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What is the tax consequence for an employee who rolls over her 401(k) distribution into an IRA?

  1. The distribution is tax-exempt

  2. It incurs a 10% penalty

  3. The distribution is subject to federal income tax withholding

  4. The rollover avoids any tax consequences

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

When an employee rolls over her 401(k) distribution into an IRA, the tax consequence is that the rollover generally avoids immediate federal income tax liability. This means that there are no taxes owed at the time of the rollover, as long as the rollover is executed properly. However, the correct response is that the distribution may be subject to federal income tax withholding, which reflects the IRS regulations on 401(k) distributions. Generally, when you receive a distribution from a 401(k), the plan administrator is required to withhold 20% for federal income tax unless the entire amount is directly rolled over into another qualified plan, such as an IRA. If the employee chooses to have the distribution withheld for taxes, that could impact their immediate tax consequences, even though the rollover itself can be tax-deferred. Understanding this context allows employees to make informed decisions regarding their retirement funds and the implications of rolling over distributions to minimize potential tax consequences.