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Retirement

Key Differences Between Direct and Indirect Rollovers

Key Similarities

  • Both direct and indirect rollovers must be reported to the IRS when you file your income taxes.
  • Both direct and indirect rollovers can move an unlimited amount of money between your accounts.
  • Both direct and indirect rollovers are not taxable events. However, missing the 60-day deadline with an indirect rollover would be counted as a distribution, which is a taxable event.

Key Differences

  • A direct rollover moves from trustee-to-trustee. The account holder never touches the money. An indirect rollover moves from trustee to the account holder. The account holder is then responsible for depositing the full amount into the new retirement plan.
  • A direct rollover can be done an unlimited times per year. An indirect rollover can only be done once per year.
  • A direct rollover does not withhold any amount of the money. Plan trustees are required by the IRS to withhold 20% of the money for a 401k and 10% of the money for an IRA.

A rollover is the movement of funds and/or assets from one retirement account to another. Usually, it involves moving from one type of retirement account into a different type of retirement account - for example, rolling over your 401k into an IRA account.

There are two types of rollovers: direct and indirect. This guide will explain the differences between the two rollover options, and how to choose which type is best for you.

What's the difference between a direct rollover and an indirect rollover?

In a direct rollover, the money is moved directly from one account to another. The account holder never touches the money. Your plan provider will write a check to the new plan provider.

In an indirect rollover, the money is sent to you rather than directly to the new account. Your plan provider will write a check to you, and not the new plan provider. As the account holder, you then have 60 days to deposit the money in full to the new retirement plan.

Direct rollovers can be done an unlimited number of times per year, while an indirect rollover can only be done once per year.

Similarities

For both direct and indirect rollovers, you're required to report the transaction to the IRS through Form 1099-R.

However, both types of rollovers are not taxable events. In a direct rollover, you never touch the money and it gets reinvested into your new account immediately. For an indirect rollover, as long as you deposit the money within 60 days, there are no taxes or penalties.

How a direct rollover works

A direct rollover is "directly" between your plan trustees. Your old trustee sends the money to your new trustee. You, as the account holder, never touch the funds.

For this reason, direct rollovers are often referred to as trustee-to-trustee rollovers. Transfers also work the same way as a direct rollover, but the difference is that transfers are the movement of funds between the same types of retirement accounts (for example, an IRA to an IRA or a 401k to a 401k).

How an indirect rollover works

In an indirect rollover, your old plan trustee will send the money to you rather than directly to your new trustee. You're then responsible for depositing the funds into your new account.

Failure to deposit the full amount into the new retirement account by the due date would result in the IRS counting it as a distribution. If you're under the age of 59½, distributions are penalized with a 10% fee, so you'll be hit with an early distribution penalty of 10% plus income taxes on the undeposited amount.

Because of the 60-day deadline, indirect rollovers are often referred to as 60-day rollovers.

Plan providers will withhold 20%

When the plan provider writes you a check, they're required by the IRS to withhold 20% of the balance for a 401k, and 10% of the balance for an IRA.

If you fail to deposit the full amount before 60 days, the withheld amount will be used to pay penalties and taxes.

Here's the tricky part, and the reason why indirect rollovers are often late

The withheld amount gets deducted from the check that you receive. However, you're obligated to deposit the full amount of your account balance into the new retirement plan. That means, you're required to come up with the 20% (or 10% if an IRA) from other sources in order to deposit the full amount.

Once you make the deposit, the withheld amount gets returned to you as a tax credit for the year after the rollover is complete.

For example, if you had $100,000 in your 401k plan and you initiated an indirect rollover into a new 401k plan, your old plan provider would send you a check for $100,000 minus 20%. You would receive $80,000, and then you would need to come up with the additional $20,000 on your own in order to deposit the full amount into your new retirement plan. Once you deposit the full amount, the rollover is complete and you'll receive the withheld $20,000 as a tax credit.

When does the 60-day countdown start?

The 60-day countdown starts the day after you receive the funds from your old plan provider. The money must be deposited into the new account before the 60 day deadline.

Why choose to do an indirect rollover?

Direct rollovers are much simpler and they protect you from being hit with penalties and taxes. Because the money goes directly to your new plan provider, with nothing withheld, you don't have to worry about making the deposit yourself.

So why would anyone want to choose an indirect rollover over a direct rollover?

The only reason to choose an indirect rollover is if you need to use the money before the 60 day deposit deadline.

When the plan provider sends you the check, the IRS doesn't set any restrictions on how you use the money, as long as you deposit the full amount within 60 days. If you have any emergency expenses, choosing to do an indirect rollover could be a viable option if you're able to still deposit the amount within 60 days.

Both direct and indirect rollovers are not taxable events. In an indirect rollover, you don't pay taxes or fees as long as you can make the timely deposit into your new account. Being able to access your retirement funds for 60 days without taxes or penalties would be the only reason to choose an indirect rollover.

You should only choose an indirect rollover if you're certain you'll be able to make up for the withheld amount on your own, and deposit the full amount within 60 days.

Wrapping Up

Direct and indirect rollovers have the same objective: To move money from one retirement account to another.

The main difference between the two is:

  • In a direct rollover, the money gets moved directly from your old retirement account to your new retirement account. The transfer is between trustee-to-trustee and you never touch the funds.
  • In an indirect rollover, the money gets sent to you rather than to your new plan provider. 20% of the amount gets withheld from the check if you're rolling over funds from a 401k, and 10% gets withheld if you're rollover funds from an IRA. You're then given 60 days to come up with the withheld amount from another source, and deposit the full amount into your new retirement plan. Once the rollover is complete, the withheld amount gets returned to you as a tax credit.

Both direct and indirect rollovers are not taxable events, but they still need to be reported to the IRS. Because of the simple nature of a direct rollover, you're allowed to do an unlimited number direct rollovers per year, but you are only allowed to do one indirect rollover in a year.

Direct rollovers are much simpler and protect you from having to pay taxes and penalties. The only reason to choose an indirect rollover is if you need access to the funds for the 60 time period before having to make the deposit into the new account.

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