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What To Check Before Rolling A 401(k) Into An Ira

Saving for retirement and taking money out require different decisions. Make the wrong one, and it could mean less money down the road or a very unwelcome tax bill. I don’t know about you, but those risks sound like they range from not-so-good to very not-so-good.

In this interview, Tim Steffen, CPA, CFP, CPWA, director of advanced planning at Baird Wealth Management, explains why moving money can cause problems accessing the cash, impact your tax bill, and add bothersome steps before you can do another transaction.

One example: someone who leaves a job at 56. Steffen explains that rolling the entire employer-plan balance into an IRA could eliminate a penalty exception available through the former employer’s plan. Other decisions involve separating after-tax contributions, handling company stock, and taking required distributions before a rollover or Roth conversion.

Also read: Treasury scrutiny raises a tax-risk question for investors

Below is a transcript of the interview with Steffen, edited for brevity and clarity.

Why should early retirees reconsider a 401(k) rollover?

Bob Powell: If someone loses their job at 56 and needs the retirement money in their plan, conventional wisdom says a withdrawal before 59½ might carry a 10% penalty. What should they know?

Tim Steffen: One of the big exceptions to the 10% penalty applies only to employer plans. If you separate from your employer in the year you turn 55 or later, you can take money out of that employer plan with no penalty.

Somebody who loses their job at 56 can access their employer retirement plan penalty-free. It’s still going to be taxable. This exception doesn’t apply to IRAs.

You have to separate no sooner than the year you turn 55. It’s not your 55th birthday, but the year you turn 55.

The knee-jerk reaction might be, “Let’s move my 401(k) to my IRA. I’m mad at my employer. I don’t want any money left with them.”

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Now it’s in your IRA, you need money and you’re under 59½. Unless you meet another exception, you’re going to pay the penalty.

In that case, you’re better off leaving at least some money in the employer plan, enough to get you through the period until you reach 59½. Think twice about a rollover because you may be limiting your options.

How can a rollover become a costly mistake?

Powell: How much of your work involves cleaning up mistakes people make when taking money out?

Steffen: More than I care to spend on it. Often, it’s well-intentioned people misunderstanding a rule or not understanding that a rule even existed.

Or it’s, “I thought I could do this because I read it somewhere,” or the old watercooler talk. In their defense, these rules are not easy. They get complicated, and they’re very easy to run afoul of.

Don’t screw up your rollovers.

Powell: When someone changes jobs, what can they do with their retirement account?

Steffen: One option is to do nothing. You leave it there. If you’ve worked at one job your entire career, maybe that’s OK. If you’ve got accounts spread around a bunch of employers, leaving them there can make everything difficult to track.

The other extreme is taking it all out. That can create a tax liability and, depending on your age or circumstances, a penalty.

What we commonly see in the middle is a rollover. You consolidate money into another account. That could be your new employer’s plan or something separate from your employer, such as an IRA.

There are pros and cons because the rules differ between employer plans and IRAs. It’s not always the right thing.

Direct versus indirect rollovers: Why the distinction matters

Powell: What’s the difference between a direct and an indirect rollover?

Steffen: A direct rollover goes directly from wherever the money is now to where it’s going. Often, that’s done electronically.

You can also receive a paper check, as long as it’s made out to the custodian of the new account. My employer could send a check to ABC Brokerage as custodian for the Tim Steffen IRA.

Even though I’m holding the check, I can’t cash it. It’s not made out to me. It’s still a direct rollover.

An indirect rollover means the old plan sent you the cash. You have a check in your name or money deposited into your checking account. You control it.

You have a 60-day window to get that money into the new account. You have to be careful about that deadline.

Powell: My daughter changed jobs, and her former employer sent her a check. She exceeded the 60-day window, and I was worried about a penalty. It turned out the check was made out to the custodian, so we avoided that issue.

Is there also a once-a-year restriction?

Steffen: With indirect IRA-to-IRA rollovers, you can only do one per 365 days. They measure from the distribution date of the first one to the distribution date of the second one. It’s not the deposit date.

An indirect rollover from an employer plan doesn’t count toward that limit. Direct transfers don’t count either.

If you transfer your IRA from one brokerage house to another, that’s a transfer. If you go from your 401(k) to your IRA, that doesn’t count for purposes of this rule.

It’s a strict rule, but it doesn’t always apply. You have to understand which distributions count.

How should you handle after-tax 401(k) contributions?

Powell: What if a 401(k) contains both pretax and after-tax money?

Steffen: We have to be careful about what “after-tax” means. You can have after-tax contributions in a traditional plan, mixed with pretax money. A Roth account is a separate thing and is handled differently.

If you have both pretax and after-tax dollars in a traditional plan, you have options when taking the money out. Most people roll the pretax dollars into a traditional IRA to maintain tax deferral.

The after-tax contributions can come directly to you without a tax cost, or you can roll those contribution dollars into a Roth IRA.

It’s often referred to as the cream-and-coffee rule. This is the one time when you can separate the cream from the rest of the coffee, when you’re taking that lump sum out of the employer plan.

Powell: You need to tell the plan what you want before the money moves?

Steffen: You want two separate checks. If they send one check made out to the custodian of your traditional IRA and the dollars go in there, that cream is blended with the rest of the coffee. You can’t take it out specifically. You have to take it out on a pro rata basis.

Powell: Suppose the account has $20,000 of after-tax contributions and is worth $110,000. How does that work?

Steffen: The other $90,000 would be taxable when it comes out.

If it’s all blended together, you divide $20,000 by $110,000. Roughly 18% of every distribution would be tax-free, and the other 82% would be taxable.

But you have this opportunity to take that $20,000 separately and put it into a different account. That $20,000 of basis is your cream.

What should you check before moving employer stock?

Powell: What should people know about company stock in their 401(k) and net unrealized appreciation?

Steffen: There’s a unique rule for people who hold employer stock inside their employer plan. It allows you to take that stock out of the plan and put it into a taxable brokerage account rather than rolling it into an IRA.

The stock has to move from the employer plan to the brokerage account. You can’t sell it and move the cash.

When you do that, you pay tax at that moment on what you paid for the stock inside the plan, its cost basis. You have to rely on the employer to provide that information.

Let’s say you paid $20 a share and it’s now worth $50. That $30 of appreciation is your net unrealized appreciation, or NUA. You don’t pay tax on that portion when you take it out. You pay tax when you eventually sell the stock, and it’s taxed as a capital gain.

It may not be right for everybody, but anybody with employer stock in a 401(k) should at least be aware of it.

You have to do what’s called a lump-sum distribution. There are additional rules we could spend all day on. You have to be careful because if you don’t do it right, you may not get another crack at it.

Powell: What happens if the stock changes value after leaving the plan?

Steffen: If it was worth $50 when you took it out and falls to $40, you have $20 of gain above that $20 basis. That would be taxed as a long-term gain.

If it rises from $50 to $60, the subsequent appreciation is also a capital gain. The difference is that the $30 of NUA is always long term.

The subsequent appreciation is short term or long term depending on how long you hold the stock after it leaves the plan. Once you’ve held it for more than a year, the entire gain would be long term.

How can periodic payments help someone retire early?

Powell: What about what people call 72(t) payments?

Steffen: Section 72(t) is the section of the Internal Revenue Code that imposes the 10% penalty and provides exceptions.

One exception involves a series of substantially equal periodic payments. It allows you to take money from a retirement account, including an IRA, and avoid the penalty if you follow a specific set of rules governing how much you take and how long you continue.

It’s not a one-time thing or something you do for a couple of years. You can’t be very flexible about how much you take each year.

I refer to it as kind of a deal with the devil. If you mess it up, they can go back to the beginning and assess a penalty on the distributions you took.

It can be valuable, but understand what you’re getting into.

Powell: Who tends to use this?

Steffen: Usually people who retire early. Sometimes it’s a divorce situation where someone receives retirement assets but doesn’t have many other assets to live on.

We had an individual whose wealth was largely in an IRA. He retired in his mid-40s, but he had very little money outside that account.

We divided the IRA into multiple accounts and established different payment streams. That’s an extreme example. We don’t see it very often, but it has happened.

When do required minimum distributions begin?

Powell: At some point, the government says, “Nice job saving. Now it’s time to take money out.” How do required minimum distributions work?

Steffen: If you take money out too early, you can face a penalty. On the back end, if you don’t take money out at a certain point, you can face a penalty there, too.

We used to know RMDs as starting at 70½. Then the SECURE Act changed that to 72. Later, it changed to 73, and to 75 for people born later.

Most of the people we’re working with now are looking at 73. If you were born in 1960 or later, your RMD age is 75.

The IRS publishes life expectancy tables. Your required distribution is based on your retirement account balance divided by the applicable life expectancy factor.

For somebody beginning RMDs at 73, the starting amount is about 3.8% of the account balance. For every $100,000, that’s about $3,800 in the first year. The percentage increases as you get older.

Powell: Can you delay the first distribution until the following year?

Steffen: The first time you have to take an RMD, you have until April 1 of the following calendar year. You only get that the first time.

The second year’s RMD still has to come out by Dec. 31 of that year. If you defer the first one, you’ll have two distributions in the second year.

From a tax standpoint, that might be better than stacking the first distribution on top of a full year’s wages. You could also take part in the first year and the rest in the second. You have flexibility, but it has to be out by April 1.

How do RMD rules differ across accounts?

Powell: What if you have several IRAs and 401(k)s?

Steffen: It depends on the account type.

With traditional, SEP and SIMPLE IRAs, you can take the total required amount from whichever one, or combination, you want. If you have three IRAs, you can take it from one or from two of the three, as long as you take the total required amount.

Roth IRAs don’t have RMDs for the owner.

With 401(k)s, each plan has its own RMD, and it must come from that plan. If you’ve left 401(k)s at several former employers, you have to take an RMD from each one.

403(b)s are separate from 401(k)s and IRAs. But if you have multiple 403(b)s, you can take the required amount from one of those accounts.

This is one of the areas where we see people make mistakes.

Powell: Can choosing which IRA to withdraw from help rebalance a portfolio?

Steffen: Yes. If you invest your IRAs differently, you can choose which assets to sell and use distributions to help rebalance.

You can also rebalance by trading inside the IRAs. There’s no tax cost to those trades.

Why must an RMD come before a rollover?

Powell: Explain the “first dollars out” rule.

Steffen: When you’re required to take an RMD, the first dollars leaving the account must be your RMD.

We see people get tripped up when they work later in life, retire and roll their 401(k) into an IRA.

They know they have to take an RMD in the year they retire. But they roll the employer plan into the IRA first, then tell their broker, “I need to take my 401(k) RMD out of those dollars I just gave you.”

They should have taken it out before the rollover happened.

Powell: How does that affect a Roth conversion?

Steffen: You might want to wait until the end of the year to take your RMD, allowing the money to keep growing in the account. But you might want to convert to a Roth at the beginning of the year to get that money growing tax-free.

You can’t do the conversion first and the RMD later. The RMD has to happen first. Then you can do your Roth conversion.

There’s no such thing as rolling over an RMD.

Powell: Could someone use money from an RMD to make a separate Roth contribution if eligible?

Steffen: As long as you’re eligible, it would be a contribution to the Roth. Those are two separate transactions.

What makes Roth withdrawal rules confusing?

Powell: Roth money goes in after taxes, grows tax-free and can come out tax-free. What qualifications should people understand?

Steffen: Think of three buckets inside a Roth IRA: contributions, conversions and earnings.

Contribution dollars come out first. They’re tax-free and penalty-free.

With conversion dollars, you’ve paid the tax to put them in. There can be penalty issues, though. There are different five-year rules, and it gets tricky keeping them straight.

The third bucket is earnings. That’s where there’s another five-year rule. To get earnings out tax-free, the account has to meet the five-year requirement, and you need what’s called a triggering event. For most people, that’s turning 59½.

People ask whether it makes sense to convert in their 60s because they think they have to wait five years to get the converted dollars out without a penalty. If they’re over 59½, they don’t have that penalty issue. The earnings are a separate question.

I wish they had put different time horizons on these rules to make them easier to keep straight.

Powell: Who is responsible for tracking this?

Steffen: Ultimately, it’s the taxpayer’s responsibility. Your accountant can help. Your financial adviser or broker can help. They have records.

If you’ve had a Roth IRA for many years and you’re past 59½, the situation is much simpler. It’s when you’re trying to withdraw within a few years of opening it that you have to be more careful.

How can IRA withdrawals support charitable giving?

Powell: What opportunities do charitably inclined IRA owners have?

Steffen: There’s something called a qualified charitable distribution, or QCD. If you make a qualifying gift directly from an IRA to charity, you don’t report that distribution as income.

You also can’t claim a charitable deduction for it. You can’t double dip.

For 2026, the maximum is $111,000 per person. If a married couple each has an IRA, each spouse could do $111,000. I can’t give $222,000 from my IRA for my wife and me. It has to come from our own accounts.

Powell: Why might that be preferable to taking a taxable distribution and then donating?

Steffen: The QCD keeps the IRA distribution out of adjusted gross income, or AGI.

A lot of tax rules are based on AGI. A lower AGI can help you qualify for benefits or avoid more punitive provisions.

For someone who has to take money out but doesn’t need it, a QCD can help keep AGI lower. That can matter for things such as income-related Medicare premiums, medical expense deductions and the net investment income tax.

Powell: What restrictions should people know?

Steffen: You can’t send a QCD to your donor-advised fund.

Donor-advised funds are popular and powerful. I have one. But for a QCD, the money has to go to the charity itself.

You also have to actually be 70½. If you reach 70½ on Aug. 1, you can’t make the qualifying distribution before Aug. 1.

This isn’t a way to reimburse yourself for charitable gifts you already made. The distribution has to go directly to charity.

What should you do before retirement?

Powell: If someone is five years from retirement, what should they do now?

Steffen: First, get your Social Security process in order. Understand what you’re going to do and whether it makes sense to wait.

For retirement accounts, know where your accounts are. We hear about people losing track of plans from former employers. Understand all the resources available to you.

Then have a game plan for taking money out. How much will come from retirement accounts versus Social Security, a pension, taxable savings or Roth accounts?

A lot of that will be tax-driven, but not entirely. What you do early in retirement might differ from what you do later.

Most importantly, make sure you can afford to retire. Don’t just say, “I think I have enough.”

Work with a planner who can run the numbers, then keep track of the plan so you don’t go off course. Once you get too far into retirement, it’s hard to undo it.

Powell: What should someone ask a prospective tax adviser?

Steffen: How long are you going to be doing this? I hear from people who had a good CPA, but the person retired and they didn’t know where to go.

Also, has that CPA worked with people like you? Someone might know international tax rules inside and out but not know an RMD from a QCD.

You want someone familiar with the issues you’re facing.

Powell: What mistake do you hope nobody makes after this conversation?

Steffen: Don’t screw up your rollovers.

People sometimes take money from an IRA to finance a home purchase before selling their old home. They expect to replace it within the 60-day rollover window once the sale closes.

Too often, that doesn’t work.

Be very careful when you take money out of an IRA. Once it’s out, you may not be able to get it back in.

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