Investing

Rollover IRAs: What They Are and How They Work

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Have you ever broken up with someone, only to realize you left your favorite sweatshirt at their apartment? A rollover IRA allows you to avoid that exact problem with your retirement savings when you leave a job.

Rollover IRAs help you move money you’ve saved in a former employer’s 401(k) to an IRA at a brokerage of your choice. But, while doing so can give you access to a broader array of investment options and potentially help you avoid some fees, a rollover IRA might not be the best choice in every situation.

What is a rollover IRA?

A rollover IRA is an IRA used to receive a distribution from a previous employer’s retirement plan, such as a 401(k). When you do a rollover the right way, you’ll avoid early withdrawal penalties and taxes while still preserving the original plan’s tax-deferred benefits.

But why would you want to roll funds over into an IRA?

Employer-sponsored retirement plans like 401(k)s often come with limited investment options and higher fees once you leave the company. So, rolling funds over into an IRA can help you access more investment options and save costs.

You can even roll over a Roth 401(k) to a Roth IRA.

Do you have to roll over when you leave a job?

The short answer is no. When you leave a job where you invested in a 401(k) or 403(b) plan, you can treat your retirement savings in a few different ways.

Leave it in your previous employer’s plan

It’s perfectly acceptable to leave the money right where it is. If you’re considering this route, be sure to ask a plan representative what fees you might face.

It is also important to note, though, that some employers won’t let you choose this option. For example, if your account balance is $5,000 or less, your employer may automatically roll your funds into an IRA or distribute the money to you.

Transfer the money to your new employer’s plan

If you’re all about consolidating funds, this could be an attractive option. Ask your new plan’s administrator what’s required to bring money over from a previous employer’s plan — you’ll likely have some paperwork to complete and your plan administrator will handle the rest.

Take the money and run

Sure, you could cash out and receive a complete distribution, but we don’t recommend it. You’ll face stiff penalties and taxes.

If the above options don’t fit with your financial goals, you can also choose to roll over your funds into a rollover IRA.

When should you use a rollover IRA?

To rollover or not to rollover? That is the question. We’re here with a few tips to help you decide whether rolling over your assets makes the most sense.

A rollover IRA might make sense for you if…

  • You want to reduce fees. If your old employer plan has maintenance fees or expensive investments, you may be able to save money with a rollover IRA.
  • You want to consolidate accounts. It may be easier to manage a single rollover IRA instead of one or more old employer retirement plans.
  • You want more control over your investments. Since you can choose the brokerage, rollover IRAs typically offer a wider range of investment options than employer retirement plans.
  • You make too much to contribute to a Roth IRA. Income limits don’t apply to Roth conversions made during 401(k) rollovers to IRAs, but be sure to consult your tax professional as the conversion could increase your tax bracket.

An IRA rollover might not make sense for you if…

  • Costs in your former employer’s plan are low. If moving your money means paying higher account and investment fees, you might reconsider a rollover.
  • Your new employer’s 401(k) is top-notch. If your new employer’s plan offers wide-ranging, low-cost investments, you might get a better bang for your buck with a plan-to-plan rollover.
  • You want to make Backdoor Roth IRA contributions. If you’re a high earner who wants to make future Backdoor Roth IRA conversion, a rollover IRA could imperil that goal.

Can you contribute to a rollover IRA?

Yes, you can contribute to a rollover IRA. You’ll be subject to the same annual contribution and income limits that apply to traditional and Roth IRAs.

There is a potential catch, though: Contributing to your rollover IRA may make it difficult to roll it into a new employer’s retirement plan down the line. Each plan will have its own rules, and your plan might prevent an incoming rollover if new contributions are commingled with your previous rollover.

Must-know rules for rollover IRA taxes

There are two different types of IRA rollovers, each of which has different tax consequences to consider.

Direct rollovers

With a direct rollover, your previous employer’s plan distributes funds directly to your rollover IRA provider. In this case, you won’t have taxes withheld and you’ll avoid potential penalties.

Indirect rollovers

With an indirect rollover, your previous employer sends you a check for the balance of your account, and you’ll then be responsible for depositing the check into your rollover IRA. In this case, you’ll have two tax consequences to navigate.

The 60-day rule

With indirect rollovers, you have 60 days from receiving the distribution to deposit the funds into your rollover IRA. If you miss that deposit deadline, your distribution will be taxed and potentially subject to a 10% early withdrawal penalty.

20% tax withholding

Indirect rollovers are typically subject to a mandatory 20% tax withholding. For example, say you have a $10,000 balance in your old employer’s plan. In that case, the plan will withhold $2,000 in taxes, and you’ll receive a check for only $8,000.

To get your $2,000 back, you’ll have to come up with $2,000 from another source and deposit the entire $10,000 into your rollover IRA. Then, you’ll receive that $2,000 at tax time via a tax credit.

Here’s the final caveat on indirect rollovers: Any amount you don’t deposit into your rollover IRA — including the amount withheld for taxes — will be subject to income tax and potentially a 10% early withdrawal penalty.

How to rollover a 401(k) to an IRA

Rolling a 401(k) into a rollover IRA is fairly straightforward and typically involves five steps:

  1. Open a rollover IRA. Decide whether you want to open a traditional IRA or Roth IRA and select a brokerage.
  2. Get check instructions. Your new IRA provider can provide specific instructions for how your previous employer’s plan should make out the rollover check.
  3. Contact your old plan’s administrator. Tell them you’re doing a rollover IRA and they’ll send you the required paperwork.
  4. Send the check to your new IRA provider. If your old employer’s plan sends you the rollover check, send it promptly to your rollover IRA provider for deposit.
  5. Invest. Once your new rollover IRA receives the funds, you’re ready to invest.

If you aren’t sure what to do, you can consider working with a financial advisor to decide whether rolling funds into an IRA makes sense for your situation. After all, sometimes it helps to have an expert weigh in on whether it’s worth it to go back for the sweatshirt — or if it’s doing fine right where it is.

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Frequently asked questions

Yes, you can roll your 401(k) into a Roth IRA. However, if you’re rolling over a traditional 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you convert. You’ll owe taxes because contributions to a traditional IRA are made before taxes, and contributions to Roth plans are made after taxes.

When making an IRA-to-IRA rollover, you’re only allowed one rollover per year. However, the IRS’s “one rollover per year rule” doesn’t apply to plan-to-IRA rollovers, IRA-to-plan rollovers, plan-to-plan rollovers or Roth IRA conversions.

Yes, you can roll an IRA into a 401(k), as long as your employer’s 401(k) plan allows for incoming rollovers and the funds in the IRA were previously held in an eligible employer-sponsored retirement plan.

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