What Is A Rollover IRA?
Rolling funds over from a 401k to an IRA is a way to take control of your retirement savings.
Rollover IRA Definition
A rollover individual retirement account (IRA) is designed to hold funds that are being transferred from an employer-sponsored retirement account, such as a 401k. Moving funds from an employer's 401k plan can be triggered by an employee changing jobs, becoming self-employed, or retiring.
Reasons for rolling funds over into a Rollover IRA include:
- A Rollover IRA may charge lower fees than an employee's 401k plan.
- IRAs typically offer more investment options than a 401k plan, such as stocks, bonds, certificates of deposit (CDs), exchange-traded funds ((ETFs)) and real estate investment trusts (REITs).
- Employees who have worked for several companies and may have more than one 401k account can consolidate all their retirement funds into a single Rollover IRA.
- IRAs offer more flexibility when it comes to withdrawing money than a 401k account.
Traditional IRAs vs. Rollover IRA Rules
In many ways, Rollover IRAs and Traditional IRAs are similar, but in some areas they are different.
Traditional & Rollover IRA Basics
- Funded with pre-tax dollars.
- Withdrawals taken after age 59.5 are taxed as regular income, however, this is still advantageous since retirees often find themselves in a lower tax bracket than they did when they were still working.
- Withdrawals taken before age 59.5 are not only taxable, but come with a 10% early withdrawal penalty as well.
- The account holder must take required minimum distributions (RMDs) once they are 72-years-old regardless of whether they are still working or not. Before December 2019, RMDs were required to begin at age 70.5, but that rule was changed by the Setting Every Community Up for Retirement Enhancement (SECURE) Act.
Rollover IRA Contribution Limits
There is no limit to the amount that can be rolled over into a Rollover IRA, while a Traditional IRA is subject to annual contribution limits, which in 2022 are $6,000 per year, or $7,000 for those age 50 or older.
Direct vs. Indirect IRA Rollover
Rollovers can either be direct or indirect.
- An employee makes a request of their 401k plan administrator to transfer their funds directly into a Rollover IRA.
- The transfer is usually done electronically, and the administrator withholds no taxes.
- No penalties are assessed, and the rollover is reported on tax returns as a non-taxable transaction.
- One advantage of a 401k over an IRA is that the money in a 401k account is protected from creditors and judgments, whereas depending on your state, money in an IRA may not be.
- An employee requests that the balance in their 401k account be sent to him or her via check.
- By law, the 401k plan administrator must hold back 20% of the total amount to cover any potential taxes, and this amount can't be recovered until the employee submits their annual tax return.
- The employee then has a maximum of 60 days to transfer the funds into a Rollover or Traditional IRA or else the money will be considered a distribution, which will trigger a 10% early withdrawal penalty unless the employee is age 59.5.
- All the money that was originally in the 401k account must be deposited into the IRA, including the missing 20%, and that money will have to come out of the employee's pocket.
How To Open a Rollover IRA
The steps for opening an IRA are:
Step 1: Decide Where To Open the IRA
You can choose from among online brokerage firms, which allow you to choose your own investments, robo-advisors that offer investment recommendations, or banks and investment firms.
Step 2: Open an Account
You will need to provide a copy of a government-issued ID, such as a driver's license or passport, your name, address, phone number, date of birth, and Social Security number, and a list of beneficiaries. If rolling funds over, you will also have to provide information about the 401k account from which you are rolling over funds, and you'll need to fill out forms for them as well.
Step 3: Fund the Account
You can fund the account through an electronic transfer from a 401k account or a bank, or by check; you will need to contact your 401k plan administrator.
Rollover Roth 401k to a Roth IRA
Another type of IRA is a Roth IRA, and it is funded with after-tax dollars. Some employers offer Roth 401k plans which are also funded with after-tax dollars.
- Funds from a Roth 401k can be rolled over into a Roth IRA and no taxes will be due since that money has already been taxed.
- Both Rollover IRAs and Traditional IRAs can be converted into a Roth IRA, however, if you move funds from a regular 401k, or a Traditional IRA into a Roth IRA, you’ll have to pay federal and possibly state tax unless you use what is known as a backdoor Roth IRA conversion.
- If you maintain a Roth IRA account for at least five years, and if you meet other requirements, you can withdraw your contributions and any earnings tax-free after age 59.5.
Roth IRAs don't require distributions during the account holder's lifetime, making them ideal for providing for heirs. However, those heirs must take distributions over a 10-year period beginning with the account holder's death according to the SECURE Act.
Rolling an IRA into a 401k
Most, but not all, 401k plans accept transfers from Traditional IRAs. The advantages and disadvantages of rolling an IRA into a 401k are:
- You can begin withdrawals from a 401k as early as age 55 if you take them over the course of at least five years, while with an IRA, you must wait until age 59.5.
- Some 401k plans come with free financial advice, while you’ll need to pay a financial advisor or robo advisor for advice on your IRA.
- If you’re still working, you can postpone distributions from a 401k until you retire, while with an IRA, you must take distributions beginning at age 72.
- 401k plans offer protection against creditors including during bankruptcy. IRAs offer protection only up to $1,283,025, and this amount may vary by state.
- Many 401k plans cost more in fees than an IRA.
- You have a much wider selection of investments with an IRA, including individual stocks and stock options.
- You can’t roll a Roth IRA into a Traditional 401k or into a Roth 401k.
- A 401k plan allows loans while an IRA doesn't.
Rollover, Traditional, and Roth IRAs all allow you to plan for your retirement. The only disadvantage a Rollover IRA has when compared to a Traditional IRA is that if you continue to contribute to a Rollover IRA, you can't then transfer that money back into a an employer-sponsored retirement account, while with a Traditional IRA, you can.
Yes, in 2022 you are limited to $6,000 per year or $7,000 if you're age 50 or older. If you mingle rollover funds and new contributions in a single IRA account, it may not be possible to move the funds back into a 401k.
A transfer is between retirement accounts of the same type, for example, between an IRA at one bank to an IRA at another bank. A rollover is between two different types of retirement accounts, for example, from a 401k to a Traditional IRA.
You can roll the balance of almost any type of employer-sponsored retirement plan over into an IRA, such as 401k, 403b, or 457 plans.
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