4004 / If a rollover is not made through a direct rollover, must income tax be withheld from the distribution?

Distributions from qualified retirement plans, tax sheltered annuities, and eligible Section 457 governmental plans are subject to a mandatory income tax withholding rate of 20 percent unless the transfer is handled by means of a direct rollover.¹ An employee receiving a distribution may not elect out of the withholding requirement. Distributions from traditional IRAs are not subject to mandatory 20 percent withholding ( Q 3674).

If a participant’s total distribution is expected to be less than $200, the participant need not be offered the option of a direct rollover.²

If a participant receives an eligible rollover distribution that is subject to the 20 percent withholding rate, the 20 percent withheld will be includable in income to the extent required by IRC Sections 402(a), 403(b)(1), or 457(a)(1)(A), even if the participant rolls over the remaining 80 percent of the distribution within the 60-day period ( Q 4016).

Because the amount withheld is considered to be an amount distributed under those sections, the participant may add an amount equal to the 20 percent withheld to the 80 percent he or she has received, resulting in a rollover of the full distribution amount.

The 10 percent early or premature distribution penalty ( Q 3677, Q 4074) may apply to the amount withheld where only the remaining 80 percent of the distribution is rolled over from a qualified plan or a Section 403(b) plan.³

A distribution from an eligible Section 457 governmental plan is treated as an early distribution from a qualified plan only to the extent that it represents funds rolled over from a qualified plan, a Section 403(b) plan, or a traditional IRA.⁴

Where a distributee elects to transfer a portion of the distribution by a direct rollover and receive the remainder, the 20 percent withholding requirement applies only to the portion of the distribution that the distributee actually receives. It does not apply to the portion of the distribution that is transferred directly to another eligible retirement plan.⁵

In calculating the amount to be withheld, there are special rules if the distribution includes employer stock, other property, or a deemed distribution of a plan loan balance.⁶