Rhode Island Life Insurance Practice Exam

An individual wanting to avoid taxes upon transferring their 401(k) funds would likely choose which option?

1. Direct rollover

2. Cash withdrawal

3. Transfer to a taxable account

4. Split into multiple accounts

The correct answer is: Direct rollover

A direct rollover is the preferred option for an individual seeking to avoid taxes upon transferring their 401(k) funds. In a direct rollover, the funds move directly from the 401(k) plan to another qualified retirement plan, such as an IRA, without the account holder ever receiving the money directly. This mechanism maintains the tax-deferred status of the funds, allowing them to continue growing tax-free until withdrawals are made during retirement. In contrast, cash withdrawals from a 401(k) trigger immediate tax liabilities. When funds are withdrawn as cash, they are subject to income tax and possibly an early withdrawal penalty if the account holder is under age 59½. Transferring to a taxable account would also lead to realizing taxable gains, as the funds would lose their tax-advantaged status. Lastly, splitting the account into multiple accounts may not significantly affect tax implications, as it could still involve withdrawals or transfers that don't maintain the tax advantages of the retirement account. Thus, a direct rollover is the most efficient choice for minimizing tax exposure in this situation.