Work long enough, and you might accumulate multiple employers’ retirement accounts. While you can no longer contribute to those accounts, you have options for an old account: roll the funds into a new workplace retirement plan, stay in your old workplace plan if your plan allows, or cash out (and pay taxes). Another option: Transfer the money into a rollover IRA. This may offer you more flexibility and investment options than keeping the workplace plan. Here’s what to know about rollover IRAs.
What is a rollover IRA?
A rollover IRA is an individual retirement account that is funded with money moved from a previous employer’s retirement plan. Workplace plans eligible to transfer to a rollover IRA include 401(k)s, 403(b)s, 457(b)s, pensions, and other employer-sponsored retirement plans. Transferring your former workplace account into a rollover IRA instead of adding it to an existing IRA could make it easier for you to transfer it to a new employer’s workplace account in the future.
How does a rollover IRA work?
Once you open a rollover IRA and transfer money from your former workplace account, you will likely have access to a wider range of investments and potentially lower administrative costs. You can use your rollover IRA to consolidate multiple former workplace plans in one place or roll over a single workplace plan and have a place to put former workplace plans if you change jobs in the future.
Can you contribute to a rollover IRA?
Yes. However, you might not want to. Since rollover IRAs are designed to receive transfers from former workplace retirement accounts, using it to make your annual IRA contribution could make it harder to transfer it to a workplace retirement plan if a future employer allows roll-in transfers.
Can you roll a 401(k) into a Roth IRA?
Yes, you can roll over an old 401(k) into a Roth IRA. There are 2 main ways to do that:
- A Roth-to-Roth rollover: If your previous employer’s plan was a Roth 401(k), or a combination of traditional and Roth assets, you can roll each asset type into a matching IRA. Say you have $10,000 in your past employer’s plan: $8,000 is traditional and $2,000 is Roth. You can move the $8,000 into a traditional IRA and the $2,000 into a Roth IRA.
- A Roth IRA conversion: If you have only traditional assets in your previous employer’s plan, you can do a Roth conversion. For example, if you want to convert $10,000 from a traditional 401(k) to a Roth IRA, you’ll pay current-year income taxes on the converted amount when you roll over. This could be a good strategy if you earn too much to contribute to a Roth IRA. Keep in mind, however, this could push you into a higher tax bracket depending on the amount you convert.
IRA rollover methods
Beyond choosing an IRA type—either traditional or Roth—there are different ways to complete an IRA rollover that might be relevant for your needs. They each have benefits worth considering.
What is a direct IRA rollover?
A direct rollover is when your previous custodian (the company that holds your retirement money) sends your funds via check made payable to your new custodian. There are a couple of benefits to direct rollovers, also known as direct transfers. First, you don’t take possession of the money. Instead, your money rolls directly into your new account, generally via a check made payable to your new account custodian. That prevents the rollover from being a taxable event. Direct rollovers don’t require your previous employer to withhold taxes from the transferred amount, which happens with indirect IRA rollovers.
What is an indirect IRA rollover?
With an indirect IRA rollover, you become the middleman. Your previous employer’s plan cuts you a check for your balance, payable to you. It’s then your responsibility to deposit those funds into your rollover IRA within 60 days, to avoid taxes and potential penalties. This option gives you more choices than a direct rollover. You can roll all or part of that check into a new IRA. If you keep some of the cash, and you’re rolling money from a traditional 401(k), you’ll pay a 10% early withdrawal penalty on that amount—plus taxes—unless an exception, like being 59½ or older, applies.
Indirect IRA rollovers and tax withholding
With an indirect IRA rollover, the IRS requires your previous employer to withhold 20% of the taxable amount for taxes. This means you’ll receive a check for 20% less than your rollover amount. You’ll also need to have cash on hand equal to the 20% withholding to complete the full rollover. Then you’ll need to fully fund your account—for the check amount plus the 20% withheld for taxes—within 60 days to avoid possible penalties.
Here’s an example. Say you do an indirect rollover of a $20,000 pre-tax balance from a 401(k). Your former employer’s plan would withhold 20% ($4,000) and send a check for $16,000 ($20,000 – $4,000), made payable to you. To complete the rollover and avoid taxes and possible penalties, you’ll need to get an additional $4,000 out of your nonretirement savings and send a total deposit of $20,000 to your new rollover IRA within the 60-day window. When you file your taxes for the year, you’ll claim the $4,000 in taxes on the withdrawal as pre-paid because they were withheld from your distribution. If your tax liability is less than $4,000, you would get a refund, but if it is greater than or equal to the amount withheld from your rollover, the prepayment would go toward reducing this outstanding amount.
Advantages of rollover IRAs
Tax-deferred potential growth
With rollover IRAs, you can protect the tax-deferred status of your retirement savings and avoid the potential penalty you’d pay if you cashed out your workplace plan instead.
Access to potentially more investment options
Since 401(k) plans can have limited investment options, a rollover IRA could open up more investment possibilities. Since you get to choose where to house your IRA, you can vet their investment options before you open the account. Funds and asset classes that weren’t available to you through your workplace plan might be accessible through an IRA, but you may also lose investment options that are not offered in an IRA.
Helpful tips and tools
A rollover IRA lets you choose a brokerage account with features and other educational tools that align with your investment style. That could give you access to different resources than you had before.
Consolidation
Rollover IRAs are a tool to help keep your investments under one roof instead of at multiple firms.
Penalty-free qualified early withdrawals
Like 401(k)s, rollover IRAs allow for penalty-free early withdrawals as long as your withdrawal qualifies for an IRS exemption. The most common exemptions are a first-time home purchase (up to $10,000), a birth or adoption expense (up to $5,000), a qualified education expense, a death, disability, or terminal illness, for health insurance (if you are unemployed), and some medical expenses. The SECURE 2.0 Act also expanded distribution options and favorable tax treatment for up to $22,000 of qualified disaster recovery distributions from eligible plans. Keep in mind that even though you may avoid the 10% early withdrawal penalty, you may still have to pay federal and state taxes on your early withdrawal.
Disadvantages of rollover IRAs
Costs could be higher
It’s possible your old employer’s retirement plan has lower administrative fees and investment costs. In that case, a rollover IRA may not make sense.
Creditor protection
If you ever face bankruptcy, money you have in a 401(k) offers protection from creditors as long as your plan qualifies. While IRA assets do offer some protection, they often don’t get the same level of protection as 401(k)s.
No loan options
If your plan allows it, you may be able to take out a 401(k) loan and borrow money from your account. IRAs, on the other hand, don’t have loan options. Here’s what to know about 401(k) loans.
The Rule of 55
The Rule of 55 allows individuals to take penalty-free withdrawals from an employer workplace plan, like a 401(k) plan, if they have separated from service from the employer that sponsored the 401(k) in the year they turn 55 or later. However, rollover IRAs are not included in this rule and non-qualified withdrawals before age 59½ could still incur a 10% early withdrawal penalty.
Access to investment options
Some 401(k)s have low-cost institutional investment options that you could lose access to if you decide to roll your 401(k) into a rollover IRA.
Rollover IRA rules
You have 60 days to roll over funds
If you opt for an indirect rollover, you must deposit the full balance from that employer-sponsored retirement account no more than 60 days after you receive the distribution. If you wait too long, you could face taxes and a 10% penalty, though certain circumstances could get the IRS to waive this.
Generally, you can’t roll over funds from an active 401(k)
If you’re still working for the employer that sponsors your workplace plan, you typically can’t move money in that account to a rollover IRA unless your plan allows for in-service withdrawals.
IRA rollovers don’t count toward annual contribution limits
You could still contribute to your IRA up to the annual IRA contribution limit in the same year you roll over funds from another retirement account.
How to roll a 401(k) into an IRA
1. Choose an IRA type
Review your previous employer’s plan and see if you have traditional or Roth assets. This can help you decide whether to open a rollover IRA or a Roth IRA. If you already have a rollover or Roth IRA, you can use that account to receive your rollover funds (unless it’s an IRA inherited from someone besides your spouse).
2. Open your IRA
If you don’t have the right type of IRA, compare brokerage firms. Look for IRA custodians with low-to-no account fees with a variety of investment choices that suit your goals. Also investigate their educational resources and investor tools. Make your choice and complete the required account paperwork.
3. Contact your previous employer’s plan for rollover instructions
Your previous employer’s plan should provide information on what’s required to roll your assets into an IRA. You’ll probably have a few forms to complete and will need the account number for your new IRA. From there, you may be able to complete the rollover request online or by phone.