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Retirement Accounts: Transfer vs. Rollover

Direct vs. Indirect Rollovers

When you move money from one type of retirement account to a different type of retirement account, that's a rollover. But there are two different kinds of rollovers with very different tax implications:

  • A direct rollover is where your money is transferred directly from one retirement account to another. No money is withheld for taxes.
  • An indirect rollover is where you essentially cash out your old retirement plan and re-invest the funds in a new plan in 60 days or less. In this case, 10 to 20 percent of the money is withheld for taxes.

Direct rollovers are pretty simple. In most cases, your retirement account administrator sends the money directly to your new account and you don't have to do a thing. In some cases, your account administrator sends you a check made out to the new IRA "for the benefit of" you [source: Lewis]. The check will read something like "Touchstone Investment IRA FBO John Smith." Your responsibility is to mail the check to the new IRA. Since the money is never technically in your hands -- you can't cash an FBO check -- the IRS does not treat it as income and no taxes are withheld.

Indirect rollovers are a different story. With an indirect rollover, your administrator cashes out your retirement account and sends you a personal check called a rollover distribution. But the check you receive will not be for the full amount in your retirement account. If you are rolling over from an IRA, 10 percent will be withheld. If you are rolling over from a 401(k) or other qualified employee plan, your administrator will withhold 20 percent [source: IRS].

That's because the IRS requires administrators to withhold money from rollover distributions to help cover the taxes that may be owed on that money. Technically, rollover distributions are considered taxable income. Even worse, if you take a rollover distribution before age 59½, you must pay a 10 percent early withdrawal penalty.

The good news is if you re-invest the funds in a new retirement account within 60 days, you won't owe any taxes or penalties. Here's the trick, though. The IRS requires that you re-invest the exact amount that was in the old retirement account, including any money that was withheld. So if your 401(k) was worth $10,000, and the administrator sent you a check for $8,000 (the total minus 20 percent), you will need to come up with $2,000 of your own money to re-invest the full $10,000 in a new IRA [source: IRS]. You'll get back the withheld $2,000 in the form of a tax credit.

Because of the potential tax implications of indirect rollovers, most investors opt for direct rollovers.

Now let's look at the difference between rollovers and retirement account transfers.