinary income tax on the earnings. And since after-tax contributions have already been taxed, you can withdraw the contribution amount at any time without tax or penalty, even before retirement age. There is one major caveat there, though: Any earnings associated with those after-tax contributions are “attached” to them, and if you withdraw any of the after-tax amount, those associated earning must be withdrawn as well. So if you do that before retirement age, you will be paying taxes plus a 10% penalty on the earnings.
The main reason people choose to make after-tax contributions to a traditional 401(k) is that they have already maxed out their regular contributions. In this case, their only options are either making after-tax 40(1k) contributions, or investing in a regular taxable account. If you don’t need the funds until retirement, choosing after-tax 401(k) contributions can have a bit of an advantage in the long run due to the untaxed growth compounding over the years. There are also special cases like the “backdoor Roth” and “mega backdoor Roth” in which you can roll over after-tax contributions into a Roth IRA for further tax savings. But that’s a whole other can of worms, and we’ll save that for another time.

Pitfalls and risks

There are a lot of advantages to funding a 401(k). The employer match is easily the best risk-free return on investment available. The tax benefits can save you tens or even hundreds of thousands of dollars over the long-term. And the protection from creditors can be invaluable in some situations. But it’s worth noting that there are some downsides to using a 401(k) that you should consider.

  • Early withdrawal penalty: If you need the money in your 401(k) before you reach “retirement age” (as defined by the IRS, currently 59.5) then you will pay a 10% penalty on the amount you withdraw. This is on top of the income taxes that you will also have to pay, and is 10% of the total amount, not just the investment gains. Let’s say you have a non-medical emergency that’s too big to cover with your emergency fund, and the only other savings you have is in your 401(k). So, you withdraw $10,000 from the 401(k). If you’re in the 22% tax bracket, you’ll pay $2,200 in taxes on that withdrawal. You’ll also pay another $1,000 in penalties. That leaves you with only $6,800 of your $10,000 withdrawal.

    There are exceptions that allow you to withdraw funds from a 401(k) without penalty. These are:

– Medical expenses (if they exceed 10% of your AGI),
– disability,
– rollovers to another 401(k) or IRA, and
– distributions made to beneficiaries in the case of the account-holder’s death.
  • Fees: Some 401(k) providers charge relatively high fees, or offer only high-fee mutual funds for you to invest in. Sometimes, these fees are high enough that your long-term net growth will barely be better than wise investing in a non-tax-advantaged account. You’ll have to run some numbers to see if your provider’s fees will be a problem for you, but in general, you want the fees to be less than 1%.
  • Fund selection: Many 401(k)s provide a very limited selection of funds for your investments. These funds may not provide access to the kinds of investments you’d prefer, or they may have high fees associated with them.
WHAT TO DO ABOUT IT?
To avoid the early withdrawal penalty, be sure to have a decent emergency fund saved up in a non-retirement account. I recommend at least six months worth of expenses, but what works for you will vary depending on your circumstances.
If your 401(k) has high fees or offers a poor selection of funds, talk to your company about it! Find out who deals with the 401(k) and politely let them know that there’s a problem, and that there are other 401(k) providers who may also be less expensive for the business, as well. Encourage your co-workers to do the same. It may not work, but it’s probably worth a try! I did this with a previous employer, and they changed providers! It took a couple of years of reminding them every few months, though…
If you can’t convince your employer to change 401(k) providers, then I’d recommend the following: Contribute enough to max out your employer match. Then, contribute to a traditional or Roth IRA at a low-fee provider. Then–once you’ve accounted for non-retirement savings, bills, and other monthly expenses–if you still have enough left in your paycheck to contribute to the 401(k), go ahead. Just be sure to be careful about your fund selection!

RMDs

You can’t defer your income taxes forever! The government is still counting on income taxes in order to fund itself. And remember, the purpose of a tax-deferred retirement account like a 401(k) is to incentivize savings specifically for retirement, not amassing generational wealth for your heirs.
That’s where RMDs come in. In order to make sure that you use your 401(k) for funding your retirement–and the government gets it’s expected income–you are required to start taking distributions from your account when you turn 72. These “Required Minimum Distributions,” are determined in part using actuarial tables defined by the IRS. The simple version is that you take your account balance at the end of the last year and divide it by your “life expectancy factor” from the IRS’s tables. As you get older, that number get’s closer and closer to “1”. The resulting of that equation is the minimum amount that you are required to withdraw by the end of the year. The actual calculation can get complicated, depending on your mix of accounts, marital status, age of your spouse, and several other factors. Fortunately, many retirement account providers will do the calculations for you. If you want to play around with the numbers to get an idea of how it works, here’s a handy calculator provided by AARP: https://www.aarp.org/…/required_minimuum_distribution…

If you’re math-savvy, you’ve probably noticed that this formula is designed so as to leave you with a zero balance in your 401(k) at the end of your life. This doesn’t mean you won’t have the money anymore–just that it will no longer be in the 401(k)… and you will have paid income taxes on the entire amount. If you pass before your 401(k) is empty and your beneficiary is someone other than your spouse, then–as of 2020–that person has 10 years to empty the account, paying income taxes on the amount as they go. Thus you cannot use a 401(k) or other tax-deferred retirement account as a way of avoiding or deferring taxes on the kind of wealth that would be passed down through many generations.

 

PENALTIES
Making sure to take the required minimum distribution is no joke. If you fail to do so in any given year, the penalty is 50% of the difference between what you took and what you were supposed to take. That can mean thousands of dollars! And it’s important to remember that the the RMD rule applies to all tax-deferred retirement accounts. This includes 401(k)s, 403(b)s, most small business retirement accounts, and all forms of IRAs other than Roth IRAs. You need to take the required distribution from each one, and on time! One good way to avoid this is to set up automatic distributions with your provider(s).

And remember, there’s no rule that says you have to spend those distributions. It might be a good idea to transfer your distributions to a regular taxable investment account, or at least a savings account, depending on how immediately you might need the funds.

 

EXCEPTIONS
There are a few instances where you are allowed to avoid these minimum distributions. The main one is: If you are still working at age 72 and your 401(k) is with your current employer, then you don’t have to take RMDs from that 401(k). Note that if you still have an old 401(k) from a previous employer that you didn’t roll over into your current 401(k), that you still need to take RMDs from the older account(s).

Other exceptions happen from time to time, but are extremely rare. For instance, RMDs were suspended in 2020 due to COVID-19. But that exception has already expired and RMDs are back for 2021.

 

CHANGES COMING
The rules for RMDs have been changing lately, so if/when you’re nearing your 70s it is important to double-check the latest updates. In 2019, the age where RMDs kick in was increased from 70.5 to 72. There’s been a push in congress to increase that age further to 75. In 2020, recipients of inherited 401(k)s can no longer take RMDs based on their age, but instead have to ensure that the entirety of the account is distributed within 10 years. (Beneficiaries that inherited a 401(k) prior to 2020 can still use the old rules.) And of course, the IRS is constantly updating its actuarial tables based on changing life expectancies.

Early retirement options

The average American retires at around 64 years old. But for many people, retirement may come before that. Some folks carefully plan and invest for an early retirement, but even if you’re not planning on retiring early, circumstances may change! You may find yourself with an unexpected inheritance or other windfall. Or, you might get laid off in your 50s and decide that you’d rather stretch your retirement dollars a bit more than you originally planned instead of going back to work for a few more years.

No matter how it happens, if you retire early you may need to access funds in 401(k) before you’re 59.5. Your specific options may vary based on your situation, but in general, these are the options you have for withdrawing funds from a 401(k) before age 59.5 without the 10% penalty.

 

RULE OF 55

If you leave your job (voluntarily or not) during or after the year that you turn 55, you may be able to take distributions from your current 401(k) without penalty. Note that not all 401(k) providers allow this, so it depends on where you work. Also not that this is only for current accounts. Old 401(k)s from prior employers are not eligible. If your 401(k) doesn’t allow this, or if you don’t turn 55 during or before the year that you stop working, you’ll need to use one of the other methods below to access your 401(k) funds without penalty.

 

RULE 72T (SEPP)
This one is a common option for folks who end up retiring a few years earlier than expected, and who don’t have enough savings in non-retirement accounts to hold them over until 59.5. “Rule 72t” allows for early distributions without penalty at any age–but it comes with some serious caveats. If you decide to set up distributions under rule 72t, you have very little choice about how much you can withdraw and when. You must set up “Substantially Equal Period Payments” (SEPP) using one of three very specific IRS calculation methods to determine the amount. (Learn more about the methods and play with some numbers using this 72t calculator: https://www.bankrate.com/…/72-t-distribution-calculator/) And you are required to withdraw that amount every year for at least five years, or until you turn 59.5–whichever comes later. So, if I decided to start taking SEPP distributions today, at age 40, I would have to continue to take equal amounts each year until I turn 59.5. Likewise if someone retires at age 58, they will have to take five annual SEPP distributions of the calculated amount–even though they will turn 59.5 well before their last SEPP distribution. If you discontinue SEPP distributions before meeting the minimums, you will owe the 10% early withdrawal penalty on the total amount of your SEPP withdrawals–even if you only missed one payment out of the required total.

One thing to note about setting up 72t/SEPP withdrawals is that the calculation is based on the dollar amount of the specific account that you choose. You do NOT have to use the total of all your retirement accounts. So, if you have a few IRAs, a current 401(k), and an older 401(k) from a previous employer, you can choose to take SEPP withdrawals from only one or two of those accounts. This can be a good way to choose the amount of your required withdrawals, keeping it in line with what you’ll need for expenses without dipping too far into your retirement reserves. Remember, leaving as much as possible in your retirement accounts for as long as possible can significantly increase your overall returns.

 

ROTH CONVERSION LADDER
While the above two options are what I would recommend to someone who unexpectedly retires a few years early, there is another option for those are are planning ahead for an early retirement. In the past, we’ve covered the options for rolling over a 401(k) into other types of retirement accounts. One such rollover option is a Roth IRA. And one of the special rules for rollovers into Roth IRAs is that, five years after the rollover, you have complete access to the funds without any taxes or penalties. Sounds great, right? But there are a few catches.
The first is that 5-year waiting period. In order to make this work, you need to have either a five-year buffer in a non-retirement account, to live on between your last paycheck and the time that you can start taking withdrawals from the Roth IRA, or you need to start the rollover process five years before your last year of work. This latter option is only available if your current 401(k) allows “in-service” distributions, or if you have an old 401(k) from a prior employer that you can roll over while you continue to work and contribute toward your current 401(k).
The second catch can be more complicated. You have to be very careful to set up the rollovers in a way that doesn’t cause an extremely high income tax bill. Remember, when you roll a traditional 401(k) into a Roth IRA, you don’t have to pay the an early withdrawal penalty, but you do have to pay income tax on the total amount of the rollover. If you wait until the date of your early retirement, and then rollover your entire 401(k) all at once, you are likely rolling over hundreds of thousands of dollars… all of which will be included as income on your taxes that year, and will push you well into the higher tax brackets.
The way to avoid this issue is to do the Roth conversion a little at a time, year after year. That’s where we get the “ladder” part of Roth conversion ladder. It also means that your 401(k) provider needs to allow partial rollovers, which many don’t. If you hope to use the Roth conversion ladder to fund an early retirement, be very careful to make sure that your circumstances allow it!

Old 401(k)s and rollovers

“What are some of the consequences of rolling old 401K plans into current ones? I was dissuaded from doing so because I was told I would pay penalties and taxes though I’ve seen conflicting information online.”
Thanks for this question, Jeremy!
The short answer is that there are no taxes or penalties for rolling over a 401(k) from one employer’s plan to another.
The slightly longer answer is that not all 401(k) plans allow you to do this, and you have to be careful to set it up as a direct transfer/rollover, and NOT as a distribution.
The even longer answer is that even if you can roll your old 401(k) into your new one, you may not want to if the new 401(k) has higher fees or does not offer the kinds of investments that you want to use. In this case, you may choose to keep the old 401(k) where it is, or roll it into an IRA or a Roth IRA.

If that answers your question, great! If you want to learn more, keep reading. I’ll go step-by-step through the process I would take if I were considering a 401(k) rollover.

 

STEP ONE: DECIDE WHY YOU WANT TO ROLL OVER YOUR OLD 401(K).
Not all 401(k)s are created equal. Some have reasonable management fees, while others are very expensive. Some offer excellent investment choices for your funds, and some… not so much. So the very first thing I would do if I had a new 401(k) would be to decide if rolling my old one into it is even desirable. I would look at the fee structures of the two accounts and see which was cheaper. And I would look at the investment options in each account and see which one has the types of funds that I would want to be invested in. If your new 401(k) only has high expense ratio mutual funds, and your old plan had cheaper index funds that you’re happy with, then there’s really very little reason to roll everything into the new account.

If I am unhappy with the fees or the investment options at my old 401(k), then I can consider a rollover. HOWEVER, the rollover does NOT have to be into a 401(k) at my new employer. That brings us to…

 

STEP TWO: DECIDE WHERE MOVE THE OLD 401(K) FUNDS
That’s right. If I’m not happy with my funds in their old 401(k), I have fours options:
1. Rollover to the 401(k) at my new provider
2. Rollover into a Traditional IRA
3. Rollover into a Roth IRA
4. Withdraw the funds as a distribution and pay income taxes plus a 10% penalty on the distributed amount. (This is a bad idea. Don’t do this.)
 
If your new 401(k) has reasonable fees, good investment options, and allows transfers in from outside accounts, go for it! There are no taxes or penalties for this kind of rollover. Just make sure you set up the rollover correctly… more on that later.
If your new 401(k) doesn’t have preferable fees and investment options, you may choose to roll your old 401(k) into an IRA account. We’ll explore more about IRAs and Roth IRAs another day, but for now the important part is that these are “Individual” retirement accounts instead of “employer sponsored.” There are IRAs provided by all sorts of banks and investment firms, and you can find all sort of investment options and fee structures by shopping around those various providers. Want your retirement funds invested in real estate? You can do that with an IRA. Want your retirement funds invested in gold? There’s an IRA that will let you do that. How about putting your entire retirement savings into bitcoin? That sounds like a terrible idea to me, but of course, there’s an IRA for that too. (Personally, I have my IRA at one of the big online investment companies. It has no management fees, and provides access to a ton of very good index funds and low-fee mutual funds.)
There is very little downside to rolling your 401(k) into an IRA. Just find the IRA that has the investment options you’re looking for and work with them to initiate the rollover.
If you choose to set up a traditional IRA, there will be no taxes or penalties on the rollover. Your funds will continue to grow tax-free, and you will pay regular income tax on distributions when you retire, just like a 401(k).

If you choose to set it up as a Roth IRA, there are still no penalties, but there will be taxes. Roth IRAs are funded with after-tax dollars, grow tax-free, and then unlike 401(k)s and trad IRAs, distributions from Roth accounts are also 100% tax-free. One additional benefit of rolling over to a Roth IRA is that after five years, you are allowed to withdraw your initial rollover amount with zero penalty, and zero additional taxes. (Remember, you already paid income taxes on the amount of the rollover at the time of the rollover.)

 

Some other things to note:
  • Creditor protection: Some folks might be concerned about the creditor protection differences between 401(k)s and IRAs. In case you didn’t know, 401(k) accounts are nearly completely protected from creditors in the case of bankruptcy or lawsuits. Only the IRS, an ex-spouse in a divorce proceeding, or a couple of other very rare and specific cases can make claims on the funds in a 401(k). IRAs have different protections that are not always as comprehensive, depending on which state you live in. In all states, funds rolled over from a 401(k) to an IRA keep their bankruptcy protection. Non-bankruptcy protection (this is generally protection in the event of a lawsuit or other court order) can vary from state to state, though. Most states protect IRA funds from lawsuits just as much as your 401(k) would be protected. Others have a lower level of protection. So, you’ll want to check out your state law if you’re concerned about this.
  • Company stock: Many companies allow employees to access company stock in their 401(k)s. There are some significant tax benefits to just keeping this stock in that 401(k). Another option with similar tax benefits is to roll that stock over to a regular brokerage account instead of an IRA. This can get complicated, but if you do it right, then when you eventually sell that stock, you will pay long-term capital gains taxes on it, instead of regular income as you would if you rolled your whole account into an IRA. And long-term capital gains taxes are almost always lower than regular income taxes. If this situation applies to you, I would recommend working with a tax professional to make sure it’s done right.
  • Are you over 55 years old, but less than 59.5? If you are, and you are no longer employed, 401(k)s allow for penalty-free distributions. If you roll into an IRA, however, you’ll have to wait until you’re 59.5 before you can withdraw without penalty.
STEP 3: MAKE THE ACTUAL TRANSFER
OK, so you have decided that you’re not happy with the old 401(k)’s fees or investment options. You’ve decided to roll it over into a different retirement account. What next?
Well, if you were hoping to put it into the 401(k) at your new employer, you first have to make sure that they allow transfer in from outside accounts. Not all 401(k)s do! Contact whoever it is at your new place of work that helps new employees set up 401(k)s. This is usually someone in HR. They will be able to tell you if your plan allows transfers, and if it does, they can get you the paperwork required.
If they don’t allow it, then set up an IRA account, and ask the provider for help initiating a rollover.
Either way, it is incredibly important that you set it up correctly, because you want to ensure that the transfer is a direct rollover, and not a distribution. What’s the difference? A rollover happens when the old provider sends a check directly to the new provider (or in rare cases, they send the check to you, but it’s written out to your new provider). A distribution happens when the check is written out to you, instead of to the new 401(k).
If you or your old 401(k) provider makes a mistake, and you end up with a check written out to you, there is still a way to make things right, but it can be painful and may require you to dip into your savings, temporarily.

When a 401(k) cuts a check to you, they will almost always withhold about 20% for taxes. The only way to get that 20% back is via your tax return. So, until then, you will have to cover the difference from your savings. That means that if you trying to roll over an account worth $100,000, and the check is made out to you, it will be for $80,000. You will have have to contribute the additional $20,000 from your own savings in order to make the rollover complete, and then get reimbursed via your tax return. If you don’t cover the $20k, that portion will be considered a distribution, and you will have to pay taxes and penalties on it. Finally, you have to ensure that all of the funds are deposited into the new retirement account within 60 days, otherwise it will be considered a distribution and you will owe taxes plus a 10% penalty on whatever balance of the rollover is not in the new account.

 

STEP 4: MAKE SURE THE FUNDS IN YOUR NEW ACCOUNT ARE INVESTED APPROPRIATELY
Whether you chose the new 401(k) or an IRA, your final step is to make sure that they rolled-over funds get invested in the way that you want them. Many times after a rollover, your money will be held in “holding” fund that is equivalent to cash or a money market fund with a very small return. Don’t let it sit there! Get it invested in your investment of choice as soon as possible. It’s a terrible feeling to check on your new account after a year of amazing stock market gains and suddenly realize that your money was sitting in a cash fund that whole time and hasn’t grown at all!

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