Most 401k rollovers are tax-free, but a few situations create a tax bill. Here is what to know.
What are the tax consequences of rolling a 401k into an IRA?
For a traditional 401k rolled into a traditional IRA via direct rollover, there are no immediate tax consequences. The money keeps its pre-tax, tax-deferred status, and you owe ordinary income tax only when you take distributions later in retirement. The transfer is reported to the IRS but is generally non-taxable. Taxes only arise if you convert pre-tax money to a Roth, take cash instead of rolling over, or mishandle an indirect rollover. Roth 401k funds roll into a Roth IRA tax-free. For help understanding your specific situation, call 1-800-MEDIGAP at 1-800-633-4427.
When does a rollover create a tax bill?
A tax bill appears when you roll pre-tax 401k money into a Roth IRA, because that conversion is added to your taxable income for the year and can push you into a higher bracket. Taking the distribution as cash also triggers income tax and a possible 10% penalty under 59 1/2. With an indirect rollover, failing to redeposit the full amount within 60 days makes the shortfall taxable. Large conversions can also raise your Medicare IRMAA surcharge two years later, so timing matters. Confirm the numbers with a tax professional before converting.