401(k) Rollover Mistakes That Cost Retirees Thousands

Rolling a 401(k) into an IRA sounds straightforward. Write a check, open an account, done. In practice, it is one of the most mistake-prone transactions in personal finance, and several of those mistakes are permanent.

The Indirect Rollover Trap

When you take a distribution directly, your plan is required to withhold 20% for federal taxes. If you asked for $500,000, you receive $400,000. You now have 60 days to deposit the full $500,000 into an IRA, which means you have to come up with the missing $100,000 out of pocket. Miss the deadline or come up short, and the shortfall is treated as a taxable distribution, plus a 10% early-withdrawal penalty if you are under 59½.

The fix is simple: always request a direct trustee-to-trustee transfer. Your old plan sends the money straight to the new custodian. No withholding, no 60-day clock, no scramble.

The Once-Per-Year IRA Rollover Limit

Many people do not know this rule exists until they have already broken it. The IRS allows only one indirect (60-day) rollover between IRAs in any 12-month period, across all your IRAs combined. A second one inside that window is a taxable distribution. The penalty on, say, a $200,000 mistake at a 32% marginal rate is $64,000 in federal tax alone, before state taxes.

Again, trustee-to-trustee transfers are not subject to this limit. They can happen as many times as you need. The once-per-year rule applies only when you take personal possession of the money.

NUA: The Rule Most Advisors Skip

If your 401(k) holds company stock that has appreciated significantly inside the plan, rolling it into an IRA may actually cost you money. Under Net Unrealized Appreciation rules, you can instead take a lump-sum distribution of the stock, pay ordinary income tax only on the original cost basis, and then sell the shares outside the plan at long-term capital gains rates on the growth.

I had a client, illustrative example, who had $180,000 in company stock with a $40,000 cost basis. Rolling it into an IRA would have eventually taxed all $180,000 as ordinary income. Using NUA, only $40,000 hit his ordinary rate. The remaining $140,000 of gain was taxed at 20% long-term capital gains rates. The difference was over $30,000. This is the kind of analysis that belongs in the Soil layer of a retirement plan, where tax architecture decisions are made before assets move anywhere. (You can read how we think about that at The Sporos Doctrine.)

When Leaving Money in the Old Plan Makes Sense

Two situations favor staying put. First, if you retire at 55 or older in the year you separate from service, 401(k) distributions avoid the 10% early-withdrawal penalty. IRAs do not get that exception until age 59½. Second, some 401(k) plans offer institutional-class funds at expense ratios retail investors cannot match. A plan charging 0.03% on a bond index fund versus 0.15% available elsewhere is a real number worth running.

What to Do This Week

Pull your most recent 401(k) statement and check two things: whether the plan holds any company stock with a low cost basis, and what penalty-free distribution rules apply given your age and separation date. Those two data points alone will tell you whether a standard rollover is the right move or whether a different path deserves a closer look.

The information provided is for educational purposes only and does not constitute investment, legal, or tax advice. Consult with qualified professionals for guidance specific to your situation.