The Rollover Mistake That Turns Your 401(k) Into a Tax Bill

You leave a job, call your old 401(k) provider, and ask them to send you the money so you can move it to an IRA.

It sounds like the responsible thing to do.

It is also the one request that can turn a tax-free move into a tax bill.

Two ways to move the money

There are two ways to get money from a 401(k) into an IRA, and they look almost the same on the form.

A direct rollover. The plan sends the money straight to your IRA provider. Sometimes it arrives as a check, but the check is made out to the new account, not to you. No tax is withheld, nothing is reported as income, and you never touch the money.

An indirect rollover. The plan pays the money to you, and you have 60 days to deposit it into an IRA yourself. This is the one that causes the damage.

Both are legal. Only one of them is safe.

Traditional, Roth, or both

Before you request anything, check what kind of money you have. Your 401(k) statement shows it by source.

Traditional (pre-tax) money goes to a traditional IRA. Ask your brokerage for a Rollover IRA. The tax rules are the same as a regular traditional IRA, but keeping old 401(k) money in its own account helps twice. If a future employer’s 401(k) accepts rollovers, you can move it back in cleanly, which is also the fix for Mistake 3 below. And in a federal bankruptcy, money rolled from a 401(k) keeps unlimited protection, while regular IRA contributions are capped at about $1.7 million. A separate account makes it easy to show which is which.

Roth 401(k) money can only go to a Roth IRA or another Roth 401(k), never a traditional IRA. Watch the clock: your years in the Roth 401(k) do not count toward the Roth IRA’s five-year rule. If you have never had a Roth IRA, that clock starts the year the rollover lands, and the growth is not tax-free until it reaches five years and you are 59½. If you are eligible, opening a Roth IRA with a small contribution years ahead solves it.

Both. Many people now have both. Ask for one direct rollover split two ways, pre-tax to the Rollover IRA and Roth to the Roth IRA, and open both accounts before you start. Check that each transfer names the right account.

Mistake 1: Taking the check yourself

When a 401(k) pays you directly, the plan must withhold 20% for federal tax. Not may. Must. It does not matter that you plan to roll the money over next week.

Say you are 45 and have $100,000 in your old 401(k). You ask for the money to be paid to you. You receive a check for $80,000. The other $20,000 went to the IRS.

Now the 60-day clock starts, and here is the part almost nobody expects: to complete a tax-free rollover, you must deposit the full $100,000. Not the $80,000 you received.

So you have two choices.

Find $20,000 from somewhere else and deposit the full amount. The rollover is clean, and you get the $20,000 back as a refund when you file your tax return. That can be more than a year later.

Deposit only the $80,000. Then the missing $20,000 is treated as a withdrawal. It is added to your taxable income, and because you are under 59½, the IRS adds a 10% penalty on top.

In the 22% bracket, that is $4,400 of federal tax plus a $2,000 penalty. $6,400 gone, before any state tax.

And the $20,000 itself never goes back into a retirement account. Left invested at 7% for 20 years, it would have grown to about $77,000.

The IRS uses almost this exact example on its own rollover page. That is how common it is.

The fix: ask for a direct rollover, every time. The easiest way is to start it from your new brokerage’s website: most large brokerages now let you open the IRA and request the rollover from your old plan online, set up as a direct rollover. If the old plan still mails a check, it must be payable to the new IRA provider “for the benefit of” you, not to you.

What if you already missed the 60 days?

The deadline is strict, but not always final. If your financial institution caused the delay, you may get an automatic waiver. If something outside your control got in the way, such as a serious illness or a lost check, you can self-certify with a model letter from the IRS, at no cost, though the IRS can still disagree in an audit. The last resort is a private letter ruling, with a $3,500 IRS fee, plus the cost of a professional to prepare it. Getting it right the first time is much cheaper.

Mistake 2: Sitting out of the market

This one costs no tax at all. It just quietly costs the most.

A rollover almost always means selling. Most 401(k) funds are institutional share classes or collective trusts that only exist inside the plan, so they cannot come with you. The plan sells them and sends cash. Until that cash is invested again, you are out of the market, and with a mailed check that can easily be a week or more.

And many people stay out far longer. Vanguard looked at investors who rolled money into its IRAs in 2022. A year later, 28% of them still had everything sitting in cash. And cash tends to stay put: of the rollovers Vanguard tracked from 2015, 28% were still in cash seven years later. Vanguard estimates that for investors under 55, investing the rollover in a target-date fund instead could add at least $130,000 in retirement wealth by 65.

The fix: keep the gap to days, not weeks.

Pick the replacement before you sell. Look up what each 401(k) fund tracks and choose the matching ETF or index fund in your IRA. An S&P 500 fund becomes an S&P 500 ETF. A 2050 target-date fund becomes a 2050 target-date fund at your brokerage. Write the tickers down.

Choose the fastest route. Request it online, and if your old plan offers an electronic transfer instead of a check, take it.

Buy the day it lands. Turn on deposit alerts. ETFs trade all day, so you can be invested within minutes of the money arriving.

Do not try to time it. The aim is fewer days out, not a better price.

Mistake 3: Spoiling a future backdoor Roth

If your income is too high to contribute to a Roth IRA directly, the usual workaround is the backdoor Roth: put money into a traditional IRA with no deduction, then convert it to Roth.

It only works cleanly if you have no other pre-tax money in traditional IRAs.

The IRS does not let you pick which dollars you convert. It looks at the total value of all your traditional IRAs on December 31 of the year you convert, and treats every conversion as a mix of taxed and untaxed money in that same proportion. This is the pro-rata rule.

Say you roll your $100,000 401(k) into a traditional IRA, then do a $7,500 backdoor Roth that same year. Your year-end balance is about $107,500, and only $7,500 of it has already been taxed. That is under 7%.

So of your $7,500 conversion, only about $523 is tax-free. The other $6,977 is taxable. And it will happen again every year you try.

The fix: if you do backdoor Roths, or plan to, roll the old 401(k) into your new employer’s 401(k) instead, if the plan accepts rollovers, or move your Rollover IRA there before December 31. Money in a 401(k) is not counted for the pro-rata rule.

Mistake 4: Giving up the Rule of 55

If you leave your job in or after the year you turn 55, you can take money from that employer’s 401(k) with no 10% penalty. It is called the Rule of 55, and it only works on that 401(k).

Roll the money into an IRA and the rule disappears. IRAs have no Rule of 55. Any withdrawal before 59½ is back to the 10% penalty unless another exception applies.

Someone who retires at 55 and needs $40,000 a year to bridge the gap to 59½ would pay $4,000 a year in penalties from an IRA. Over four and a half years, that is about $18,000, for nothing.

The fix: if you are leaving work at 55 or later and might need the money before 59½, leave at least enough in the old 401(k) to cover those years. You can roll the rest.

Forget 59½: The IRS Rule That Unlocks Your 401(k) Five Years Early

Mistake 5: Rolling over company stock

This one only applies if your 401(k) holds shares of your own employer. If it does, stop before you roll anything.

Normally, everything that comes out of a 401(k) or IRA is taxed as ordinary income. But there is a special rule for company stock called net unrealized appreciation, or NUA.

If you take the shares out of the plan as part of a lump-sum distribution, you pay ordinary income tax only on what the shares originally cost. All the growth since then is taxed later, when you sell, at long-term capital gains rates.

Say the shares cost $50,000 and are now worth $250,000.

Rolled into an IRA, all $250,000 is eventually taxed as ordinary income. In the 24% bracket, that is $60,000.

Taken out using NUA, you pay 24% on the $50,000 now, which is $12,000, and 15% on the $200,000 of growth when you sell, which is $30,000. Total: $42,000.

That is $18,000 saved. And once the shares are inside an IRA, the option is gone for good.

NUA has strict conditions. The whole account has to come out within one calendar year, and if you are under 55 when you leave, the 10% penalty can apply to the cost amount. It is worth one call with a tax professional before you sign anything.

One more for anyone still working past 73

If you are 73 or older and still working, your current employer’s 401(k) usually lets you delay required minimum distributions until you retire, unless you own more than 5% of the company. IRAs have no such exception. Move that money into an IRA and the required withdrawals start, working or not.

Before you roll over

Six questions, in this order, before you sign the form.

Is this a direct rollover? If the money is being paid to you, stop.

Do I have Roth money too? If yes, open a Roth IRA next to the Rollover IRA and split the request.

Do I do backdoor Roths? If yes, look at your new employer’s 401(k) instead of an IRA.

Am I leaving at 55 or later? If yes, keep enough in the old plan to reach 59½.

Does my 401(k) hold company stock? If yes, ask about NUA before anything moves.

Have I picked the replacement funds? Write the tickers down now, and buy the day the money lands.

A rollover is one of the few big money moves that should cost you nothing. Most of the time, it does. The difference is a few words on a form and a few minutes the day the money arrives.

Your 401(k) might be losing you money right now.

Have you rolled over an old 401(k), and did any of these catch you? Tell me in the responses, and follow along for more on keeping what you build.