Rollover IRAs: A Detailed Guide

Are you in the midst of a career transition, left wondering about the future of your trusty 401(k) or 403(b)? The options laid out before you may seem like a menu with too many choices: leave it as is, cash out, move to the new job’s plan, and so forth. But have you considered the potential advantages of a rollover IRA?

This guide aims to shed light on the intricacies of this retirement tool. From tax implications to investment flexibility, we’ll explore how a rollover IRA can help you secure your retirement in the most autonomous and tax-advantaged way.

What Is a Rollover IRA?

A rollover IRA is an account that facilitates the transfer of funds from an old retirement plan, like a 401(k), into an individual retirement account (IRA)*. The key aim is to maintain the tax-deferred status of your funds.

*An individual retirement account is a financial vehicle that offers a way for you to save for your retirement while benefiting from certain tax advantages.

An IRA rollover actually involves moving funds from employer-sponsored plans, such as 401(k)s or 403(b)s, or profit-sharing plans from a previous retirement account or qualified plan to an IRA. An IRA rollover could also take place from one IRA to another - a person may opt to do this if they are looking for better investment choices or benefits that their current plan doesn’t offer.

To better understand this, let’s suppose you recently left a job where you were part of a 401(k) plan and are now faced with the question of how to manage your 401(k). First things first, do not ignore your 401(k) as many people often do.

Should you cash it out?

Now while this may seem to you like a fairly straightforward option, its cons far outweigh the pros, and it is generally not an advisable course of action. If you choose to withdraw your funds from a traditional 401(k) account without rolling them over, you’ll be liable to pay income taxes on the amount.

In addition to the regular income taxes on the distributed amount, you’ll face a 10% early withdrawal penalty if you’re under 59½ years of age. However, there are exceptions outlined by the IRS on its website that may allow you to bypass this penalty.

However, even if you are able to escape this penalty, by cashing out, you could end up really hurting your retirement savings.

Can you leave it as is?

If your 401(k) holds an investment exceeding $5,000, most plans do allow you to retain it even after you’ve parted ways with your employer. So, if you’ve managed to amass significant savings and are satisfied with your plan’s investment options, keeping your 401(k) in place can be a prudent decision.

However, it’s worth noting that this choice comes with many drawbacks:

• You cannot make further contributions to the plan.
• Your old company could undergo a major change; it could cease to exist or be acquired.
• You will lose access to the company information system that usually updates you on these plans, as well as the support of its human resources team.
• You may encounter higher 401(k) fees as a former employee.

If you do decide to go with this option, get in touch with your 401(k) provider and take a relook at the initial investment selections you made. Why? You may have made investment selections at the beginning that do not align with your current financial strategy. Ideally, this should be a yearly exercise that you undertake with the help of a financial advisor. But what better time to analyze and modify these decisions than when you leave your job.

What about transferring it to a new 401(k)?

This could really be a viable option if you’re with a new employer and you find that the new plan is a good one. However, do note that you might come across an IRA with reduced or fewer fees.

What’s more, IRAs offer a broader selection of financial products for investment compared to 401(k)s and 403(b) plans. Within an IRA, you have the flexibility to invest in various options, including mutual funds, bonds, stocks, exchange-traded funds (ETFs), real estate, and more.

Should I roll it over into an IRA?

As we said earlier, transferring your 401(k) into an IRA provides the advantage of a wider array of investment choices. Additionally, while you can’t make contributions to a 401(k) after departing from the company, you can if you opt for an IRA rollover.

An IRA rollover can occur in one of two ways: either from a retirement account like a 401(k) into an IRA or through an IRA-to-IRA transfer. While the majority of rollovers happen when individuals change jobs and seek to transfer assets from a 401(k) or 403(b) into an IRA, they can also occur when one wants to switch to an IRA offering improved benefits or investment options.

Why Opt for a Rollover IRA?

When you undertake a rollover of retirement plan funds, what typically happens is that you defer taxation until you make a withdrawal from the new plan. This has a positive effect on your retirement savings, as your funds continue to accumulate without immediate tax implications.

If you choose not to go through with the rollover, the payment, i.e., the distribution from your retirement plan, becomes taxable (with exceptions such as qualified Roth distributions and previously taxed amounts). You might also face additional taxation, as discussed earlier, unless you qualify for an exception to the 10% additional tax on early distributions.

What Are the Types of IRA Rollovers?

There are two types of rollovers: direct and indirect.

Direct rollovers

In a direct rollover, the financial institutions involved in the process take care of the transition of assets from your retirement plan to an IRA. To initiate a direct rollover, you must request your plan administrator to directly transfer the funds to the IRA. In IRA-to-IRA transfers, the custodian of the original IRA sends the rollover amount to the custodian of the new IRA. But remember to contact your plan administrator for instructions. They may issue your distribution in the form of a check made out to your new account. No taxes will be withheld from your transfer amount.

Indirect rollovers

Here’s what happens in an indirect rollover. Instead of your funds being directly transferred to your new account, the funds from your current retirement account or plan are converted into cash, and the custodian or plan sponsor issues a check in your name or directly deposits the funds into your personal bank or brokerage account. It then becomes your responsibility to reinvest the funds into your new IRA.

60-day window

Now, here’s the catch: For the rollover to be considered tax-free, the money must be reinvested in the IRA within a 60-day window. If you miss this 60-day deadline, the IRS views the transaction as a distribution. What does this mean?

This means that this distribution could be subject to income tax and an early withdrawal penalty if you’re under the age of 59½. These rules also extend to an IRA-to-IRA rollover.

Also, if you receive a check in your name, your former employer is required by the IRS to withhold 20% of the funds, which can only be recovered when you file your annual tax return.

However, if the check is made out to the IRA directly, no withholding is applied. Custodians typically withhold 10% from IRA distributions intended for rollover, unless you choose to opt out of withholding.

To ensure you recover this 20%, what you need to do is deposit the entire sum (including the 20%) into your IRA.

Example

For instance, suppose the balance in your 401(k) was $25,000, and your former employer sends you a check for $20,000 (the full account balance, minus 20%).

You would need an additional $5,000 to complete the $25,000 deposit into your IRA.

Come tax season, the IRS will note that you successfully rolled over the complete retirement funds and will reimburse the 20% that was withheld.

What happens if you don’t do this?

Well, if you only transfer $20,000 into your IRA, the IRS will view the remaining $5,000 as an early withdrawal, leading you to incur both the early withdrawal penalty and income tax.

IRA One-Rollover-Per-Year Rule

The IRS restricts IRA-to-IRA indirect rollovers to once per 12-month period. This one-year timeframe commences from the date of the distribution and pertains to both traditional IRA-to-traditional IRA rollovers and Roth IRA-to-Roth IRA rollovers. You’re typically restricted from conducting more than a single rollover from the same IRA within a 12-month period. Additionally, within this timeframe, you cannot perform a rollover from the IRA to which the distribution was initially rolled over.

This rule came into effect from January 1, 2015, onward and applies regardless of how many IRAs you possess. This may include SEP and SIMPLE IRAs, as well as traditional and Roth IRAs. Essentially, they are treated as a unified IRA for this limitation.

However, it’s important to note that the once-a-year limit does not pertain to:

• 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

Tax consequences of the one-rollover-per-year limit

From 2015 onward, if you receive a distribution of untaxed funds from an IRA:

• If you made an IRA-to-IRA rollover in the preceding 12 months, you must include the distribution amounts in your gross income.
• You could be subject to the 10% early withdrawal tax on these amounts included in your gross income.

Additionally, if you pay the distributed amounts into another (or the same) IRA:

• They may be treated as an excess contribution.
• They may be taxed at 6% per year for the duration that they remain in the IRA.

IRA Rollovers: Tax Considerations

If you choose an indirect rollover, you must be mindful of these guidelines to prevent a hefty tax liability:

• Missing the 60-day window could lead the IRS to categorize it as an early withdrawal, potentially resulting in both income tax and a 10% early withdrawal penalty.
• In an indirect rollover from a workplace retirement plan, the check you receive is typically for your 401(k) balance minus 20%. This 20% is withheld by the plan administrator for tax purposes. If you intend to reclaim this amount, you must deposit the complete account balance, including the withheld tax into your IRA.

Contributing to a Rollover IRA

You can contribute to a rollover IRA. In 2023, the annual contributions are capped at $6,500 (or $7,500 if you’re 50 years of age or above). Now, if you opt for a Roth IRA, different considerations come into play: There are income limits on your IRA contributions. You can read more about IRAs and their contribution limits here.

What happens if you combine IRA contributions with IRA rollover funds in a single account? It could become challenging to transfer your rollover funds back to a 401(k), particularly if you start a new job with an employer offering an exceptional 401(k) plan. So you need to ensure that you make this decision carefully.

Also note that your ability to claim tax deductions for traditional IRA contributions will be constrained if you or your spouse have access to a workplace retirement plan and your earnings surpass a specific threshold.

Is a rollover considered a contribution?

No. Your rollover IRA is treated as a distinct entity from your yearly contribution cap. This means that in the year you establish it, you have the opportunity to add extra funds up to the permissible contribution limit.

What type of IRA is a rollover IRA?

A rollover IRA has the potential to function as a traditional IRA. Additionally, if you’re interested in transferring funds from a Roth 401(k), it can also serve as a Roth IRA. While it’s possible to move money from a traditional 401(k) to a rollover Roth IRA, bear in mind that this would incur income tax on the rolled-over amount.

Is there a limit on my rollover amount?

Nope! However, it’s important to remember that you must still adhere to the annual contribution limits for any subsequent contributions that you make to your IRA.

Can I Take a Loan From My IRA?

Although IRAs do not offer loan provisions as found in many 401(k) plans, you could use the 60-day rollover rule to borrow funds from your IRA without incurring taxes and penalties. This means that you can withdraw the required funds from your IRA, provided you repay the entire sum within 60 days. So what you’re essentially getting (if you play this right) is an interest-free short-term loan.

Key Takeaways

• A rollover IRA allows for the transfer of funds from an old retirement plan, such as a 401(k), to an individual retirement account, with the aim of maintaining the tax-deferred status of the funds.
• IRA rollovers can occur from various retirement accounts, including employer-sponsored plans like 401(k) or 403(b), as well as profit-sharing plans.
• Cashing out a 401(k) without rolling it over can result in income taxes on the withdrawn amount, along with a 10% early withdrawal penalty if you’re under 59½. There are exceptions outlined by the IRS for certain circumstances.
• Leaving a 401(k) with an ex-employer is an option if the investment exceeds $5,000, but it comes with limitations, such as the inability to make further contributions and potential higher fees.
• Transferring a 401(k) to a new employer’s plan is a viable option if the plan is favorable, but rolling it over into an IRA offers more diverse investment choices and potential fee advantages.
• There are two types of rollovers: direct and indirect. Direct rollovers involve the direct transfer of assets facilitated by the involved financial institutions, while indirect rollovers require you to reinvest the funds into the new IRA within a 60-day window.
• The IRS enforces a one-rollover-per-year rule for indirect IRA rollovers, applicable to both traditional and Roth IRAs. This rule started in 2015 and treats all IRAs, including SEP and SIMPLE IRAs, as one entity for this limitation.
• Tax consequences may apply if the one-rollover-per-year limit is exceeded, potentially resulting in additional taxes and penalties.
• A rollover IRA is treated separately from the annual contribution limit, allowing you to transfer additional funds up to the contribution limit in the year it's established.
• A rollover IRA can function as either a traditional or Roth IRA, with the main distinction being the flexibility to transfer any amount of money into the rollover IRA.
• While IRAs do not offer loans like some 401(k) plans, you can borrow from your IRA using the 60-day rollover rule, essentially providing an interest-free, short-term loan if you repay the full amount within 60 days.

Conclusion

Even if retirement is a long way off, switching jobs offers you an opportunity to begin taking control of your future. By carefully considering your options, such as rolling over your retirement account into an IRA, you’re not only making a career move, but also a strategic financial one. This simple step now can lead to a more prosperous and secure retirement down the line.