Rolling Over Employer Plans: Steps to Avoid Tax Traps

Quick summary

A rollover moves retirement savings from an employer-sponsored plan into another qualified plan or an IRA without triggering current income tax. The safest path is a direct rollover (plan-to-plan or trustee-to-trustee). An indirect rollover — where you receive a distribution and then redeposit it — carries a 60-day deadline and often 20% mandatory withholding that can create permanent tax consequences if not handled properly (IRS: Rollover Options: https://www.irs.gov/retirement-plans/plan-participant-employee/rollover-options).

Why this matters

Mistakes during a rollover can turn a tax-deferred asset into a taxable distribution, reduce your retirement balance, and trigger early-withdrawal penalties. In my 15 years helping clients move retirement accounts, the most common costly errors are choosing an indirect rollover without planning for withholding, failing the 60-day redeposit rule, and mishandling after-tax or Roth balances.

Step-by-step: How to avoid the main tax traps

1. Choose a direct rollover whenever possible

• What it is: Your plan administrator transfers funds directly to the receiving plan or IRA. There’s no distribution paid to you. This avoids the mandatory 20% federal withholding and the 60-day clock.
• Why it avoids tax traps: The IRS treats the funds as remaining tax-deferred when moved directly (IRS rollover guidance).

1. If you must use an indirect rollover, plan for the 60-day rule and withholding

• The plan will typically withhold 20% of the taxable portion for federal taxes when it issues a distribution to you. To avoid taxes on the withheld amount, you must deposit the full distribution amount (including the withheld portion) into the receiving account within 60 days. That means you must come up with the withheld 20% from other funds and then claim it as a credit when you file your federal tax return.
• Example: You receive a $40,000 distribution; the plan withholds $8,000. To avoid taxation on the whole $40,000, you must deposit $40,000 into the new IRA within 60 days — you’ll need to add $8,000 from other cash to make up the shortfall. If you deposit only the $32,000 you received, $8,000 becomes a taxable distribution (and may be subject to early withdrawal penalty if under age 59½).

1. Understand Roth vs. traditional rollovers and conversion taxes

• Moving pre-tax (traditional 401(k)) money into a Roth IRA or Roth 401(k) is a conversion and generates taxable income in the year of the rollover. If you plan a partial Roth conversion, calculate the tax cost and consider spreading conversions across years to manage your tax bracket.
• Rolling Roth 401(k) funds to a Roth IRA generally keeps the tax-free growth intact, but be mindful of RMD rules: Roth IRAs do not have RMDs while the original owner is alive, but Roth 401(k)s do — rolling into a Roth IRA can eliminate future RMDs (see IRS rules on RMDs and Roth accounts).

1. Track after-tax (non-Roth) contributions and basis

• If your employer plan contains after-tax (non-Roth) contributions, the tax treatment on a rollover depends on where you send those dollars. You can often roll after-tax amounts into a Roth IRA (taxable on earnings, not the basis) or into a traditional IRA that preserves the non-taxable basis. Misallocating basis can create taxable events later. Keep plan statements and Form 5498/1099-Rs and ask the plan administrator for a record of after-tax basis before rolling.

1. Watch for plan-specific rules and small-balance options

• Employers can require cash-outs for very small balances (commonly under $1,000 or $5,000 depending on plan rules) or force a distribution when a plan is terminated. Know your plan’s distribution rules and deadlines to avoid forfeiting employer contributions or missing rollover windows.

1. Consider outstanding 401(k) loans

• If you have a loan from your 401(k) and leave your employer, the outstanding loan balance may be treated as a distribution unless repaid. That treated distribution can be taxable and subject to penalty. Confirm loan repayment or rollover rules with your plan sponsor.

1. Keep records and expect tax forms

• Your plan will issue Form 1099-R for distributions and the receiving IRA will show Form 5498 for rollovers accepted. Keep these documents; they are the IRS trail that proves you completed a rollover.

Common tax traps and how to fix them

• The 60-day miss: If you fail the 60-day redeposit deadline, the distribution is taxable and possibly subject to a 10% early distribution penalty if you’re under 59½. The IRS permits relief in limited circumstances (for example, errors or hardships) and offers ways to request a waiver (see IRS guidance on 60-day rollover waivers). Consider requesting a private letter ruling or using the IRS relief procedures, and contact a tax professional quickly.
• Not replacing withheld tax in an indirect rollover: You can avoid this by insisting on a direct rollover or, if that is not allowed, making sure you have funds to “make up” the withheld amount before completing the rollover.
• Mixing Roth and pre-tax amounts incorrectly: Have the plan issue separate 1099-R codes for Roth and pre-tax portions, and document which went where. Rolling pre-tax funds into a Roth without planning will generate taxable income.

Real-world scenarios (short examples)

• Direct rollover success: A client left a job with $85,000 in a 401(k). We arranged a trustee-to-trustee transfer to an IRA. No withholding, no tax bill, and investments continued growing tax-deferred.
• Indirect rollover problem avoided: Another client received a lump sum with 20% withheld and planned to redeposit. I advised them to request a direct rollover instead; the employer reissued a trustee-to-trustee transfer and we avoided using personal funds to replace withholding.

When to keep funds in the old employer plan

Keeping money in your former employer’s plan can make sense if:

• The plan offers low-cost institutional investments you can’t replicate in an IRA.
• You want to continue borrowing from the account (if allowed).
• You are protected by unique plan features such as favorable creditor protection.
  See our guide on the Pros and Cons of Leaving Your 401(k) with a Former Employer for a deeper comparison.

Consolidation and tax simplification

Consolidating small balances into a single IRA can simplify recordkeeping and reduce fees. If you have Roth and traditional accounts, consider how conversions affect your future tax picture; our article on Rolling a Roth 401(k) vs Rolling to a Roth IRA: Tax Considerations explains special rules for Roth rollovers.

Checklist before you roll

• Confirm plan rules and whether a direct rollover is allowed.
• Ask the plan administrator to split pre-tax, Roth, and after-tax amounts when issuing distributions.
• Request payoff/rollover paperwork and estimated processing time in writing.
• Verify whether any outstanding loans will become distributions upon separation.
• Keep copies of 1099-R and 5498; confirm the amounts reported match your rollover.

Authoritative sources and where to read more

• IRS — Rollover Options: https://www.irs.gov/retirement-plans/plan-participant-employee/rollover-options
• IRS — Frequently Asked Questions about rollovers and the 60-day rule (linked from the rollover page above).
• Consumer Financial Protection Bureau — retirement resources and planning tools (https://www.consumerfinance.gov/).

Final notes and professional disclaimer

In my practice, a direct rollover solves most tax traps. When clients correctly move accounts trustee-to-trustee and document after-tax basis or Roth designations, they avoid surprises at tax time. This article is educational and does not replace personalized tax or legal advice. Consult a qualified tax advisor or ERISA attorney for help with complex rollovers, basis tracking, or relief requests from the IRS.

(Originally prepared using IRS guidance current as of 2025.)