How Rollovers Work: Avoiding Tax Pitfalls

Quick overview

A rollover moves retirement money from one qualified account to another while aiming to keep the funds tax-deferred (or tax-free for Roth accounts). Common moves include 401(k) to IRA, 401(k) to 401(k), or traditional IRA to Roth IRA (a Roth conversion, which is taxable). When done correctly, a rollover avoids ordinary income tax and early withdrawal penalties. When mishandled, it can trigger withholding, taxable distributions, or penalties.

Sources: IRS – Rollovers of Retirement Plan and IRA Distributions (https://www.irs.gov/retirement-plans/rollovers-of-retirement-plan-and-ira-distributions) and IRS Retirement Plan Participant Resources (https://www.irs.gov/retirement-plans/plan-participant-employee).

How rollovers actually work (step-by-step)

1. Identify the accounts involved. Typical scenarios include leaving an employer and moving a 401(k) to an IRA or moving money from one IRA to another for consolidation.
2. Choose the rollover type: direct or indirect (see below).
3. Request distribution or trustee-to-trustee transfer paperwork from the sending plan/custodian.
4. Complete the transfer or deposit within the applicable deadline and keep records and Form 1099-R and Form 5498 for tax reporting.

Direct rollover (recommended)

A direct rollover—also called a trustee-to-trustee transfer—moves assets directly from Plan A to Plan B without you receiving the money. This method avoids mandatory withholding and removes most usual tax risks. Most plan administrators and IRA custodians will offer a direct rollover option and prepare the forms to complete it.

Why I recommend direct rollovers: in my practice, direct rollovers reduce administrative errors and the common taxpayer confusion that leads to unintended taxable events.

Indirect rollover (use with caution)

With an indirect rollover, the plan sends the distribution to you. You then have 60 days to deposit the entire distribution into another qualified account. Employer plans generally must withhold 20% for federal income tax from eligible rollover distributions unless you do a direct rollover. To complete a tax-free indirect rollover, you must replace the withheld amount out of pocket when you deposit to the receiving account, then claim the withheld amount on your tax return as a refund.

Example: if your plan sends you $8,000 after withholding 20% of a $10,000 distribution, you must deposit $10,000 into the receiving account within 60 days to avoid a $2,000 taxable distribution. That means using $2,000 of personal funds to make the rollover whole; you may recover the $2,000 when you file your tax return if your situation warrants a refund.

Reference: IRS rollover rules and withholding on distributions (Form 1099-R reporting) (https://www.irs.gov/retirement-plans/plan-participant-employee).

Key rules and common traps (what to watch for)

• 60‑day deadline: For indirect rollovers you must deposit funds into a qualified account within 60 days. Missing this deadline converts the amount into a taxable distribution and may trigger the 10% early withdrawal penalty if you’re under 59½. There are rare IRS exceptions (disaster relief and some hardship waivers); always check the current IRS guidance before assuming an exception applies (IRS may issue extensions for federally declared disasters).

• 20% withholding on employer plan distributions: For eligible rollover distributions paid to you from an employer plan, the payer generally must withhold 20% for federal income tax. Avoid this by using a direct rollover.

• One‑rollover‑per‑12‑months rule (IRA‑to‑IRA): You can make only one indirect IRA‑to‑IRA rollover per 12‑month period across all of your IRAs. Trustee‑to‑trustee transfers don’t count against this rule. See IRS guidance for details.

• Required Minimum Distributions (RMDs): RMD amounts cannot be rolled over. If you’re subject to RMDs (age rules under the SECURE Acts), take them before attempting rollovers. (SECURE Act changes updated RMD ages; check current IRS rules for your birth year.)

• Roth conversions are taxable: Rolling a traditional IRA or pre-tax 401(k) balance to a Roth IRA (a Roth conversion) is allowed but treated as a taxable conversion in the year of the rollover.

• Plan rules and in‑plan options: Not every employer plan accepts incoming rollovers, and some plans offer in‑plan Roth conversions or in‑service distributions. Always verify plan terms before initiating.

Authoritative source: IRS “Rollovers of Retirement Plan and IRA Distributions.” (https://www.irs.gov/retirement-plans/rollovers-of-retirement-plan-and-ira-distributions)

Practical checklist before you rollover

• Confirm eligibility: Check the sending plan’s distribution options and the receiving plan’s acceptance policy.
• Prefer direct rollovers: Ask the sending plan for a trustee‑to‑trustee transfer form.
• For indirect rollovers: understand the 20% withholding rule and prepare to replace withheld amounts if you expect a full tax‑free rollover.
• Review RMD status: Don’t roll over money that represents an RMD.
• If converting to Roth: estimate the tax bill and consider spreading conversions over multiple years to manage tax brackets.
• Keep documentation: save the distribution paperwork, the receiving account deposit confirmation, and Forms 1099‑R and 5498 for your tax return.

Real-world decisions and examples

Example 1 — Job change and direct rollover: Sarah left her employer with a $75,000 401(k). She set up a rollover IRA and requested a trustee‑to‑trustee transfer. The plan transferred the full balance directly to the new custodian. Result: no withholding, no immediate tax, and a clean record for consolidation.

Example 2 — Indirect rollover gone wrong: Mike received a $20,000 eligible rollover distribution from his plan; $4,000 was withheld. He deposited only the $16,000 he received into an IRA within 60 days and did not replace the $4,000 withheld. The $4,000 became taxable income for the year and—because Mike was under 59½—subject to the 10% early withdrawal penalty unless an exception applied.

Tax reporting and paperwork

• Form 1099‑R: The plan that distributes funds reports the distribution on Form 1099‑R. That form will show whether the distribution was rolled over and whether tax was withheld.
• Form 5498: The receiving IRA custodian reports rollovers contributed to the IRA on Form 5498. Keep this for your records but note it may arrive after tax season.

IRS guidance: See Form 1099‑R instructions and rollover information on the IRS website (https://www.irs.gov/forms-pubs/about-form-1099-r).

Professional tips I use with clients

• Use direct rollovers whenever possible to avoid the 20% withholding trap and simplify recordkeeping.
• If converting to Roth, run projected tax scenarios. Spreading conversions over years can reduce bracket spikes.
• When consolidating small balances, confirm investment options and fees at the receiving custodian; consolidation makes sense only if it reduces fees or improves investment choices.
• Keep a digital folder of all rollover paperwork and Form 1099‑R/5498 statements for at least seven years in case of IRS questions.

When to get professional help

• If you have large balances and are considering a partial Roth conversion.
• If your distribution involves after‑tax contributions and you need to preserve basis (special IRS rules apply to after‑tax amounts).
• If you received an indirect rollover and may have missed the 60‑day deadline — a professional can advise on hardship exceptions or corrective options.

Further reading and internal resources

• Read our detailed guide to 401(k) rollovers for plan‑to‑IRA specifics and step‑by‑step forms.
• If you’re weighing leaving funds with a former employer, see our analysis: Pros and Cons of Leaving Your 401(k) with a Former Employer.
• For tax considerations when moving Roth balances, read Rolling a Roth 401(k) vs Rolling to a Roth IRA: Tax Considerations.

Professional disclaimer: This article is for educational purposes and does not constitute personalized tax or investment advice. Rules change and individual circumstances vary—consult a qualified tax advisor or financial planner before making rollover decisions.

Authoritative sources cited:

• IRS: Rollovers of Retirement Plan and IRA Distributions (https://www.irs.gov/retirement-plans/rollovers-of-retirement-plan-and-ira-distributions)
• IRS: Retirement Plans Participant and Employee Resources (https://www.irs.gov/retirement-plans/plan-participant-employee)
• IRS Forms & Publications (Form 1099‑R; Form 5498; Publication 590‑A)

In my practice, careful planning around rollovers often saves clients thousands of dollars in unnecessary taxes and penalties. Follow the checklist above, document every step, and lean on direct rollovers to keep the process simple and tax-safe.