Indirect Rollover

What Is an Indirect Rollover?

An indirect rollover involves the liquidation of assets where the administrator of the 401(k) issues a check in the name of the account holder. The account holder is then responsible for depositing the money into a new 401(k) plan or IRA.

An indirect rollover can take place at two different times. First, there is the in-service 401(k) rollover, where an account holder rolls over from a 401(k) into a traditional IRA or Roth IRA while still being employed. Second, there is the “after-service” rollover that takes place when an account holder switches jobs. This can be a rollover into another 401(k) or an IRA.

There is also the option to do a direct rollover, which entails a trustee-to-trustee transfer. It may or may not involve a liquidation of underlying assets depending on the trustees involved.

To determine whether an indirect rollover is right for you, consider your retirement plan and whether it aligns with your goals.

A rollover is a sensible way to consolidate your retirement accounts and reduce unnecessary administrative burden. When moving funds from a traditional account to a Roth-style account, a rollover can also help you avoid future taxes, assuming the market environment is conducive.

Thomas J. Brock, CFA®, CPAInvestment, Corporate Finance and Accounting Professional

Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.

How Does an Indirect Rollover Work?

First, the administrator of the existing 401(k) will liquidate the assets. Then — unlike a direct rollover — the administrator will deduct a 20% withholding tax (WHT) on the amount realized. After that, they will issue a check for the post-tax funds in the name of the account holder. Finally, the account holder will deposit the funds into the new 401(k) or an IRA, depending on whether it is in-service or after-service.

If the rollover is directed to another 401(k) or a traditional IRA, the account holder does not owe taxes. Instead, taxes will be paid when the account holder withdraws money from the account in retirement. Therefore, the account holder can recover the amount of taxes withheld when filing their annual tax return. To recover the taxes withheld, the account holder will have to deposit the whole pre-tax funds into the new 401(k) or traditional IRA.

For example, if the funds in the existing 401(k) is $50,000, the administrator will deduct $10,000 as WHT and give $40,000 to the account holder. To recover this tax withholding, the account holder will have to deposit the entire $50,000 into the new 401(k) or the traditional IRA.

If the account holder only deposits the post-tax funds — in this case, $40,000 — then they will recover the $10,000 already paid. However, they will still incur taxes on the $10,000, which will now be taken as a distribution or withdrawal. Additionally, an early withdrawal penalty may be incurred.

If the rollover is into a Roth IRA, taxes will be paid on the current funds while later withdrawals from the account will be tax-free. In this case, the account holder does not need to deposit the whole pre-tax funds since they cannot recover the WHT already paid. However, they will still pay the difference between the actual tax liability and the tax withholding to the IRS.

Do Indirect Rollovers Have Rules?

According to an article from the IRS, indirect rollovers must be completed within a 60-day window. This is known as the 60-day rollover rule. If the rollover is not completed within 60 days, the IRS considers it a distribution or withdrawal. Consequently, it will be taxed. If it’s not a qualified distribution, the account holder will have to pay penalty on the withdrawal.

Another important part of the 60-day rollover rule is the one-rollover-per-year rule. This means that account holders can only make one rollover within a 12-month period. However, this rule has exceptions where account holders can do more than one rollover in a 12-month period:

When Account Holders Can Do More Than One Rollover in a Year

• Trustee-to-trustee (direct) rollover
• Traditional IRA to Roth IRA conversion
• Rollover from or to a qualified retirement plan

Since a 401(k) is a qualified retirement plan (QRP), an indirect rollover from or to a 401(k) is an exception to the one-rollover-per-year rule.

Is an Indirect Rollover Right for You?

The main advantage of an indirect rollover — when compared to a direct rollover — is the opportunity to take a loan. Many account holders use the 60-day rollover rule to take loans from their 401(k) while still in service. You cannot take loans with a direct rollover since the funds never get to your account. So, if you want to take a zero-interest, short-term loan within the first 60 days, an indirect rollover may be right for you.

On the other hand, the major disadvantage of an indirect rollover is taxation. If you are rolling over to a 401(k) or a traditional IRA, you will need to deposit the whole pre-tax funds. Following our previous example, this means you will have to look for an extra $10,000 to avoid incurring tax on the WHT already paid — which will be taken as a distribution. In other words, if you don’t deposit the tax paid, your indirect rollover will lead to higher taxes compared to a direct rollover.

Also, you will incur taxes and possible penalties if you don’t complete an indirect rollover or redeposit the funds back into the 401(k) within 60 days. The whole funds withdrawn will be treated as a distribution.

So, should you make a direct or an indirect rollover? It all depends on your situation. There are advantages and disadvantages to an indirect rollover when compared to a direct rollover. Before you decide, speak to your financial advisor to help determine which option is best for your financial needs.