Understanding Trustee-to-Trustee Transfers, Direct Rollovers, and Indirect Rollovers

There will likely be at least one point during your career when you'll want to roll an old 401k or IRA into another retirement account. Some reasons might include getting a new job, consolidating accounts, an old plan closing down, getting rid of pre-tax IRA balances for backdoor Roth IRA conversions, or reducing account-related fees. To accomplish this while preserving the tax advantages of your retirement accounts, you have three options: trustee-to-trustee transfers, direct rollovers, and indirect rollovers. In this blog post, I discuss the nuances of each method to help you make informed decisions about your rollovers.

Trustee-to-Trustee Transfers

Also known as direct transfers, trustee-to-trustee transfers are the smoothest way to move your retirement savings from one account to another. They involve the direct movement of funds from one retirement account custodian (or trustee) to another, with the funds never passing through your hands.

The main benefit of a trustee-to-trustee transfer is its logistical simplicity (at least for you). This shows up in three ways.

1. The transfer process is handled by your old and new retirement account custodians. With no need to handle the funds personally, there's less risk of error or oversight.
2. Trustee-to-trustee transfers are not subject to the 20% federal tax withholding requirement, which means you won't have to add additional money into your account to "make it whole".
3. Trustee-to-trustee transfers are not reportable events for tax purposes, so a 1099-R (which is used to report distributions from retirement accounts) isn't issued. This is one less thing to deal with at tax time.

To initiate a trustee-to-trustee transfer, you'll first need to contact the administrator or custodian of the destination retirement account to collect the necessary information for the transfer. Then, contact the administrator or custodian of the retirement account you want to move (e.g. an old 401k) and provide the information and instructions to transfer the funds directly to your new retirement account. The two financial institutions will communicate and handle the transfer electronically.

The limitation with trustee-to-trustee transfers is that they're limited to transfers between "like-kind" accounts. For example, 401k to 401k, Traditional IRA to Traditional IRA, and Roth IRA to Roth IRA transfers would be eligible. If you want to roll a 401k over into an IRA, for example, you should consider the similar method up next.

Direct Rollovers

Direct rollovers are another method for moving funds between retirement accounts. They are similar to trustee-to-trustee transfers in many ways, and people often use the terms interchangeably. The main distinction is that with a direct rollover, you'll usually receive a physical check made out to the destination account that you must mail to them. Another is that you'll be issued a 1099-R from the old retirement account custodian, and a Form 5498 if the destination account is an IRA, which you'll use to report the rollover when filing your taxes.

The start of the process for direct rollovers is similar to trustee-to-trustee transfers. You'll first contact the custodian of the destination account for relevant information, then provide that information to the old administrator and request a rollover from your old account. At this point, it's crucial that any check you receive is not written out to you directly. It must be deliverable to your new retirement account, so the "pay to the order of" line might say something like "JP Charles Investments FBO Stanley Himeno-Okamoto" with the account destination on the memo line, "Rollover IRA #123456". This makes it so you're only able to deposit the check into the destination retirement account and not into your own personal bank account.

The main thing to look out for with direct rollovers is making sure that you're not inadvertently paying taxes that you shouldn't. Line 4a or 5a on your individual tax return (Form 1040) reports your rollover from an IRA or 401k respectively, while 4b or 5b reports the taxable amount of any distribution. Expect to see $0 in box 4b or 5b and "ROLLOVER" next to it. If you see something different, check with your tax preparer - there could be a valid reason why you had a taxable distribution, or your return might need to be fixed.

Properly executing a direct rollover avoids the 20% federal tax withholding requirement so you won't have to add additional money into your account to "make it whole". Be aware that if a rollover check is made out to you personally (e.g. "Pay to the order of Stanley Himeno-Okamoto"), it becomes an indirect rollover subject to additional requirements and restrictions.

Indirect Rollovers

Indirect rollovers, also known as 60-day rollovers, require caution due to their potential tax implications and requirements. An indirect rollover involves personally receiving funds from one retirement account and depositing them into another retirement account within 60 days.

To perform an indirect rollover, you'll request a distribution from your old retirement account with the check made out to you personally. Once received, you must deposit the funds into the destination retirement account within 60 days to avoid taxes and penalties.

Here are three things to keep in mind when considering an indirect rollover:

1. You can only make one indirect rollover from IRAs in a given 12-month period, regardless of how many IRAs you have. However, this limitation doesn't apply to 401ks and you can perform as many indirect rollovers from 401k plans as you wish.
2. Timing is critical. Missing the 60-day deadline results in the distribution being treated as a taxable distribution, and if you don't meet the requirements for a qualified distribution or penalty exception, it might also be subject to an additional 10% penalty.
3. 20% federal tax withholding is mandatory. Your check will be 20% smaller than it needs to be for a complete rollover, which means you'll need to come up with the difference and deposit that into your destination retirement account as well. If you don't, that 20% shortfall will be considered a taxable distribution and possibly subject to an additional 10% penalty.

Exceeding the 60-day time limit to complete an indirect rollover doesn't just result in taxes and penalties. A failed rollover is treated as a taxable distribution and subsequent regular contribution, so if the amount deposited exceeds your regular annual contribution limit, you'll need to remove the excess or face additional penalties.

The 20% tax withholding requirement might be the most challenging aspect to work through. Even though your intention is to complete a non-taxable rollover, 20% of any potentially taxable funds (i.e. pre-tax money or taxable earnings) have to be sent to the IRS anyway. If you don't have that money readily available to deposit within 60 days, you could be facing an expensive tax season.

For example, a $100,000 rollover would be subject to $20,000 of tax withholding, so the check cut out to you would only be $80,000. You still have to deposit the full $100,000 into your new retirement account to fully complete the rollover, so you'll need to find the missing $20,000 somehow. If you only successfully roll over $80,000, the $20,000 shortfall is considered a taxable distribution subject to taxes and potential penalties.

Like with direct rollovers, expect a 1099-R reflecting the distribution. However, the form will look slightly different, so if you successfully completed an indirect rollover in full, make sure your tax preparer knows this so they don't report a taxable distribution.

In my opinion, indirect rollovers have no benefits (within the scope of just rolling an account over) and simply aren't worth the risk. Direct rollovers and trustee-to-trustee transfers are much easier and safer.

Choosing the Right Method for You

Before rolling over a retirement account, consider your specific circumstances, including your financial goals and your familiarity with the process. While trustee-to-trustee transfers are the safest and simplest option, direct rollovers are the most widely available when performing rollovers across account types. Indirect rollovers should be approached very cautiously due to their potential pitfalls.

If your goal is simply to get the money from one retirement account into another, I can't imagine a situation where I'd recommend an indirect rollover over a trustee-to-trustee transfer or direct rollover. The 20% mandatory tax withholding and risk of missing the 60-day deadline for indirect rollovers come with no benefits, in my opinion. There are situations where an indirect rollover might make more sense, like if you need an extremely short-term cash bridge, but that's another planning topic completely.