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How do I avoid paying taxes on a 401(k) rollover?

According to a Marist Poll released in September 2022, roughly 4 in 10 (38%) Americans have switched jobs since 2020. This movement is known as the Great Resignation, which is motivated by the desire for better compensation, including health benefits and retirement accounts. In this article, we’ll explain how to rollover 401(k) funds without incurring a tax liability.

401(k) options when changing jobs

One of the concerns with transitioning to a new job is how to retain all the retirement savings you built up at your previous job. Some companies will allow you to keep your current 401(k) with them, but you’ll pay a fee for them to maintain it. A common practice is either rolling over your 401(k) with your new employer or cash it out. There are several ways to do this.

Rollover into a new 401(k): This is the simplest and most cost-effective way to handle this. If your new employer has a 401(k) plan, speak to the plan administrator about rolling over your retirement savings. This typically involves signing a few forms and allowing the 401(k) provider to handle the transition for you.
Rollover into an IRA: There are two types of IRAs. A traditional IRA accumulates with pre-tax contributions, like a 401(k). Contributions to a Roth IRA come after taxes have been taken, so a rollover will incur a tax liability. Those taxes will need to be paid when you file income tax for the year you initiated the rollover.
Take a check for the entire balance: Cashing out the 401(k) may seem like a good idea because you get all the money in one lump sum, but it’s the least cost-effective way to handle your money. There will be a tax liability and a penalty for doing this if you’re under 59 ½ years old. We’ll get into that in more detail below.

Taxes and penalties for 401(k) withdrawals and rollovers

A 401(k) rollover directly to another 401(k) does not come with a tax liability. The contributions are tax-deferred on a 401(k), so you won’t need to pay taxes until you start taking distributions in retirement. This is an advantage for you because income is typically lower in your golden years, putting you in a lower tax bracket.

Traditional IRAs are built with pre-tax contributions, so you can do the rollover without a tax liability. If you’re rolling over into a Roth IRA, you’ll need to pay taxes. In both cases, your maximum contribution levels will go down. In 2023, the IRS allows up to $6,500 a year in contributions to an IRA, $7,500 if you’re over 50. The maximum for a 401(k) is $22,500.

You’ll need to pay regular income tax on 401(k) funds rolled into a Roth IRA. That ranges from 10% to 37%, depending on your income bracket. Keep in mind that the funds themselves will push you into a higher income bracket. Taking a check could be worse. You’ll pay a 20% flat tax plus another 10% penalty for withdrawing the funds before retirement age (59 ½).

The Bottom Line

The best way to avoid paying taxes on a 401(k) rollover is to roll it into a 401(k) account at your new employer. That process is tax-free. If it’s unavailable, your next best option is to rollover into a traditional IRA, which is also a tax-free transition. Rolling over into a Roth IRA incurs a tax liability of 10% to 37%. Cashing out will cost you 20% plus a 10% penalty for early withdrawal.