Colorado Life Producer License Practice Test

When a participant in a 401(k) plan rolls over their distribution to an Individual Retirement Account (IRA) within 60 days, the correct understanding revolves around the tax implications of such a rollover. Typically, this rollover can occur without immediate tax consequences if certain conditions are met, specifically the direct rollover from the 401(k) to the IRA, which allows the entire balance to be transferred without the participant facing any tax liabilities at that moment.

However, if the distribution is received directly by the participant before being rolled over to an IRA, it may be subject to mandatory federal income tax withholding. In this case, 20% of the distribution would typically be withheld for federal taxes. If the participant chooses to roll over the entire amount, they would need to make up the 20% that was withheld from their own pocket to avoid it being taxed. Therefore, while the total rollover itself can be tax-free when executed correctly, the withholding is an important aspect to consider because it impacts how much money the participant ends up with for the rollover.

This understanding helps clarify why it would be misleading to think that the total rollover amount is entirely tax-free without acknowledging the implications of tax withholding that many may face if the funds are not directly transferred from the