Rollover IRA: How to Rollover a 401(k) & FAQs

A rollover IRA is an account used to move and consolidate money from old 401(k)s or other employer-sponsored retirement plans into an IRA. A benefit of a rollover IRA 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.

A rollover IRA can be a traditional IRA. It can also be a Roth IRA if you want to roll money from a Roth 401(k). You can roll money from a traditional 401(k) into a rollover Roth IRA, but then you'd owe income tax on the money you rolled over.

One main difference between a traditional or Roth IRA and a rollover IRA is that you can roll over as much money as you want into the rollover IRA.

» MORE: Learn how to move money from one 401(k) to another 401(k)

Yes. However, in 2020 and 2021, 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.

Rollover IRAs are subject to the same withdrawal rules as all IRAs. Unless you have qualifying circumstances, a withdrawal from an IRA before you reach age 59 1/2 is likely to come with income taxes and potentially a 10% penalty from the IRS.

Here are the traditional IRA withdrawal rules and the Roth IRA withdrawal rules.

If you have an existing IRA, you can transfer your balance into the IRA you have (as noted above, this may make it difficult to roll your money back to a 401(k) later; consider opening a new account if that's a concern for you).

If you don’t have an existing IRA, you’ll need to make two decisions up front: which type of rollover IRA you want and where to open that account.

There are three steps to a rollover IRA.

» Check out our complete list of top IRA account providers

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 over. This is the best choice for many people: You can roll your money into a new employer’s retirement plan or into an IRA. 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 a short list of investment options and higher administrative fees.

• 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.

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.

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.

• 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 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 for your IRA at a broker.

• If you opened your new account at a robo-advisor, that company’s computer algorithms will select and rebalance 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 else.

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