What is a Rollover IRA?

Rollover IRAs are a particular kind of individual retirement account designed for people who have changed jobs or retired and who want to transfer their 401(k)s or other retirement plan assets into a traditional or Roth IRA.

Opening a Rollover IRA will allow you to transfer assets from an old employer-sponsored retirement plan to an IRA account and maintain the tax advantages. The IRS states that “if you’re getting a distribution from a retirement plan, you can ask your plan administrator to make the payment directly to another retirement plan or to an IRA.”

Bear in mind that if you decide to roll over your plan assets into a Roth IRA, you will have to pay taxes. This is because qualified employer retirement plan contributions are made pre-tax while Roth IRAs are funded with post-tax contributions.

Rollover IRA

How does a Rollover IRA work?

A Rollover IRA is a great way for transferring your funds from a 401(k) or other retirement plan into an IRA. If you decide to leave your job, a Rollover IRA will keep your retirement money safe from taxes if you do the process correctly.

To transfer the assets, you can choose between a direct rollover and an indirect rollover. The former is the more straightforward and easier process where you as the account owner have minimal involvement.

This is how it works. After selecting the type of IRA account you want to open (provided you do not already have one) and the provider, you should request your former employer’s plan administrator to transfer your savings directly to the new IRA account or to send a check payable to your IRA service provider. With a “direct rollover” the money never touches your hands and you avoid having 20% of the transferred assets being withheld by the IRS. If the check is payable by you, make sure it’s deposited within 60 days to avoid the funds being taxed and penalties being charged.

Alternatively, you can use an indirect rollover to transfer the plan assets. In this case you take possession of the assets and then place them into another eligible retirement plan within 60 days. Note, however, that 20% of the account’s assets may be withheld by the IRS and you will only be able to recover them once you file your annual tax return. If the assets are not moved to a Rollover IRA correctly, you will be taxed and you may be subject to early withdrawal penalties.

Rollover IRA

Benefits of a Rollover IRA

The primary reason people transfer their employer-funded retirement assets to an IRA is that IRA accounts offer a wider range of investment options than most 401(k) plans.

In general, IRAs allow the accumulation of almost any type of asset: stocks, bonds, mutual funds, exchange-traded funds, certificates of deposits (CDs), etc. If you set up a self-directed IRA, the array of available investment options is even larger.

The decision whether to set up a traditional or a Roth IRA depends on how you envisage your future tax burden. The tax treatment of contributions is the main differentiator between a Roth IRA and a traditional IRA. If you expect to be in a higher tax bracket later on in your career, opening a Roth IRA may make more sense. Conversely, if your tax burden is set to decrease in the future, a traditional IRA may be a wiser solution. A rollover from a traditional 401(k) to a Roth IRA takes place in two steps: first, you roll over the money to an IRA, then you convert the account to a Roth IRA.

Rollover IRA

Rules governing rollovers

The strictest rule to bear in mind is that you generally cannot make more than one rollover from the same IRA within a 1-year period. You also cannot make a rollover during this 1-year period from the IRA to which the distribution was rolled over. Starting from January 2015, the one rollover per year applies to all of your IRA accounts in aggregate. The exceptions to the one-per-year limit are the following:

  • rollovers from traditional IRAs to Roth IRAs (conversions)

  • trustee-to-trustee transfers to another IRA

  • IRA-to-plan rollovers

  • plan-to-IRA rollovers

  • plan-to-plan rollovers

Direct trustee-to-trustee transfers between IRAs are not considered distributions and thus are not subject to the once-per-year limit.

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