What is the tax consequence for an employee who receives a lump sum distribution from her 401(k) account and rolls it into an IRA?

The tax consequence for an employee who receives a lump sum distribution from her 401(k) account and rolls it into an IRA is primarily that no immediate tax is due on the amount rolled over when done correctly. However, if the employee decides not to directly roll the distribution over into the IRA, and instead takes possession of the funds first, the IRS requires that a mandatory federal income tax withholding of 20% be applied to the distribution.

If the employee rolls over the funds directly from the 401(k) to the IRA (known as a direct rollover), then there are no tax consequences at the time of the transfer, and it avoids the withholding requirement. Nevertheless, if the employee cannot or does not complete a direct rollover and receives the distribution in their possession, the withholding takes effect, leading to a potential tax consequence.

It’s essential to understand that while rolling over the lump sum distribution into an IRA allows the employee to avoid immediate taxation, if the distribution amount is not rolled over correctly, the 20% withholding will apply, affecting the total amount of funds available for investment in the new retirement account. This scenario points to the importance of understanding how to properly execute the rollover to manage tax implications effectively.