Guides IRA 101

How to Open a Rollover IRA

Arielle O'Shea
January 7, 2019

A rollover IRA is a great option if you have money still sitting in a former employer’s 401(k) plan. In just four simple steps you can take back control of your retirement savings.

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Rolling a 401(k) into an IRA

When it comes to a 401(k), you can take it with you. In fact, you probably should, in the form of a rollover IRA — an individual retirement account created by transferring money from a 401(k).

But making the most of the money you’ve built up means performing the rollover correctly. Here’s the four-step process for turning a 401(k) into a rollover IRA.

1. Evaluate your choices

If you’re leaving a job, you have three basic choices — none of which allows you to continue contributing to the plan, but all of which ensure that the money you’ve already contributed remains yours.

  • Leave it be. If your ex-employer lets you, you can leave the plan right where it is. This isn’t ideal, for a couple of reasons: You’ll no longer have an HR team at your disposal to help you with plan questions, and you may be charged higher 401(k) fees as an ex-employee.

  • Roll it over. This is the best choice for many people: You can roll your money into either your current employer’s retirement plan or into an IRA, and in many cases, the IRA is the destination of choice. There, you’ll have a wide variety of investment options and low fees, particularly compared with a 401(k), which can have tightly curated investment options and high administrative fees.

  • Cash out. This is almost certainly your worst option. Not only does cashing out sabotage your retirement — you’ll lose the power of compound interest, especially if you’re early in your career — but it comes with some brutal penalties and taxes levied by the IRS. You’ll pay a 10% early withdrawal fee, plus ordinary income taxes on the amount distributed. That means you might hand over up to 40% of that money right off the top.

The 401(k)-to-IRA rollover option is what we’re going to focus on here.

2. Open an IRA

If you have an existing IRA, you can just roll your balance into that. If you don’t, you’ll need to make two decisions: which type of IRA you want and where to open that account.

Roth vs. traditional IRA

Traditional IRAs and Roth IRAs are by far the most popular types of individual retirement accounts. The main difference between them is their tax treatment:

  • Traditional IRAs can net you a tax deduction on contributions in the year they are made, but withdrawals in retirement are taxed. If you choose to roll over a 401(k) into this account, you will not pay any taxes on the rolled-over amount until retirement.

  • Roth IRAs don’t include an immediate tax deduction, so rolling to a Roth means you’ll have to pay taxes on the rolled amount. (The exception is if you’re rolling over a Roth 401(k), a type of 401(k) that mimics the tax treatment of a Roth IRA.) The upside of Roths is that withdrawals in retirement are tax-free after age 59½.

The bottom line: Rolling to a Roth IRA may be a good option if you wish to minimize your tax bill in retirement, but you shouldn’t go with a Roth if you need to use cash from the rollover to foot the tax bill today.

Also, if you wish to make ongoing contributions to your new account, you’ll want to check the contribution rules for both types of accounts.

Where to open an IRA

Note that your choice of IRA provider is not the biggest driver of your portfolio’s growth. It is the investments you place within the IRA that determine most of that. However, selecting a provider is critical for keeping fees low and gaining access to the right investments and resources you need to manage your savings.

When deciding where to open a rollover IRA, the choice often boils down to two options: an online broker or a robo-advisor.

  • An online broker may be a good fit for you if you want to manage your investments yourself. Look for a provider that charges no account fees, offers a wide selection of low-cost investments and has a reputation for good customer service.

  • A robo-advisor may make sense if you want account management — choosing low-cost funds and rebalancing your portfolio over time according to your personal preferences and investment horizon — for a fraction of the cost of a human financial advisor. If you’re unsure how this works, check out our explainer on what is a robo-advisor to see if it’s the right choice for you.

In either case, you can review NerdWallet’s analysis of the best IRAs of 2019, which highlights top providers of both types.

3. Initiate a direct rollover from your old 401(k) plan

The IRA provider will offer ample support to help you do this — many have “rollover specialists” on staff — but the basics are simple: You’ll contact your former employer’s plan administrator, complete a few forms, and ask it to send a check for your account balance to your new account provider. (The new account provider should give you pretty explicit instructions for how the check should be made out, what sort of information should be included — like your new IRA account number — and where it should be sent.) Some providers allow you to wire the funds instead.

The key to all of the above is the phrase “direct rollover”; in other words, the money never touches your hands. You can also opt for an indirect rollover, which essentially means you’re withdrawing the money and moving it to the IRA provider yourself, a process that needs to be completed within 60 days.

On its face, an indirect rollover can feel like a short-term loan. But before you go rolling around on your mattress of money, consider: Your employer will withhold 20% of the distribution as a safeguard for the IRS, in case you get too comfortable in your riches and decide to keep that cash.

If the full balance — including that 20% — is deposited into the new IRA within 60 days, you’ll get the amount withheld back … but not until you file your tax return. That means if you want to make your 401(k) balance whole, you’ll need to come up with that 20% elsewhere. If you can’t, you may owe taxes and a 10% penalty on it, as it will be counted as an early distribution.

Bottom line here: A direct rollover is much easier on your wallet — not to mention your accounting skills, or lack thereof.

4. Invest your funds

Once the money lands in your new IRA account, you can get down to the fun part: selecting your investments.

If this is your first IRA, you’ll probably be surprised at the vast number of investments on your doorstep, especially compared with the measly selection of 10 to 20 funds in your 401(k): You can invest in mutual funds — a much wider selection of them, including index funds and exchange-traded funds (ETFs) — as well as trade stocks and options.

But for most people, the best choice is to select a few low-cost index mutual funds or ETFs, based on the asset allocation — meaning the way you divide your money among stocks, bonds and cash — that makes sense for your age and risk tolerance.

If you’re not up for that, there are more hands-off options: If you were invested in a target-date fund in your 401(k), you can find a similar (and perhaps less expensive) fund through an IRA. And if you opened your new account at a robo-advisor, that company’s computer algorithms will take care of selecting and rebalancing your investments based on questions you answer about your timeline and stomach for risk.

That’s not to say you can turn a blind eye — we’d never recommend that — but there’s something to be said for turning over the bulk of the dirty work to someone (or, in the case of a robo-advisor, something) else.

For more details on choosing your own investments, see our guide on how to invest in your IRA.