What Is a 401(k) Rollover? Quick Guide for Employers

A 401(k) rollover transfers retirement savings from one qualified account to another without triggering immediate taxes or penalties. This process helps employees consolidate savings and maintain tax advantages when changing jobs or retiring.

What Is a 401(k) Rollover?

A 401(k) rollover occurs when an employee transfers funds from their existing 401(k) account to another qualified retirement plan or IRA. The term "rollover" encompasses several types of transfers. This process allows employees to consolidate retirement savings, maintain tax advantages, and continue building their nest egg even after leaving your organization. The key benefit of a rollover is that it maintains the tax-deferred status of retirement savings, allowing the money to continue growing without immediate tax consequences.

A rollover IRA is simply a traditional or Roth IRA used to receive funds from an employer-sponsored retirement plan. Many employees choose this option when leaving a job because IRAs often provide more investment choices and lower fees than employer plans.

Types of 401(k) Rollovers

Understanding the different rollover options helps you communicate effectively with employees about their choices:

How Does a 401(k) Rollover Work?

The rollover process varies depending on which method the employee chooses. Understanding these procedures helps you provide accurate guidance and process distributions correctly.

Direct Rollover Procedure

A direct rollover is the simplest and most tax-efficient method:

• Funds transfer trustee-to-trustee
• Employee never touches the money
• No mandatory 20% tax withholding
• Employees typically complete a distribution request form
• Typically takes 2-4 weeks

Indirect Rollover and the 60-Day Rule

An indirect rollover occurs when your plan distributes funds directly to the employee, who then has 60 days to deposit the money into another qualified retirement account. While this method offers flexibility, it comes with risks.

Here’s how it works:

• Plan distributes funds to employee
• 60-day deadline to deposit into new account
• 20% mandatory federal tax withholding
• Employee must replace withheld amount from other sources
• Missing deadline = full taxation + 10% penalty (if under 59½)

Tax Implications of 401(k) Rollovers

• Traditional-to-traditional: No immediate taxes
• Traditional-to-Roth: Entire amount taxable in conversion year
• Roth-to-Roth: No taxes

Common 401(k) Rollover Mistakes To Avoid

Educating employees about common pitfalls helps them protect their retirement savings and avoid unnecessary taxes and penalties.

• Missing the 60-day deadline for indirect rollovers
  • Results in full taxation plus potential penalties
  • Employers should emphasize direct rollovers to avoid this risk
• Forgetting the one-rollover-per-year rule
  • IRA-to-IRA rollovers limited to once per 12-month period
  • Doesn't apply to direct trustee-to-trustee transfers or employer plan rollovers
• Not understanding tax withholding on indirect rollovers
  • Plan must withhold 20% for federal taxes
  • Employees must replace withheld amount from other sources to avoid taxes on that portion
• Rolling over employer stock incorrectly
  • May forfeit valuable net unrealized appreciation (NUA)
  • Employees with significant employer stock holdings should consult tax advisors first
• Cashing out instead of rolling over
  • Results in immediate taxation and penalties (if under 59½)
  • Loses potential tax-deferred growth
• Mixing up Roth and traditional accounts
  • Roth 401(k) must go to Roth IRA or Roth accounts
  • Traditional 401(k) must go to traditional IRA or pre-tax accounts (unless converting to Roth)
  • Improper mixing triggers unexpected taxes
• Failing to report rollovers to the IRS
  • Must report on tax return using Form 1099-R (even if non-taxable)
  • Common oversight when employees don't understand filing requirements
• Not checking for outstanding 401(k) loans
  • Loan balance may be treated as taxable distribution
  • Understand how leaving employment affects loan obligations
• Overlooking rollover fees and timing
  • Some institutions charge processing fees
  • Consider market conditions when moving investments

What Employers Should Know About 401(k) Rollovers

Your organization has specific responsibilities when employees request rollover distributions.

Employer Responsibilities When Employees Leave

Provide clear information and required notices to departing employees:

• Provide clear distribution options information
• Issue Special Tax Notice (IRS Notice 402(f))
• Explain rollover rights, tax consequences, withholding rules

Distribution Forms and Documentation

Establish efficient procedures to handle rollover requests promptly:

• Maintain a clear distribution request process
• Process within plan document timeframes (typically 30-60 days)
• Issue Form 1099-R to employee and IRS

Required Tax Reporting

After processing a rollover distribution, employers must issue Form 1099-R to the employee and IRS. This form includes:

• Distribution amount
• Taxes withheld
• Distribution code (indicates rollover status)

Accurate reporting helps employees file correctly and avoid IRS inquiries.

Communicating With Departing Employees

Help employees understand their options without providing specific financial advice:

• Provide educational materials in plain language
• Answer questions without giving investment/tax advice
• Encourage consultation with financial advisors

How Paychex Can Help

Paychex streamlines 401(k) rollover administration with comprehensive retirement services including:

• Automated distribution requests and required notices
• Tax reporting and IRS compliance tracking
• Paychex Flex® integration for employee transitions
• Educational support and complex situation guidance

Contact us today to simplify your retirement plan administration.