What Is a Rollover IRA and How Do I Open One?

A rollover IRA is a great option if you have money sitting in an old 401(k) plan. But to get the full benefit and to avoid a tax hit, you have to roll your money over the correct way.

Arielle O'SheaOctober 25, 2019

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What is a rollover IRA?

A rollover IRA is an individual retirement account created by transferring money from a 401(k) or other type of retirement account. A major benefit of a rollover IRA is that it keeps your retirement dollars safe from taxes when the process is done correctly.

When you open a rollover IRA, you can choose the type of IRA you want. If you're moving money from a regular 401(k), then a traditional IRA usually makes the most sense. If you're moving money from a Roth 401(k), then you'd want your rollover IRA to be a Roth IRA. See below for more on the differences between traditional and Roth IRAs.

What are the benefits of a rollover IRA?

If you’re leaving a job, you usually have three choices:

  • 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.

How do you open a rollover IRA?

If you have an existing IRA, there’s no need to start a new account: You can just roll your balance into the one you have. If you don’t, you’ll need to make two decisions up front: which type of IRA you want and where to open that account.

Choosing an account type

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.

If you wish to keep things simple and preserve the tax treatment your 401(k) offered, a traditional IRA is an easy choice. That said, rolling to a Roth IRA may be a good option if you wish to minimize your tax bill in retirement. The caveat here is that you will likely face a decently sized tax bill today if you go with a Roth — unless your old account was a Roth 401(k). And if you need to use cash from the rollover to foot the tax bill today, this option is likely a bad choice, as you'll open yourself up to even more tax complications. Stick with a traditional IRA when that's the case.

Choosing a provider

Your choice of IRA provider is not the biggest driver of your portfolio’s growth. It's 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 IRA accounts of 2019, which highlights top providers of both types. Or you can browse the providers below, each of which were highlighted in that report: Merrill Edge is a DIY brokerage that won in our category for best retirement tools, and Betterment, a robo-advisor, claimed top honors in our category for the best provider for hands-off investors.

How to do your rollover the right way

When you know what type of account you want and where you want to open it, it's time to start the rollover process.

Virtually all IRA providers 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. But this process can expose you to all sorts of further tax complexities, which is why we recommend a direct rollover in virtually all cases.

Taxes on rollover IRAs

If you do a direct rollover as described above, you’re good to go. No taxes to consider until that day when you start withdrawing money in retirement.

If, however, you do an indirect rollover — that is, you receive a check made out to you — then there are some rules to watch for so that 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 the income tax bill, 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) account minus 20% of the account balance. That 20% is withheld by the plan administrator to pay taxes on your distribution.

But if you’re planning to roll your money into an IRA, you can avoid paying taxes now by taking steps to make sure you get that money back from the IRS. (The exception to this is if you want to open a Roth IRA, which will require taxes paid on the distribution, unless your money was in a Roth 401(k).) However, 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 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.

That way, come tax time, the IRS will see that you’ve rolled over the entire retirement account, and will refund you the amount that was withheld in taxes. You also avoid a 10% penalty, because if you only put $16,000 into the IRA, the IRS will say you’ve taken an early withdrawal of $4,000. You’ll owe the early withdrawal penalty on the $4,000 — and, believe it or not, income tax, too.

How to choose your 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, especially compared with the measly selection of 10 to 20 funds in your 401(k). 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.

More rollover questions? We have answers

A rollover IRA can be a traditional IRA, with the same withdrawal rules. Or, you can open a rollover IRA that's a Roth - that's what you would do to roll money from a Roth 401(k). You're allowed to roll traditional 401(k) money to a rollover Roth IRA, but then you'd owe income tax on the money you rolled over. The 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. If you make IRA contributions in addition to your rollover, you're limited to a maximum of $6,000 in 2019, or $7,000 if you're age 50 or older.

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.

Yes. The only cautions here are 1) contributions to an IRA are limited to $6,000 per year ($7,000 if you're age 50 or older), 2) if you chose a Roth IRA for your rollover, your ability to contribute may be further restricted based on your income, 3) if you mingle IRA contributions with IRA rollover funds in one account, that may make it difficult to move your rollover funds back to a 401(k) if, say, you start a new job with an employer with a stellar 401(k) plan, and 4) your ability to deduct your 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 IRA contribution limits for more details.

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 $19,000 ($25,000 of age 50 or older), compared with the IRA contribution limit of $6,000 ($7,000 if 50 or older). (There's no limit on how much you can roll into an IRA from a 401(k).)