Qualified Plan Rollovers and 20% Withholding

A client recently complained that his 401(k) plan sponsor made an error and withheld 20% for taxes when all he did was “roll my funds over to an IRA.” He was under the impression that transferring his 401(k) to his IRA was a tax-free and penalty-free transaction. Ultimately, yes, it would be tax and penalty-free but there’s a small catch…

When a distribution is made from a qualified plan directly to a plan participant, the plan sponsor is required to withhold 20% for federal income tax purposes.

In this case, instead of requesting a trustee-to-trustee transfer or “direct” rollover, the client’s paperwork revealed that he actually requested a distribution of eligible funds from his qualified plan to be paid directly to himself, not to his IRA.

Of course this client can still complete a timely rollover (within 60 days) with the amount he received and use out of pockets funds to make up the difference. Alternatively, he may choose to treat the missing 20% as ordinary taxable income on his return. However, this client is only 52 years old so if he elects to keep the 20% as a distribution, he will owe ordinary income taxes on that amount plus an additional 10% early distribution penalty since he is under 59½ years old.

If you intend to do a simple, tax-free and penalty-free transfer of your qualified plan to an IRA, make sure you have the correct forms and your transfer paperwork is filled out accurately.

If you are confused or are unsure what transfer or rollover forms you need, don’t hesitate to reach out to your local retirement distribution professional for assistance.