Are 401(k) Rollovers Really Taxable? – Avoid This Mistake + FAQs

Rolling over a 401(k) can be one of the smartest moves for your retirement—but do it wrong and you could face an unnecessary tax bill.

Over 10 million 401(k) rollovers occur each year, moving about $1.1 trillion in retirement assets, yet many Americans are unsure about the tax consequences.

Key Takeaways:

• Most 401(k) rollovers are not immediately taxable under federal law if done correctly (taxes are deferred until you withdraw in retirement) ✅
• Direct rollovers (trustee-to-trustee transfers) avoid taxes and the 20% mandatory withholding; indirect rollovers (taking a check) can trigger withholding and potential taxes if not completed within 60 days ⚠️
• Rollover to a Roth IRA = Taxable conversion 💸 – Moving pre-tax 401(k) funds into a Roth account means you’ll owe income tax on the amount rolled over (since Roths are funded with after-tax money)
• No early withdrawal penalty – A properly executed rollover (completed on time) does not incur the 10% early distribution penalty (that penalty only hits if you actually take money out and don’t roll it over)
• State taxes generally mirror federal rules 🌐 – Most states won’t tax a qualified rollover, though future withdrawals may be taxed as income (unless you live in a state with special retirement income exclusions)

Are 401(k) Rollovers Taxable? Here’s the Answer (Federal & State)

Under federal law, a 401(k) rollover is typically not a taxable event if done correctly.

When you move funds from a qualified retirement plan like a 401(k) into another eligible retirement account (such as an IRA or another employer’s 401(k)), you generally do not include that amount as taxable income in the year of the rollover.

In IRS terms, you’re simply transferring your retirement money, not cashing it out. This tax-free treatment applies to traditional (pre-tax) 401(k) funds rolled into a traditional IRA or another qualified plan. The money continues to be tax-deferred until you eventually withdraw it in retirement.

However, there’s an important exception: Rollover to a Roth account. If you choose to roll over pre-tax 401(k) funds into a Roth IRA (or a Roth 401(k) account), it will be taxable. Essentially, this type of rollover is a Roth conversion, meaning you’re converting tax-deferred money into after-tax money.

The amount you convert must be reported as income on your tax return for that year. For example, rolling over a $50,000 traditional 401(k) into a Roth IRA will add $50,000 to your taxable income for the year, potentially bumping you into a higher tax bracket.

You’d owe federal income tax (and state tax, if applicable) on that $50k, though no early withdrawal penalty would apply, since it’s a qualified rollover. The upside is that once in the Roth IRA, those funds can grow tax-free and qualified withdrawals in retirement will be tax-free.

Designated Roth 401(k) balances, on the other hand, can be rolled into a Roth IRA tax-free (since you already paid taxes on Roth contributions). In summary:

• Traditional 401(k) → Traditional IRA or new 401(k): No immediate tax (tax continues to be deferred).
• Traditional 401(k) → Roth IRA: Taxable event (you’ll owe income tax on the rolled amount, as a Roth conversion).
• Roth 401(k) → Roth IRA: No immediate tax (it stays within the Roth family, so no tax due on rollover; future qualified withdrawals remain tax-free).

It’s worth noting that proper reporting is required even for a non-taxable rollover. You’ll typically receive a Form 1099-R from your 401(k) plan reporting the distribution, and if it was a direct rollover, it will be coded to show it’s not taxable.

On your tax return, you’ll list the rollover amount but indicate $0 as the taxable portion (assuming it was all rolled over correctly). The IRS gets a heads-up that the money moved, but they see it wasn’t a taxable withdrawal.

What About State Taxes on a Rollover?

For the most part, states follow the federal treatment on retirement rollovers: if it isn’t taxable federally, it isn’t taxed at the state level in the year of rollover.

A direct 401(k) rollover to an IRA is not taxable for state income tax purposes either, as long as it meets the federal requirements for a tax-deferred rollover. The rolled amount won’t show up as taxable income on your state return, so you won’t owe state tax at rollover time.

That said, state tax nuances can come into play when you eventually withdraw the money in retirement. States have varying rules on taxing retirement income:

• A handful of states have no state income tax at all, so any distributions (now or later) are state-tax-free. (Eight states, including Florida and Texas, levy no personal income tax, meaning your 401(k)/IRA withdrawals won’t be taxed by those states.)
• Some states exclude or deduct retirement income up to certain limits. For example, a state might allow you to subtract some of your 401(k)/IRA withdrawals after you reach a certain age or exclude certain types of retirement pay.
• Others tax retirement plan withdrawals fully, just like the feds, but might exempt other types of income (common: most states don’t tax Social Security benefits, and a few tax 401(k)/IRA distributions but not pensions).

The key point is: a rollover itself (moving the money) isn’t creating taxable income if done properly. You’re preserving the tax-deferred status of your retirement savings. But once that money is later paid out to you in retirement, it becomes income—taxable by the feds and by your state, unless your state law says otherwise.

Always check your state’s rules if you’re unsure, but rest assured that moving your 401(k) to an IRA or another plan now won’t suddenly trigger a state tax bill. (One exception: if you cash out and don’t roll over, that would be taxable income federally and in most states.)

Bottom line: Under federal law, 401(k) rollovers are tax-free events in most cases. You won’t pay taxes at rollover time unless you convert to a Roth. States generally conform, so a qualified rollover won’t be taxed by your state either. Just be mindful of taxes when you eventually withdraw your savings, and plan for any Roth conversion taxes if you go that route.

⚠️ Common 401(k) Rollover Mistakes That Trigger Taxes (and How to Avoid Them)

Even though rollovers should be straightforward, there are several pitfalls that can turn your well-intentioned rollover into a taxable (and costly) mess.

Here are some common mistakes people make with 401(k) rollovers – and how to avoid them:

Pitfall 1: Missing the 60-Day Rollover Deadline 🕒

If you opt for an indirect rollover (where your 401(k) plan sends you the check and then you deposit it into a new IRA or plan), you must redeposit that money within 60 days. This 60-day window is strict. Miss the deadline, and the entire amount becomes a taxable distribution.

The IRS will consider it as if you withdrew the money completely. You’ll owe income taxes on the full amount, and if you’re under age 59½, you’ll likely get hit with a 10% early withdrawal penalty on top.

For example, if you took a $50,000 distribution intending to roll it over but missed the 60-day cutoff, that $50k is now ordinary income for the year – a potentially big tax bill and a $5,000 penalty (unless you qualify for an exception).

How to avoid it: Start the rollover process ASAP and mark your calendar well before the 60 days are up. Better yet, use a direct rollover to skip this deadline altogether.

If an emergency or error causes you to miss the deadline, the IRS does have a self-certification process to waive the 60-day requirement for specific hardships (e.g. a serious illness or lost check), but it’s better not to go there if you can avoid it.

Pitfall 2: Taking Possession of the Money (Indirect Rollover Woes) 💼

Many people mistakenly have their 401(k) balance paid out to them personally when leaving a job, thinking they can just roll it over themselves.

The trouble is, when a 401(k) distribution is paid to you, the plan is required to withhold 20% for federal taxes. So, if you had $100,000 in your 401(k), you’d receive a check for $80,000 – your employer withholds $20,000 and sends it to the IRS as a pre-payment.

You can still roll over the $80,000 (within 60 days) and even get that $20,000 back at tax time if you complete the rollover properly, but to avoid any tax on the full $100k, you’d need to come up with that missing 20% ($20k) out of pocket and include it in your rollover.

Otherwise, the IRS will treat the withheld $20k as if you cashed it out. Let’s illustrate:

• Scenario: Jordan (age 42) leaves her job and indirectly rolls over a $10,000 401(k) balance. The plan withholds $2,000 (20%), so she gets a check for $8,000 in hand.
  • If Jordan deposits only the $8,000 she received into an IRA, she’s effectively rolled over 80% of her distribution. The remaining $2,000 will be reported as taxable income, and she’ll owe income tax plus a 10% penalty on that $2k (since she’s under 59½).
  • If Jordan comes up with $2,000 from her savings and rolls over the full $10,000 into her IRA, then nothing is taxable now. She will report a $10,000 rollover (non-taxable) on her tax return and claim the $2,000 as taxes paid (the withheld amount, which will count toward her tax bill or refund).

Failing to replace the withheld amount turns part of your rollover into a taxable withdrawal.

How to avoid it: Whenever possible, do a direct rollover (money moves directly trustee-to-trustee). If you did get a check payable to you, try to roll over the full gross amount – which means you’ll need to use other funds to cover the amount withheld.

Remember, the 20% withholding is just a default – your actual tax could be more or less, but you’ll reconcile that at tax filing. Avoid the headache by not letting the money touch your hands at all.

(Note: If the check is made out to your new IRA or plan for your benefit (FBO), and just mailed to you to forward, that’s technically a direct rollover and no withholding applies.)

Pitfall 3: Rollover of an RMD (Required Minimum Distribution) 🎯

Once you reach the age for required minimum distributions (RMDs) – currently age 73 for most retirees as of 2023 (it was 72 under the SECURE Act 2019, and will move to 75 in coming years) – you cannot roll over your RMD.

An RMD is the government-required withdrawal of a portion of your retirement account each year. By law, RMDs are not eligible for rollover. If you try to roll it over, you’ll run into problems: the rollover amount will be off, and you could face a 50% excise tax on the amount of the RMD for not actually taking it as required.

Common mistake: Someone retires, turns 73, and decides to roll their 401(k) to an IRA. They forget that the year they turn 73 (or 72 under prior law), the first dollars out of the 401(k) are deemed to satisfy the RMD.

So if they roll over the entire account, they unintentionally attempted to roll the RMD too. The correct approach would be: take the RMD amount out first (pay taxes on that RMD as normal income), and then roll over the remainder.

How to avoid it: If you’re subject to RMDs, ensure you take any required distribution before doing a rollover of the rest. RMDs can’t be deferred or avoided via rollover – the IRS wants its tax on that portion now.

(Also, note that Roth 401(k) accounts were subject to RMDs in the past, but starting in 2024, Roth employer accounts no longer have RMDs thanks to SECURE 2.0 law change. This means fewer folks will face this pitfall when rolling over Roth 401(k)s to Roth IRAs, but traditional accounts are still subject to RMD rules.)

Pitfall 4: Exceeding the “One Rollover per Year” Rule 🔄

This one trips up people rolling IRAs more often, but it’s worth mentioning. The tax code allows you to do only one IRA-to-IRA indirect rollover in any 12-month period (this does not apply to direct transfers).

If you take possession of IRA funds and roll them into another IRA, you can’t do another 60-day rollover from any of your IRAs for a year.

A famous tax court case in 2014 shut down the loophole of doing multiple rollovers from different IRAs – now it’s one total, not one per account.

How does this affect 401(k) rollovers? If you roll a 401(k) to an IRA and later want to move that IRA again via 60-day rollover, be careful. While the initial 401(k)-to-IRA rollover does not count toward the one-per-year limit (nor do direct transfers), any subsequent IRA-to-IRA rollover would.

Also, if you for some reason take an IRA distribution and roll it into a 401(k) (less common, but sometimes done to consolidate accounts or enable a backdoor Roth strategy), that would count as your one rollover.

Violate this rule and the second rollover is treated as a taxable distribution (and possibly an excess contribution if you put it into another IRA).

How to avoid it: The simplest advice is to use direct trustee-to-trustee transfers whenever possible, especially with IRAs. Direct rollovers between plans or plan-to-IRA aren’t limited.

If you must do a 60-day rollover, keep track of the date and don’t do another from any of your IRAs for a year. (This rule can be confusing – when in doubt, consult a tax professional.)

Pitfall 5: Rolling Over After-Tax 401(k) Contributions Incorrectly 💡

Some 401(k) plans allow after-tax contributions (not to be confused with Roth 401(k); these are after-tax dollars in the traditional 401(k) bucket). If you have after-tax money in your 401(k), you have a great opportunity during rollover – but also a pitfall if you’re unaware.

The opportunity: You can direct the plan to send your after-tax contributions to a Roth IRA (where future gains become tax-free) and send the pre-tax portion to a traditional IRA. This way, the after-tax dollars get converted to Roth tax-free (since you already paid tax on them).

The pitfall: If you instead roll everything into a traditional IRA together, those after-tax dollars (called “basis”) will be co-mingled in the IRA. You won’t owe tax on the rollover, but you’ll now have to track that basis on IRS Form 8606 for years to come, and any future IRA withdrawals will be taxed proportionally on the pre-tax portion. You’d lose the chance to get that clean, tax-free Roth conversion of the after-tax money.

How to avoid it: Check your 401(k) statement or ask HR if you have any after-tax contributions (apart from Roth). If yes, consider a split rollover – direct the after-tax portion to a Roth IRA and the rest to a traditional IRA.

Most plan administrators can do this in a single distribution with two checks/direct transfers. If you’re not sure, get advice from a financial planner to make the most of it. It can mean more tax-free money for you in the long run.

Pitfall 6: Forgetting Special 401(k) Tax Breaks (NUA and Age 55 Rule) 🔍

These aren’t rollover “mistakes” per se, but important to mention:

• Net Unrealized Appreciation (NUA): If you hold employer stock in your 401(k), rolling it over might not always be the best tax move. There’s a special tax break where you can take the stock out of your 401(k) and pay only capital gains tax on the growth when you sell, instead of ordinary income tax (this is the NUA strategy).
• If you roll that stock into an IRA, you lose the NUA opportunity and future withdrawals will be taxed as ordinary income. So, if you have a lot of company stock, consult a pro before rolling it – sometimes it’s better to transfer the stock to a brokerage account (pay tax on the original cost only) and roll over the rest.
• Age 55 Exception: If you separated from your job at age 55 or older (age 50 for certain public safety jobs), you can take distributions directly from the 401(k) without the 10% early withdrawal penalty. This is a valuable exception if you need income before age 59½.
• But if you roll that 401(k) into an IRA, you generally lose this age-55 penalty exemption. Any withdrawals from the IRA before 59½ would incur the 10% penalty (unless you qualify for another exception). So if you think you might need those funds in the interim, you might avoid rolling all of it to an IRA right away.
• One strategy is to roll over most of the money but leave an amount you might need in the 401(k) to use under the age-55 rule.

Avoid these pitfalls by planning your rollover carefully. Stick with direct rollovers whenever possible, mind the 60-day deadline if you do get a check, handle any special components (like after-tax money or company stock) with care, and be aware of any unique rules that apply to your situation (age, etc.). A little foresight can save you from an unwelcome tax surprise. 😅

🗝️ Key Terminology for 401(k) Rollovers (Direct vs. Indirect, Roth Conversion, RMDs)

Before we go further, let’s clarify some key terms you’ll encounter in the rollover process. Understanding these will make the whole topic a lot easier:

• Direct Rollover: This is the gold standard for moving retirement money. In a direct rollover, the funds go straight from your old 401(k) to the new retirement account (whether an IRA or new employer’s plan). You never touch the money. Often this is done by the plan sending a check payable to your new account (for example, “Fidelity FBO [Your Name]”) or an electronic transfer.

• Because the money isn’t made payable to you, no tax is withheld and the transaction is not taxable at the time. The IRS encourages direct rollovers – in fact, rolling over directly means no 20% mandatory withholding applies. On tax forms, direct rollovers from a 401(k) are typically coded with a “G” on Form 1099-R, indicating a direct rollover/transfer.

• Indirect Rollover: Also known as a 60-day rollover, this is when the 401(k) plan cuts a check to you personally, and then you have up to 60 days to deposit those funds into an IRA or another qualified plan.

• With an indirect rollover, the plan by law must withhold 20% for federal taxes from a pre-tax 401(k) distribution (you’ll get the rest). If you complete the rollover, that withheld amount is credited toward your taxes, but you still have to make up the 20% from your own pocket to roll over the full amount.

• Indirect rollovers give you a short-term use of the money (some people briefly use it as an interest-free loan during the 60 days), but they’re risky – miss the deadline or fail to roll over the full amount, and part or all of the distribution becomes taxable. Also, remember the one-rollover-per-year rule applies to indirect rollovers between IRAs (though not for 401(k)-to-IRA or plan-to-plan). Whenever possible, opt for a direct rollover instead, to keep things simple and tax-safe.

• Roth Conversion (Rollover to Roth): In the context of rollovers, a Roth conversion means taking money from a tax-deferred account (like a traditional 401(k) or traditional IRA) and rolling it into a Roth IRA. Because Roth accounts are funded with after-tax money, you’ll owe income tax on the amount converted at the time of the rollover.

• This is a voluntary taxable event – essentially pre-paying taxes now in exchange for tax-free growth and withdrawals later. For example, converting a $100k 401(k) to a Roth IRA might add $100k to your taxable income this year. Roth conversions via rollover are common when people expect to be in a higher tax bracket later, or want to leave tax-free money to heirs.

• Note: if you have a designated Roth 401(k) (which is already after-tax), rolling that into a Roth IRA is not a conversion (no tax due, since it was after-tax to begin with).

• Also keep in mind that converting to Roth starts the 5-year clock on withdrawals of earnings (a Roth IRA rule), and you should plan to have funds to pay the tax from outside the retirement account. Always weigh the pros and cons (and possibly consult a financial advisor) before doing a big Roth conversion rollover.

• Required Minimum Distribution (RMD): These are the mandatory withdrawals that must start once you reach a certain age (for traditional 401(k)s and IRAs). As mentioned earlier, currently age 73 (if you reached 72 before 2023 it was 72; legislation is pushing it to 75 in coming years).

• RMDs cannot be rolled over – they’re essentially the government saying “time to take some money out and pay taxes.” If you’re doing a rollover in a year you have an RMD, you must take the RMD out first, separately. RMDs are calculated based on account balance and life expectancy each year.

• Importantly, if you continue working past RMD age and do not own 5%+ of the company, you may be able to delay RMDs from your current employer’s 401(k) until you retire (this is the “still working” exception). But IRAs don’t have that exception (RMD always by age 73).

• Also, note that Roth IRAs have no RMDs for the original owner, whereas Roth 401(k)s did have RMDs but that requirement ends in 2024 due to a recent law change.

• This term is key in rollovers because you cannot include an RMD in a rollover – doing so would be an excess contribution in the new account and come with penalties. Always satisfy any RMD requirement first, then roll over the rest.

• Eligible Rollover Distribution: This phrase simply means a distribution from a retirement plan that is allowed to be rolled over to another plan or IRA.

• Most distributions are eligible, except things like RMDs, hardship withdrawals, certain periodic payments, or corrective distributions.

• When your 401(k) gives you the paperwork or notice about your distribution, it will usually spell out if your amount is an “eligible rollover distribution.”

• If it is, you have the option to roll it into another plan/IRA (and thus defer taxes). If it isn’t (e.g. if it’s an RMD or a hardship withdrawal you took), then you can’t defer taxes via rollover on that amount.

• Tax Withholding (Mandatory 20%): If you take a distribution from a 401(k) that is payable to you (not directly rolled over), the plan must withhold 20% for federal income tax upfront.

• This is not a penalty or tax in itself, but a prepayment of the tax the IRS assumes you might owe. You can get it back if it turns out you didn’t owe that much (or any, because you rolled over the full amount including substituting that 20%). IRAs, by contrast, have a default 10% withholding on distributions to you, but you can opt out.

• Direct rollovers avoid withholding entirely, which is one reason they’re preferable. If you live in a state with income tax, there may be state withholding on distributions too (varies by state), but again, direct rollovers usually bypass that.

These terms cover the basics you need to navigate the rollover process. If you understand these, you’ll be able to ask the right questions and make the best decisions for keeping your rollover tax-free.

Examples: How Different 401(k) Rollover Scenarios Are Taxed 📊

Let’s walk through some real-world examples of 401(k) rollovers and their tax outcomes. The following scenarios illustrate what happens in various cases – direct vs indirect rollovers, traditional vs Roth, etc.

Assume in all cases the person is under 59½ (so early withdrawal penalties could apply if something goes wrong), and the federal marginal tax rate is 22% for illustration.

Example 1: Direct Rollover from Traditional 401(k) to Traditional IRA

Situation: Maria has $50,000 in a 401(k) from her old job. She initiates a direct rollover to her traditional IRA at a brokerage. The 401(k) plan sends the funds electronically directly into her IRA.

Tax result: No taxes withheld, no taxable income now. The entire $50,000 goes into her IRA. Maria will pay taxes later when she eventually withdraws from the IRA in retirement. On her tax return, she’ll report a $50,000 rollover, $0 taxable. This is considered a non-taxable transfer—no tax due until future withdrawal.

Penalty: None. This isn’t a distribution to her personally, so no early withdrawal concerns.

Example 2: Indirect Rollover (60-day) from Traditional 401(k) to IRA

Situation: John leaves his job with $20,000 in his 401(k). He requests a payout to roll over himself. The plan cuts him a check for $16,000 (having withheld $4,000 in federal taxes, 20%).

John deposits the $16,000 into a new IRA 10 days later. He doesn’t have spare cash to replace the $4,000 withheld, so only $16,000 gets rolled over.

Tax result: John will owe income tax on the $4,000 that was withheld and not rolled over. Come tax time, he’ll report $16,000 as a non-taxable rollover and $4,000 as a taxable distribution. The $4,000 will be taxed at his ordinary rate (say 22%, so about $880 in federal tax).

Additionally, because he’s under 59½, the $4,000 not rolled over is subject to a 10% penalty (an extra $400). The $4,000 withheld is applied toward his tax bill, but it wasn’t enough to cover all the tax and penalty in this case.

Had John managed to roll over the full $20k (by adding $4k from his savings), nothing would have been taxable or penalized, and he’d get credit for the $4k withholding on his tax return.

Penalty: Yes, on the portion not rolled ($4k), because he’s under 59½. This could have been avoided by rolling over the full amount.

Key lesson: Indirect rollovers can be tricky—John essentially lost $4,000 from his retirement account to taxes and penalty due to not rolling it all over.

A direct rollover would have been cleaner (no withholding to worry about).

Example 3: 401(k) Rollover to Roth IRA (Roth Conversion)
Situation

Lisa has a traditional 401(k) with $100,000. She decides to roll it directly into a Roth IRA to take advantage of tax-free growth (a strategic Roth conversion). She arranges a direct rollover from her 401(k) to a new Roth IRA.

Tax result: Because this is a rollover to a Roth, the entire $100,000 is treated as taxable income in the year of the rollover (essentially, Lisa is converting pre-tax dollars to after-tax). Assume she’s in the 24% federal tax bracket.

This adds $100k of income, resulting in about $24,000 in federal taxes due (and potentially state income tax if her state applies additional tax). There is no 20% mandatory withholding on a direct rollover to a Roth IRA. Lisa needs to make sure she can cover the tax bill from other funds.

The benefit: that $100k is now in a Roth IRA growing tax-free, and she’ll never pay tax on it again if withdrawals are qualified.

Penalty: None. Although it’s taxable, it’s not penalized because it’s a rollover/conversion (the 10% early withdrawal penalty does not apply to funds converted to Roth—only to funds taken out and not rolled over).

However, if Lisa withdraws money from the Roth IRA within five years of the conversion (and before age 59½), a penalty could apply to those withdrawals. But the conversion itself isn’t penalized.

Key lesson: Rolling a 401(k) into a Roth IRA will cost you upfront in taxes. It can be worth it long-term, but you need to plan for the immediate tax impact.

Example 4: Roth 401(k) to Roth IRA Rollover
Situation

Kevin has $30,000 in a Roth 401(k) from a previous employer. He rolls it directly into his Roth IRA.
Tax result: No tax now. Both accounts are Roth (post-tax money). The rollover of a designated Roth account to a Roth IRA is tax-free and not reported as taxable income. The entire $30k goes into his Roth IRA and will continue to grow tax-free. He will get a 1099-R for the rollover, but it will show that $0 is taxable (often coded appropriately to indicate a Roth rollover).
Penalty: None. It’s a direct rollover. (And since it’s Roth-to-Roth, even if he had taken it out, those contributions were post-tax – but that’s another story. Direct rollover keeps it intact.)
Note: The rollover does not reset the age of contributions in the Roth IRA for withdrawal purposes. His Roth 401(k) contributions count as contributions in the Roth IRA. However, the 5-year rule for the Roth IRA itself starts from when he first opened any Roth IRA. In many cases, this rollover has no negative effect and actually avoids the RMD that Roth 401(k)s would have had if he left it in the plan.

Example 5: Rolling Over After-Tax Funds Separately
Situation

Sarah’s 401(k) balance is $50,000, of which $40,000 is pre-tax contributions and earnings, and $10,000 is after-tax contributions (non-Roth). She does a direct rollover but smartly directs the $10k after-tax portion to her Roth IRA, and the remaining $40k to her traditional IRA.

Tax result: The $40k to the traditional IRA is not taxed now. The $10k to the Roth IRA is also not taxed – because those were after-tax dollars (she had already paid tax on that $10k when earned). Essentially, she has converted $10k of after-tax funds into a Roth IRA with no additional tax.

Any earnings that were on that after-tax money in the 401(k) would go with the $40k (they were pre-tax earnings). Now, Sarah has $10k more in her Roth IRA that will yield tax-free earnings going forward.

Had Sarah instead rolled all $50k into a traditional IRA, she’d still owe no tax now, but she’d have to track that $10k as basis in her IRA and eventually part of each withdrawal would be tax-free. Splitting the rollover simplified her future and got more into Roth.

Penalty: None, as it’s a direct rollover.

Key lesson: Use the rules to your advantage. The IRS allows direct rollovers of after-tax contributions to a Roth IRA – a great way to boost your Roth savings without tax, as long as you execute it right.

These examples underscore a few big takeaways: direct rollovers keep things tax-free, indirect rollovers can be done but require caution (and often extra cash to cover withholding), Roth conversions will cost you now but potentially reward you later, and special cases (Roth funds, after-tax funds) have their own twist.

Below is a handy table summarizing some of the scenarios and their tax treatment:

📝 In the above table: “Immediate Taxable” refers to whether the rollover transaction itself triggers current income taxes. Federal withholding is what the plan must withhold from a distribution to you (not applicable for direct rollovers to another account). Early withdrawal penalty assumes the person is younger than 59½ and no exception applies.

As you can see, the best way to preserve your savings is usually to do a direct rollover to another tax-deferred account or like-kind Roth account. Cashing out a 401(k) is by far the costliest choice tax-wise – between federal, state, and penalty, you could forfeit nearly half your money! Even an indirect rollover, if done carefully, can avoid taxes, but you have to be on the ball.

Next, we’ll compare some options and highlight IRS rules that back all this up.

Comparing Rollover Options and Tax Outcomes 🔄💡

It’s helpful to compare the main options you have when leaving a job with a 401(k): roll it over, leave it where it is, or cash out. We’ve touched on these, but let’s put them side by side in terms of taxes:

• Roll Over to IRA or new 401(k): No immediate tax, as long as you do a direct rollover (or complete an indirect rollover properly). This is generally the smartest move to keep your retirement money growing tax-deferred.

• There are also no penalties for rolling it over. The IRS explicitly notes that when you roll over a retirement plan distribution, you generally don’t pay tax on it until you withdraw from the new plan. This option keeps Uncle Sam at bay for now. (You can roll into an IRA you control, or into your new employer’s 401(k) if they allow it. Either way, taxes are deferred.)

• Leave it in the old 401(k): Also no tax now. If the plan allows you to keep it (most do if over a certain balance), you can just leave it there. No taxes or penalties for leaving it; the money stays tax-deferred.

• You can’t contribute new money to that old plan, but you won’t trigger any tax by doing nothing. You would eventually take distributions in retirement and pay tax then, or later roll it over. One thing to watch: once RMD age hits, you’ll have to start RMDs from that old 401(k) too (unless you’re still working for that company, which usually you wouldn’t be).

• Cash Out (Take a Lump-Sum Distribution): This is where the taxes hit hard. Cashing out means you tell the 401(k) provider to just send you the money without planning to roll it over.

• It becomes a normal taxable distribution. You’ll owe ordinary income tax on the full amount (since contributions were pretax and earnings tax-deferred) and if you’re under 59½, a 10% early withdrawal penalty on top. The plan will withhold 20%, but that might not cover all your taxes.

• When state tax is included, the total tax can approach 40-50% of your balance for a younger worker. Ouch. Plus, you lose all future tax-deferred growth on that money. This option is usually a last resort (or if the balance is very small).

So in a nutshell: both rolling over and leaving it in the plan keep the tax man away for now, while cashing out feeds him immediately. Rolling over gives you more control and often more investment choices (in an IRA), while leaving it in the plan might offer other benefits (like institutional funds or the age 55 penalty exception).

What about rolling into a Roth IRA? That’s essentially a hybrid of rollover and paying tax now. You’re voluntarily taking the tax hit now (like a partial cash out in terms of taxes, except you’re not pocketing the money but moving it to a Roth).

This can be a smart tax strategy long-term, but it’s not tax-free – it’s tax-now, tax-free-later. So if your question is “are rollovers taxable,” a rollover to a Roth is the one scenario where the answer is yes (taxable) – by design.

It’s also worth highlighting that the IRS has a lot of rules to ensure people don’t abuse rollovers to skirt taxes. We’ve mentioned the key ones: the 60-day completion rule, the one-rollover-per-year rule for IRAs, and restrictions on what can be rolled over.

These rules exist so that people don’t continually defer taxes on distributions beyond what’s allowed. A rollover is meant to be a one-time (per distribution) bridge to another retirement account, not a way to float money interest-free for extended periods.

The IRS also provides some safety nets – like the ability to self-certify a late rollover if you met one of the specific hardship reasons (e.g. an error by the financial institution or postal error) – but these are exceptions, not the norm.

Pros and Cons of Direct vs. Indirect Rollovers

To drive home one of the biggest decisions (direct vs indirect rollover), here’s a quick comparison:

As shown, direct rollovers win on simplicity and safety. Indirect rollovers give a bit of flexibility (short-term use of funds), but any mistake can be costly. Many financial experts say there’s rarely a good reason to do an indirect rollover unless you truly need a short-term loan from your 401(k) money. Otherwise, it’s not worth the risk of a taxable event.

Relevant Legal Rulings & Regulations Impacting Rollovers ⚖️

Understanding the history and legal framework can further build your confidence (and credibility) when dealing with rollovers. Here are a few key rulings and rules that have shaped how 401(k) rollovers are treated:

• Bobrow v. Commissioner (2014): This Tax Court case in 2014 had a big impact on IRA rollovers. Bobrow tried to do multiple 60-day IRA rollovers in one year using different IRAs. The court ruled that the one-rollover-per-year limit applies to all IRAs aggregated, not per account.

• The IRS adopted this interpretation starting in 2015. While this case was about IRAs, not 401(k)s, it’s important because many folks roll their 401(k) to an IRA and might later do an IRA rollover.

• The Bobrow rule means you can’t do another 60-day IRA rollover for 12 months after any IRA rollover. Direct transfers are still unlimited. Essentially, Bobrow closed a loophole and now everyone has to be careful to not do more than one indirect IRA rollover in a year.

• IRS Revenue Ruling 78-406 (1978): An older ruling, but foundational – it’s what allows direct trustee-to-trustee transfers to not count as a rollover for the one-per-year rule.

• It clarified that moving IRA money directly between trustees is not a rollover (and thus not subject to the rollover limitations) and is why we emphasize direct transfers; you can do those as often as needed without running afoul of the rules.

• Tax Code & Regs (IRC §§402(c), 408(d)(3)): These sections of the Internal Revenue Code and regulations set the basic rollover rules. They define eligible rollover distributions, the 60-day requirement, and the 20% withholding on plan distributions, etc.

• For instance, IRC 402(c) covers rollovers from employer plans like 401(k)s, stating that if you transfer the distribution to an eligible retirement plan within 60 days, it’s not included in gross income. These laws are implemented in IRS publications and notices.

• SECURE Act (2019) & SECURE 2.0 (2022): These are recent laws that, while not directly about rollovers, affect retirement accounts. The original SECURE Act raised the RMD age from 70½ to 72, and SECURE 2.0 raised it further to 73 (and eventually 75).

• This means many people can wait longer before they have to take money out (and thus before they face the RMD rollover pitfall). SECURE 2.0 also eliminated RMDs for Roth 401(k) accounts starting in 2024, which means fewer unnecessary rollovers of Roth 401(k)s just to avoid RMDs.

• Another provision allows employer plans to let employees do in-plan Roth conversions (which is like a rollover to a Roth within the plan). While these don’t change the fundamental tax rules of rollovers, they influence planning decisions around rollovers.

• CARES Act (2020): As a one-time relief, this act allowed certain COVID-related distributions to be repaid to retirement accounts within 3 years and waived RMDs for 2020. It’s a reminder that in special situations, Congress and the IRS might adjust rollover rules (e.g. giving more time or flexibility).

• For example, those who took a COVID distribution had a 3-year window to roll it back – much longer than 60 days. Though this was temporary, it showed the rollover concept being used as relief (treating repayments as rollovers).

• State-Specific Rulings: While federal law governs the taxability of rollovers universally, occasionally state tax rules can surprise people. For instance, some states have slightly different bases for taxation of retirement income.

• The general guidance is that if it’s federally tax-deferred, the state won’t tax it either in that year. However, be aware of any state-specific guidance, as state tax forms usually mirror federal treatment for rollovers.

In summary, the legal landscape supports the idea that rollovers, when done by the rules, are meant to be tax-neutral transactions. The IRS has provided clear guidelines (60 days, one-per-year for IRAs, etc.) and the courts have upheld those rules (or tightened them, as in Bobrow).

As long as you operate within this framework, you can confidently move your retirement money without incurring taxes or penalties.

FAQs: Common Questions About 401(k) Rollovers and Taxes

Finally, let’s address some frequently asked questions that savers often have (many of these pop up on forums like Reddit and Bogleheads). We’ll give a quick yes/no answer and a brief explanation for each:

• Are direct 401(k) rollovers taxable? No. A direct rollover to an IRA or new 401(k) isn’t considered taxable income. You avoid taxes by transferring funds directly between retirement accounts, keeping the tax deferral intact.

• Is a 60-day indirect rollover taxable if I redeposit the money? No (if timely). As long as you roll over the full amount within 60 days, the IRS treats it as if it went straight over. Miss the deadline or don’t roll it all, and that portion becomes taxable.

• Do I have to pay state taxes on a 401(k) rollover? No (in most cases). If the rollover is tax-free federally, states generally won’t tax it either. You’re just moving funds, not taking a spendable distribution. (Future withdrawals may be taxed by your state, though.)

• Does a 401(k) rollover count as income on my tax return? No (not if done properly). A direct or completed rollover is reported, but as a non-taxable rollover. It doesn’t count toward your gross income for the year.

• Do I need to report a rollover on my taxes? Yes. Even though it’s not taxable, you do report the distribution and rollover on your 1040. The key is you’ll mark it as rolled over, so the taxable amount is zero.

• Will I get a 1099-R for a rollover? Yes. The 401(k) provider will issue a 1099-R showing the distribution. For a direct rollover, it typically has a code indicating a rollover. You use that to report the rollover on your tax return. Don’t be alarmed when you get a 1099-R – it’s routine for rollovers.

• Can I roll over my 401(k) to a Roth IRA without paying taxes? No (not for pre-tax funds). Moving a traditional 401(k) to a Roth IRA is a taxable conversion. You’ll owe income tax on the amount. The only way to not owe tax is if that 401(k) money was already after-tax (rare in a traditional 401(k), except for after-tax contributions, which can go to Roth as discussed).

• Does the 10% early withdrawal penalty apply to rollovers? No. A rollover, if done correctly, is not a withdrawal subject to penalty. Even if you’re under 59½, moving money via a direct rollover (or timely 60-day rollover) avoids the penalty.

• How many rollovers can I do in a year? Unlimited (direct rollovers). There’s no limit on direct plan-to-plan or plan-to-IRA rollovers. For 60-day rollovers between IRAs, the limit is one per 12 months. This doesn’t restrict rolling 401(k) money to an IRA or to another 401(k), which you can do whenever you change jobs or wish to consolidate.

• Can I split my 401(k) rollover into multiple accounts? Yes. It’s possible (and sometimes smart) to split a rollover – for example, send pre-tax portion to a traditional IRA and after-tax portion to a Roth IRA. As long as the total distribution is properly rolled into eligible accounts, it’s all tax-free (except any part converted to Roth, which is taxed by design).

• If I leave my company at 55, should I roll over or keep 401(k)? It depends. If you might need the money before 59½, keeping it in the 401(k) lets you use the age-55 rule (withdraw without penalty). Rolling to an IRA would forfeit that and impose the 59½ rule for penalty-free access. If you don’t need early access, rolling over for potentially better investment choices could be beneficial.

• If I leave my company at 55, should I roll over or keep 401(k)? It depends. If you might need the money before 59½, keeping it in the 401(k) lets you use the age-55 rule (withdraw without penalty). Rolling to an IRA would forfeit that and impose the 59½ rule for penalty-free access.

• Will my rollover affect my Social Security benefits? No. The rollover itself does not count as income for Social Security purposes. It only affects taxes when you start taking distributions later.