When you have money in a 401(k) or other type of retirement account, you may need to move it if you leave your job (or for other reasons). In this situation, you may consider transferring the money to a type of account known as a rollover IRA.

What is a rollover IRA?

A rollover IRA is an individual retirement account that can receive funds from a 401(k) or other type of retirement account. Rollover IRAs are most often used when an employee leaves a job and needs to move funds from a 401(k), 403(b), or profit-sharing plan into their own account.

IRA rollovers can have several benefits, the biggest one being that they preserve the tax-advantaged status of the funds that you move. A rollover IRA also allows you to consolidate retirement assets in one place, making them easier to track, expanding your investment options, and possibly saving money on fees. 

How does an IRA rollover work?

IRA rollovers have many benefits, but it’s crucial to understand the transfer rules to avoid an unnecessary tax hit. The easiest way to stay clear of tax penalties is to do a direct transfer of your funds from your employer-sponsored plan into an IRA Rollover account. The process is fairly simple, but it may help to call the company where you plan to direct the money for guidance. 

You should be able to transfer the funds directly via wire transfer, but if not, have the plan trustee make out the check in the name of the new account in care of its custodian, which is your new financial institution. This will allow the transfer to qualify as a direct rollover.

You can have the check made out to you, but be sure to deposit with the IRA custodian within 60 days so that the IRS doesn’t count it as a taxable distribution and require you to pay taxes on the entire amount. 

Even if you make the 60-day deadline, you still risk paying unnecessary taxes because 20 percent of your funds will be withheld to pay income taxes. You will need to find cash to replace that money and put it in your rollover IRA within 60 days so that it is not counted as a taxable distribution. And if you don’t replace the funds deducted as taxes, and you are younger than 59 ½, you may have to pay a 10 percent early-withdrawal penalty. Direct transfers can eliminate that risk. 

Can I shift money to a rollover IRA without leaving my employer?

Yes, but only if your employer’s plan allows it. This type of transfer is known as an in-service distribution.

What are the rollover IRA alternatives?

Instead of rolling the money from your old employer’s retirement plan into a rollover IRA, you could:

  1. Leave the funds there if the plan allows it. You typically need at least $5,000 in the plan to do this. If you pursue this route, be sure to ask whether your company charges higher fees to ex-employees.
  2. Transfer the money to another employer’s plan. You will want to review the plan’s investment options and fees to decide whether this is a wise choice.
  3. Cash out of the plan. This option may be tempting, but be aware that you will lose 20 percent to income taxes and pay a 10 percent early withdrawal penalty if you are younger than 59 ½ years old. In addition, you will lose the tax-deferral on the account.

What happens when I rollover into a traditional IRA vs. a Roth IRA?

There are a few different types of IRAs, each with their own set of rules. Here’s what happens when you roll over your 401(k) into one of these types of IRAs:

A traditional IRA allows you to get a tax deduction in the year of the contribution but pay taxes when you withdraw the funds, usually in retirement. If you roll your retirement-plan funds into a traditional IRA, you will not owe taxes on the money until retirement as long as you adhere to the IRA rollover rules for transfers. You may use an existing IRA to deposit the rollover funds.

A Roth IRA works differently. You pay taxes on contributions but not when you withdraw from the account. This means that if you roll over money into a Roth, you will have to pay income taxes on the amount. Roth IRAs have some benefits that may make this worthwhile. Unlike a traditional IRA, for example, Roth IRAs do not have required minimum distributions, allowing funds to accumulate tax-free for longer periods. 

But you may need a significant sum of money to pay the taxes for the Roth, and if you take that out of your rollover funds, it will count as a distribution and you will owe taxes on it and may owe penalties as well. It may be worth consulting with a tax advisor to decide whether a Traditional or Roth account makes sense for your IRA rollover. 

How is my rollover IRA invested?

It’s important to understand that an IRA is a type of account, not a type of investment. You may invest the funds as you like to achieve your financial goals. Options typically include investment products such as mutual funds, index funds, money-market accounts, and individual stocks and bonds. 

Is a rollover IRA taxable? 

When you roll over your IRA, it must be reported on your tax return. Assuming you follow the IRA Rollover rules, this will be considered a non-taxable distribution. Check the Form 1099-R that you will receive to make sure the rollover was recorded accurately.

Be sure your tax preparer understands the rollover transaction. 

Is there a Downside to an IRA Rollover?

If you move the money out of a 401(k), you will lose the ability to take a loan against the funds. You could also lose access to certain investments available only to participants in the retirement plan. 

Is a rollover IRA right for you?

Saving enough for retirement is one of the most important steps in securing your financial future. When you need to move retirement money, maintaining the tax advantages of those funds can help you build wealth more quickly. A rollover IRA is a type of account that may allow you to extend the tax advantages of your 401(k) or similar plan, should you need to move that money.