20% Mandatory Withholding

The 20% mandatory withholding rule is the tax trap at the center of every indirect rollover. Federal law (IRC section 3405(c)) requires an employer plan — a 401(k), 403(b), or pension — to withhold 20% for federal income taxes from any eligible rollover distribution paid to you personally. It is not optional, the plan cannot waive it, and telling the plan you intend to roll the money over does not stop it. The only way to avoid it is a direct rollover, where the money goes custodian-to-custodian.

Here is the worked math. Your 401(k) holds $100,000 and the plan cuts a check in your name: $20,000 goes to the IRS and you receive $80,000. To complete a tax-free rollover, you must deposit the full $100,000 — the amount distributed, not the amount received — into the new account within 60 days. That means finding $20,000 of your own cash to cover the withheld portion.

If you deposit only the $80,000 you received, the missing $20,000 is treated as a taxable distribution. You owe ordinary income tax on it, plus a 10% early-withdrawal penalty if you are under 59½. On a $100,000 balance, that single gap can cost $7,000–$9,000 or more.

The withheld $20,000 is not gone forever — it is credited as federal tax withheld on your tax return, and whatever exceeds your actual tax bill comes back as a refund. But that refund arrives when you file, months later. The cash-flow gap is now, and it is the reason indirect rollovers wreck so many plans.

IRA distributions play by different rules: the mandatory 20% applies only to employer-plan distributions. An IRA distribution defaults to 10% withholding, which you can decline entirely. The 60-day deadline and the one-rollover-per-year rule still apply to IRA money, though.

The fix is simple: never let a check be made out to you. Request a direct rollover, and if a physical check is unavoidable, insist it be made payable to the receiving custodian 'FBO [your name]' — an FBO check carries no withholding.