If an employee receives a lump sum distribution from her 401(k) account and rolls it over into an IRA, what is the tax consequence?

When an employee receives a lump sum distribution from a 401(k) plan and rolls it over into an Individual Retirement Account (IRA), the primary tax consequence is that the distribution is subject to federal income tax withholding. This means that the Internal Revenue Service (IRS) requires the plan administrator to withhold a portion of the distribution for federal taxes unless the distribution is rolled over directly into another qualified retirement account.

If the employee opts for a direct rollover from the 401(k) to the IRA, no withholding tax applies, but if they take the distribution in cash and then contribute it to the IRA within 60 days, the plan must withhold taxes from that distribution. If the employee does not perform the rollover correctly, they may end up facing taxes on the entire amount as income for that year.

The requirement for tax withholding serves as an important compliance measure, ensuring that the IRS collects any owed taxes upfront before the funds are placed in a tax-deferred retirement account. Thus, choosing this option correctly reflects the federal tax implications associated with the rollover process.