Rhode Island Life Insurance Practice Exam

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

1. The distribution is tax-free

2. No tax consequence for the rollover

3. Distribution is subject to federal income tax withholding

4. Only partial taxes apply to the distribution

The correct answer is: Distribution is subject to federal income tax withholding

In this scenario, the employee's direct distribution from her 401(k) account and subsequent rollover into an IRA has important tax implications. When a direct distribution is taken from a 401(k), the IRS requires that the amount be subject to federal income tax withholding. Therefore, the correct understanding is that the distribution is indeed subject to federal income tax withholding at the time it is disbursed. However, if the employee promptly completes the rollover into an IRA—typically within 60 days—the taxation of the distribution can be deferred, and the amount rolled over will not be taxed when placed into the IRA. It's essential to recognize that while the employee may later avoid taxes on the rolled-over amount, the immediate consequence of taking a distribution includes mandatory withholding for income taxes. Options related to tax-free distributions or no immediate tax consequences overlook this requirement. The distribution's taxable nature is a crucial part of understanding the 401(k) to IRA rollover process.