You've Been Warned: This Common 401(k) Rollover Mistake Will Cost You

Starting a new job is always an exciting and invigorating step in one's career path. That said, what happens to your 401(k)? The one you've been nurturing and growing at your old employer. It turns out you have a few basic options to consider, with the first being to leave the account alone and do nothing. While perhaps simplest, that might not be the ideal way to proceed. For starters, you won't be able to make contributions to the old 401(k) account anymore, which can lead you to mentally forgetting about the account altogether.

Another option is to transfer your old 401(k) into a new 401(k) or independent retirement account (IRA), which will open up a wider selection of investment options going forward. This is known as "rolling it over." Similarly, you can shop for a retirement account administrator that potentially offers lower fees than the one your previous employer selected, which may be especially true if your prior workplace was paying a portion of the account management fees, and will no longer be doing so.

Now that we've established that taking your 401(k) account with you when leaving a job is a potentially wise move, let's look at the logistics of rolling it over so you don't make this common mistake, one that will result in a considerable (and avoidable) tax bill.

Note that once you've cashed out your old retirement account, you'll have just 60 days to get those funds reinvested in a new retirement account — otherwise, the IRS will assume you've permanently withdrawn the funds and tax that amount as regular taxable income. That could incur up to a 37% tax rate, depending on your federal income tax bracket (here's how to tell which you're in). Even worse, you could owe an additional 10% early-withdrawal penalty, in addition to income tax.

By the way, the process of cashing out an old 401(k) and opening up a new retirement account is known as an indirect transfer. With indirect transfers, besides the 60-day window, another obstacle exists in that your old account's administrator will withhold 20% of your old account's balance as advance payment of taxes in the event you don't manage to reinvest the funds within 60 days.

For example, if your old 401(k) account has a balance of $5,000, you'll receive a check for $4,000 when the account closes. However, you'll still need to write a check for $5,000 to the new retirement account administrator. In essence, you will need to pay the missing $1,000 out-of-pocket until the time comes to file annual income taxes, when you'll get the $1,000 returned to you as a refund.

But both of the above pitfalls can be avoided by doing a direct rollover. Like the name implies, a direct rollover involves your old retirement account provider sending your account balance, by check or electronically, directly to your new account administrator. In this way, you don't actually handle the funds and the entire amount is transferred over, with nothing held back for future payment of potential taxes.

Regardless of whether you opt for a direct rollover or indirect rollover, you will definitely want to notify the new account administrator that the money to fund the account is coming from an existing 401(k). Failing to do so in advance is a common mistake that will cost you greatly. That's because if the new investment firm receives a check at random, it might not realize that it's rollover money.

If the funds are deposited into the new account as a contribution instead of a rollover, the IRS will view the closing of your previous 401(k) account as cashing out, and you'll have to pay income tax and possibly early-withdrawal tax on the old account balance (the same as if you missed the 60-day deadline with an indirect transfer). Also, those funds will apply toward — or possibly exceed — your annual contribution limit, which is a bummer. Therefore, we can't reiterate enough to let your new retirement account administrator know that the initial incoming funds are via a rollover, not a new contribution.

Even if you think your old account administration will make all this clear, as in the case of a direct rollover, it's still wise to say something rather than be sorry later. Finally, if your employer — new or old — offers a matching contribution to your 401(k) as a perk, by all means take advantage. That's literally free money.