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What is a rollover IRA?
A rollover IRA is an account used to move money from old employer-sponsored retirement plans such as 401(k)s into an IRA. A benefit of an IRA rollover is that when done correctly, the money keeps its tax-deferred status and doesn't trigger taxes or early withdrawal penalties.
Rollover IRAs can also provide a wider range of investment options and low fees, particularly compared with a 401(k), which can have a short list of investment options and higher administrative fees.
Options for an old 401(k)
If you’re leaving a job, you usually have three choices and they all have benefits.
Leave it be. If your ex-employer lets you, you can leave your money where it is. This isn’t ideal: You’ll no longer have an HR team at your disposal to help you with questions, and you may be charged higher 401(k) fees as an ex-employee.
Roll it into retirement plan. This is the best choice for many people: You can roll your money into an IRA or a new employer’s retirement plan.
Cash out. This is almost certainly your worst option. Not only does cashing out sabotage your retirement, 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.
» Dig deeper to see if a 401(k) rollover to IRA is right for you
How to transfer a 401(k) to IRA
There are three steps to a rollover IRA.
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Taxes for rollover IRAs: 2 rules to know
If you do a direct rollover, you’re good to go. No taxes to consider until you start withdrawing money in retirement.
If you do an indirect rollover — that is, you receive a check made out to you — then mind these rules so you don’t end up owing a big tax bill:
1. The 60-day rule
With an indirect rollover, you have 60 days from the date you receive the distribution to get that money into an IRA. If you miss that deadline, the IRS will likely deem this an early withdrawal, which means that in addition to income tax, you could owe a 10% early withdrawal penalty.
2. Taxes are withheld
With an indirect rollover from a workplace retirement plan, usually the check you receive will be for the amount of your 401(k) balance minus 20%. The plan administrator withholds the 20% to pay taxes on your distribution. (If you have a traditional 401(k) and you want to rollover into a Roth IRA, you will need to pay additional taxes, unless your money was in a Roth 401(k).)
To get your money back, you must deposit into your IRA the complete account balance — including whatever was withheld for taxes.
For example, say your total 401(k) account balance was $20,000 and your former employer sends you a check for $16,000 (that’s the full account balance, minus 20%). Assuming you’re not planning to go the Roth route, you'd need to come up with $4,000 so that you can deposit the full $20,000 into your IRA.
At tax time, the IRS will see you rolled over the entire retirement account and will refund you the amount that was withheld in taxes.
You also avoid a 10% penalty. On the other hand, if you had only put $16,000 into the IRA, the IRS would consider that an early withdrawal of the remaining $4,000. You’d owe the early withdrawal penalty on that $4,000 — and, believe it or not, income tax, too.
» Learn more about IRA rules before doing a rollover
Can you contribute to a rollover IRA?
Yes. However, in 2021 and 2022, contributions are limited to $6,000 per year ($7,000 if you're age 50 or older). If you chose a Roth IRA for your rollover, your ability to contribute may be further restricted based on your income.
Your ability to deduct traditional IRA contributions from your taxes each year may be restricted if you or your spouse has access to a workplace retirement plan and you earn over a certain threshold. See this article for more details.
If you mingle IRA contributions and IRA rollover funds in one account, it may be difficult to move your rollover funds back to a 401(k) if, say, you start a new job with an employer that has a stellar 401(k) plan.