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What is a Direct Rollover?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 13 September 2016
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Direct rollovers are transactions that move the assets of one type of retirement or pension plan to a similar qualified pension plan. By going with one simple transaction to accomplish this task, it is possible to avoid the necessity of paying taxes on any funds accumulated in the originating plan, as there was not actually any payout made to the individual covered under the terms of the plan. In fact, the individual has to do very little to execute a direct rollover, other than authorize the transfer from one plan to another.

One common example of a direct rollover occurs when an individual chooses to leave a current employer in order to take a position with a different employer. Any retirement funds accumulated under the plan operated by the former employer must be disbursed with a specified period of time. The former employee essentially has two options: receive a cash payout of any funds in the plan or roll the balance over to a new retirement plan.

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If the decision is to receive a cash payout, the individual must count the funds as income in most cases. This means that the proceeds received as cash are subject to taxation and will be counted as part of all income earned for the current tax period. By contrast, a decision to do a direct rollover means the individual is not receiving the immediate benefit from the balance of the retirement plan and the balance is not counted as current income.

By going with the direct rollover option, the individual continues to save for retirement. The balance of the account is not subject to taxes, since the individual is not receiving the funds for immediate use. Instead, the proceeds continue to be saved for the retirement years and will not be subject to taxes until such time as the funds are withdrawn for retirement in later years. Choosing this option not only preserves the amount of the retirement, but also minimizes the possibility of the individual entering a higher tax bracket, a phenomenon that sometimes happens when a cash payout option is exercised.

While the funds involved in a direct rollover are not subject to taxes, the roll over activity must be reported to tax agencies as taking place in a given tax period. This helps to ensure that the transfer to a new qualified retirement plan did take place, and that the individual did not receive any taxable income from the transaction.

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Charred
Post 2

@MrMoody - I always do a direct rollover when I switch employers. However, you should become familiar with the direct rollover rules before you do so.

This would include not only rules as they are laid out by your retirement plan but also those rules laid out by the IRS for such money transfers.

They may have different stipulations depending on whether you are moving from IRA to Roth IRA, or how long the money can be held in a temporary account or things like that. While the general rules are the same from year to year, the tax code does tend to change, so be sure you are up to speed on the specifics.

MrMoody
Post 1

I think that an IRA direct rollover makes sense in most cases. There’s usually no point in taking that money as cash, only to be penalized in taxes.

I have usually done a direct rollover with one exception. It was shortly after I first opened up a 401K for the first time in one company, and was laid off a few years later.

In that time I had very little money in the 401K, and as I was unemployed, I thought I needed all the money I could get my hands on, in reserve. So I took the cash payment (which wasn’t a lot) and paid the typical penalty.

It wasn’t a lot, and in the end, it turned out I didn’t even need it – I found a new job in short order and didn’t have to tap the retirement funds. Still, I think it was a prudent decision in that case.

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