What Is a Rollover IRA, and How Does It Work?

If you’ve been contributing to a 401(k) or employer-sponsored retirement account for several years but are now leaving your job, you may be wondering what to do with your retirement account. Do you cash out your nest egg and let the money sit in a bank account until you retire?

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It may be tempting to have unrestricted access to a lump sum of cash. But unfortunately, holding your retirement in a bank account could cost you a fortune. Furthermore, the small returns generated won’t keep up with inflation and your nest egg will actually lose value.

A more suitable option: a rollover IRA. Keep reading to learn how they work, along with key benefits and how to initiate an IRA rollover.

What is a Rollover IRA?

In a nutshell, a rollover IRA is an account that is designed specifically to hold funds transferred from employer-sponsored retirement plans, including 401(k), 403(b), profit-sharing and Keogh plans.

The purpose of a rollover IRA is to keep the tax-deferred status of those assets. Rollover IRAs also offer several distinct benefits.

What are the benefits of a Rollover IRA?

When you cash out or take distributions from retirement plans, two things happen. For starters, the funds are subject to taxation and the tax deferral benefit goes out the window. And if you haven’t yet reached 59 ½, you’ll also incur a 10% early withdrawal penalty.

However, an IRA rollover allows you to avoid taxation as long as you transfer the funds properly. Even better, you’ll also escape the 10% penalty.

Other benefits:

  • It’s free. You read that correctly. That are no fees to open a rollover IRA and transfer the funds from your 401(k) or other employer-sponsored plans into the new account.
  • Low fees. You may have to pay minimal fees to cover brokerage commissions and fund expenses associated with transactions. But there are financial entities, like Schwab, that offer rollover IRAs devoid of annual or maintenance fees.
  • No rollover limits. Fortunately, you’re allowed to roll over all the funds in your retirement account, regardless of the amount, without incurring a penalty.
  • Flexible investment options. Most 401(k) plans only allow you to select from a limited pool of assets, typically in the form of mutual funds, to build your portfolio. But with a rollover IRA, you’ll be afforded the opportunity to choose from an array of assets, including stocks, ETFs, and bonds, just to name a few.
  • Funds can be transferred to a new employer’s plan. If you find employment elsewhere and they offer a qualifying retirement plan, you will be able to transfer the funds from the rollover IRA to their plan if you choose to. You also have the option to leave the funds where they are.

How to Roll Over a 401K to an IRA

Direct Rollover

To ensure the funds from your 401(k) or other employer-sponsored plan are moved seamlessly, a direct transfer is the preferred option. Selecting this option also minimizes the chances of an error occurring with the transfer. You’ll also avoid having to pay taxes on your nest egg and incurring early withdrawal penalties.

Even better, it’s easy to execute direct transfers. As all you need to do is contact your former employer and request that they transfer the funds to the entity that the rollover IRA will be housed. Expect to complete paperwork on both the sending and receiving end, but it shouldn’t take too much of your time. And once you’ve done your part, the direct transfer of funds will be completed in a brief window of time.

Indirect Rollover

If you prefer to set up the new account on your own, you have the option to do what’s referred to as an indirect rollover. Rather than having your former employer send the funds directly to the new entity that will manage the rollover IRA, you’ll need to obtain the funds via check and set up the account yourself.

Another important consideration: with direct transfers, your employer usually won’t deduct income tax before sending the funds to the company in charge of managing the rollover IRA. But if you take the indirect rollover route, there’s a chance they will, to the tune of 20%.

This means you could find yourself paying this amount out of pocket to avoid incurring additional penalties and fees when opening up a new account. Even worse, you won’t be eligible to recoup the funds until you file your annual tax return.

You should also know that you have 60 days to do so or you’ll be on the hook for federal income tax and a 10% early withdrawal fee (if you aren’t yet 59 ½ years of age or older). To give yourself the best possible chance of avoiding any issues, promptly deposit the funds and notate your rollover IRA account number on the check.

Furthermore, follow up regularly until the funds are posted to your account and you’ve confirmed the account is all set.

Other Important Considerations

  • Annual Rollover Limits: In most instances, you are limited to one rollover per year.
  • Roth IRAs: If you’re interested in a Roth IRA, you have the option to convert the proceeds from the rollover IRA. However, you will have to pay taxes right away, as Roth IRAs are comprised of post-tax contributions and distributions are tax-free.

See also: What’s the Difference Between a Traditional IRA & a Roth IRA?

Bottom Line

Rollover IRAs are an ideal way to avoid taxation and penalties when you leave your employer and are no longer eligible to participate in their retirement plan. But, if you’re uncertain if your plan is eligible for a rollover IRA, inquire with your plan administrator to determine what options are available to you. You can also view IRS Topic Number 413 for additional guidance.

Rollover IRA FAQs

Why would I want to roll over my retirement account?

There are several reasons why you might want to roll over your retirement account. For example, you may want to move your money to a new IRA with lower fees, better investment options, or more flexibility.

Can I roll over any type of retirement account into a rollover IRA?

Yes, you can roll over most types of retirement accounts into a rollover IRA, including 401(k)s, 403(b)s, and traditional IRAs.

How do I choose the right rollover IRA provider?

When choosing a rollover IRA provider, you should consider factors such as fees, investment options, customer service, and the provider’s reputation. You may also want to consider whether the provider offers any additional services, such as financial planning or investment advice.

Allison Martin
Meet the author

Allison Martin is a syndicated financial writer, author, and Certified Financial Education Instructor (CFEI). She has written about personal finance for almost ten years and holds a master's degree in Accounting from the University of South Florida.