After exiting a job, one big tax question is what to do with the money in any qualified retirement plan accounts with your former employer including 401(k), profit-sharing, stock bonus and other plans. The standard advice is to roll everything over into an IRA.

This generally makes sense, because it lets you take over management of your retirement funds while continuing to defer taxes on the income those funds generate. But make no mistake: If you don t handle your rollover properly, it can be costly. So let s look at the right way to arrange for tax-free rollovers.

Make a Direct (Trustee-to-Trustee) Rollover

If you decide to do a rollover, be sure to arrange for a direct or trustee-to-trustee rollover from the retirement plan into your rollover IRA. Instead of being made out to you personally, the check from the company plan should be made out to the trustee or custodian of the rollover IRA. (You may be able to arrange for a wire transfer into the rollover IRA.) While the IRA must be set up in advance to receive the rollover, the account can be empty prior to the transaction.

Here s why a direct rollover is important. If you receive a retirement plan distribution check payable to you personally, 20% of the taxable amount of the distribution must be withheld for federal income taxes. You ll then have only 60 days to come up with the missing 20% and get that amount into your rollover IRA. Otherwise you ll owe income tax on the 20%. In addition, you ll generally owe the dreaded 10% premature withdrawal penalty tax if you re under age 55.

I know this is confusing, so here s an example: After leaving your job in 2010 at age 52, you re due $100,000 from the company 401(k) plan. You want to roll over the entire $100,000 into an IRA, but you fail to make the arrangements for a direct rollover. So you receive a distribution check made out to you.

Surprise! The check is for only $80,000. The missing $20,000 went straight to the IRS for mandatory federal income tax withholding. Now you ll need to to scrape up $20,000 and get it into your rollover IRA within 60 days to pull off a totally tax-free rollover.

Now assume you manage to gather together the missing $20,000 and roll it into your IRA within 60 days. Great--you ve pulled off a totally tax-free rollover. However, you can only recover the $20,000 sent to the IRS via reduced tax payments over the remainder of 2010 and/or by claiming a refund on your 2010 Form 1040. Either way, it could take a long time to get your money back. Not good. You could have avoided this whole mess by doing your rollover right in the first place.

And what if you fail to scrape up the missing $20,000? You ll owe federal income tax on the $20,000 (because it wasn t rolled over) plus you ll owe the 10% premature withdrawal penalty tax on the $20,000 (because you re under age 55). If you assume a marginal federal income tax rate of 25%, the unexpected federal income tax hit on your half-baked rollover attempt is $7,000 [(25% + 10%) x $20,000]. That money is gone forever.

You ll eventually get $13,000 back from the IRS (the difference between the $20,000 that was withheld and the $7,000 that you actually owe). But, as explained earlier, getting that money back could take a long time. In addition, your rollover IRA balance is 20% less than it could have been, which means lost tax deferral benefits. You could have avoided all these bad tax consequences by doing the rollover right.

(Note: The mandatory 20% federal income tax withholding rule doesn t apply when you re simply rolling over money over from one IRA into another. It only applies to distributions received from a qualified retirement plan, such as a 401(k), in the form of a check made out in your name.)

Age 55 or Older? Don t Roll Over Money You Might Need

While rollovers are generally a good idea because they defer taxes, think about this. If you re 55 or older when you receive the payout from your former employer s plan, you won t owe the 10% premature withdrawal penalty tax on money you choose to keep in your own hands (you ll still owe income tax). In contrast, if you roll the money into your IRA and then need to withdraw it later on, before reaching age 59 , you generally will owe the 10% penalty tax.

Obey the 60-Day Rule

Another big rollover pitfall to avoid is failing to meet the 60-day rule. Specifically, you must deposit the retirement account distribution into your rollover IRA within 60 days in order to achieve a tax-free rollover. The 60-day period starts the day after you receive the funds from the company retirement plan. You don t get any extra slack if the end of the 60-day period falls on a weekend or holiday.

The Bottom Line

Arranging for a tax-free rollover of retirement account money might sound like a simple task. But I see the recurring theme of failed rollover attempts year after year, with no end in sight. Please carefully read what I ve said here, and seek advice from a tax pro if you still have questions.