What Is a Direct Rollover?

By Maurie Backman Markets Fool.com

A large number of workers save for retirement through their employers' 401(k) plans. But what happens when you leave your job and go elsewhere? Though you may have the option to keep your money where it is, many employees who leave their jobs prefer to move their savings as well. If you cash out your 401(k) and put it into a regular savings or brokerage account, however, you'll lose out on the tax benefits of a 401(k) and face early-withdrawal penalties if you're not yet 59-1/2. A better option, therefore, is to roll your existing retirement account into another qualified plan, typically an IRA.

Continue Reading Below

In financial speak, a rollover is simply a transfer of funds from one retirement plan to another, but you have two choices for moving your money. With a direct rollover, your plan balance is transferred directly from your old plan to your new plan. Because you'll never actually see that money yourself, you won't have to pay tax on it at any point. With an indirect rollover, you'll receive a check from your former plan administrator for the amount you have in your account, and it will be up to you to complete the transfer to another institution to avoid penalties.

IMAGE SOURCE: GETTY IMAGES.

Why choose a direct rollover?

With a direct rollover, the money in your qualified retirement plan is transferred directly to a second qualified plan of your choice. As such, the money you roll over isn't subject to taxes. Furthermore, all you need to do to complete your direct rollover is contact your plan administrator for instructions on how to authorize the transfer to your new account. You may need to sign some paperwork on both ends, but once that's out of the way, your job is done. You can sit back and relax, knowing that your account balance will be automatically transferred to a new qualified plan.

Indirect rollovers work differently. With an indirect rollover, you'll receive a check from your plan administrator for the balance of your account value, and it will be up to you to get that money transferred into a new qualified plan.

Continue Reading Below

The downside of an indirect rollover is that it puts the burden of completing the transfer on you. If you fail to move your money into a new qualified plan within 60 days, you'll be considered to have taken an early withdrawal from your initial plan (assuming you're under the age of 59-1/2), and at that point, you'll be subject to a 10% early-withdrawal penalty. You'll also be required to pay taxes on your distribution (regardless of your age at the time), just as your withdrawals would be subject to taxes when taken in retirement.

Another thing you should know about indirect rollovers is that they're often subject to an automatic 20% IRS withholding, which means you'll only get a check for 80% of your account value. But here's the kicker: If you don't replace that withheld portion with your own money when transferring funds into your new retirement plan, that amount will be considered a distribution, which means it'll be subject to further taxes and, depending on your age, an early-withdrawal penalty. Ouch.

If you know where you want your old plan balance to go and you don't have a temporary need for that money, then your best bet is to opt for a direct rollover. Not only will a direct rollover help you avoid taxes, but it'll ensure that your money gets transferred automatically. Just as importantly, it'll eliminate the temptation to use that money for non-retirement purposes.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.