IRA Rollover Tax is usually avoided unless you do something stupid, explained below. When money is moved from a retirement plan to an IRA or from an IRA to another retirement plan, this is typically a non-taxable distribution. These movements usually happen when you change jobs or at retirement. The way to insure this distribution is non-taxable is to do a direct transfer, also known as a trustee to trustee transfer.

For example, let’s say you have money in a employer-sponsored plan, such as a 401k.  You leave the company and desire to rollover your funds to your own traditional IRA account.  Your employers will provide a form to do this.  When you complete the form it is essential that you tell your employer to send a check DIRECTLY to the new custodian (the bank or brokerage firm that acts as custodian for your traditional IRA). Do NOT have them send the check to you or payable to you as this requires that 20% of the account value be withheld and you have created a nightmare in order to complete your rollover IRA on a tax free basis.

Let’s say you just read this the day after you received the check from your employer and realize that you have screwed up. Here’s the fix illustrated with a hypothetical example for clarity. Say you had $100,000 in the 401k plan.  You had a check sent payable to you and 20% was withheld (your employer is required by IRS to do so if the check is paid to you).  You now have a check for $80,000 in your hands. If you deposit the $80,000 into an IRA within 60 days of receiving the check, then you will have completed a tax free IRA rollover for $80,000 but you will owe tax on the $20,000 you did not rollover.  But how could you rollover the $20,000 that you did not receive? You screwed up and now IRS provides a nightmare. If you don’t have $20,000 of your own funds that you can add to the $80,000 and complete a 60 day rollover of the entire $100,000, you will owe tax.  Sorry.

There may be an incidence when you want to pay the IRA rollover tax because the tax now will be less than the tax later. For example, you may want to rollover your 401k balance to a Roth IRA. The special feature of the Roth IRA is that the money grows tax free and is distributed tax free.   However, in the year that you roll over funds to a Roth, you must pay tax as if you had taken the money yourself.  This could be a wise move in the following case.  Let’s say you left your job in January and had earned $5,000. You had trouble finding work the rest of the year and had no additional earnings. The 2010 tax tables show that a single individual can report taxable income up to $34,000 and pay 15% at most in federal taxes. Given that you think tax rates in the US can only go up, you take $29,000 from your 401k and roll it over to a Roth IRA.  (This $29,000 is added to your $5,000 income for a total income of $34,000 keeping your total federal tax bite under 15% in this simplified example). You are happy to pay a 15% tax today rather than a 40% tax rate you project for yourself in the future. For the rest of your 401k funds from your employer sponsored plan, you could execute an IRA rollover to a traditional IRA on a tax free basis.

One other way to avoid IRA rollover tax is if you are in the fortunate case of being well heeled, over age 70 1/2 and you may give up to $100,000 of IRA funds to charity each year and avoid paying tax on that IRA distribution.  This is sometimes referred to as an IRA charitable rollover.

Learn more about IRA Rollover Tax implications….  Get your free copy “Six Best and Worst IRA Rollover Decisions“