Rollover IRA: What it is and How to Rollover a 401(k)

A rollover IRA can be a great option for money in old retirement accounts. To avoid a tax hit, do it the right way.
Arielle O'SheaSep 3, 2021

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What is a rollover IRA?

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 and low fees, particularly compared with a 401(k), which can have a short list of investment options and higher administrative fees.

Is a rollover IRA a traditional IRA?

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.

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How to transfer 401k to IRA

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.

Traditional IRAs and Roth IRAs are 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 go this route, you won't pay taxes on the rolled-over amount until retirement.

  • Roth IRAs don’t offer an immediate tax deduction for contributions. Rolling into a Roth means you’ll pay taxes on the rolled amount, unless you’re rolling over a Roth 401(k). The upside is that withdrawals in retirement are tax-free after age 59½.

Here are three things to consider:

  1. If you want to keep things simple and preserve the tax treatment of a 401(k), a traditional IRA is an easy choice.

  2. A Roth IRA may be good if you wish to minimize your tax bill in retirement. The caveat is that you'll likely face a big tax bill today if you go with a Roth — unless your old account was a Roth 401(k).

  3. If you need cash from the rollover to foot the tax bill today, a Roth IRA could open you up to even more tax complications.

Your choice of rollover IRA provider is not the biggest driver of your portfolio’s growth — that's where your investments come in. However, selecting a rollover IRA provider is critical for keeping fees low and gaining access to the right investments and resources to manage your savings.

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 someone to manage your money. A robo-advisor will choose investments and rebalance your portfolio over time — for a fraction of the cost of a human advisor. Check out our explainer on robo-advisors to see if it’s the right choice for you.

When you know what type of account you want and where you want to open it, you can start the rollover process. Virtually all rollover IRA providers help you do this — many have “rollover specialists” on staff — but the basics are simple:

  • 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 information to include — like your new IRA account number — and where it should be sent.

  • Some providers allow you to wire the funds instead.

The key is the phrase “direct rollover.” That means 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, which needs to be completed within 60 days. But this process exposes you to further tax complexities, which is why we generally recommend a direct rollover.

» Check out our complete list of top IRA account providers

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.

How to choose rollover IRA investments

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.

Can you contribute to a rollover IRA?

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.

Can you take money out of a rollover IRA?

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.

Other 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 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.

Rollover IRA FAQs

No. It is considered separately from your annual contribution limit. So you can contribute additional money to your rollover IRA in the year you open it, up to your allowable contribution limit.

No. But again, you'll need to abide by your annual contribution limits for future contributions to your IRA.

Yes. There is no limit to the number of IRAs you can have. However, you may find it easier if you keep your number of IRAs low, as this will make it easier to keep track of your funds and assess things like asset allocation.

Generally, you set up a rollover IRA so that you can move money from a 401(k) without paying income tax when you move the money. (If you were to simply withdraw the money from your 401(k), rather than roll it over, you'd owe income tax and probably an early withdrawal penalty.) A rollover IRA lets you move money out of a 401(k) without sacrificing the benefit of delaying your tax bill until retirement. While 401(k) and rollover IRA accounts have some similarities, they’re also quite different. Both types of accounts offer pre-tax savings: You can put money in before you pay taxes on it and you can delay your income tax payment until you take the money out in retirement. But with a 401(k), your investment choices are dictated by your employer. With an IRA, your investment choices are almost unlimited, because most brokers offer a wide array of investment options. On the other hand, 401(k)s offer a higher annual contribution limit of $19,500 for 2021 ($26,000 for those age 50 or older), compared with the IRA contribution limit of $6,000 in 2021 ($7,000 if age 50 or older). (There's no limit on how much you can roll into an IRA from a 401(k).)

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