According to recent data from the U.S. Bureau of Labor Statistics, 67% of all private industry employees have access to an employer-sponsored retirement plan, such as a 401(k). These retirement savings accounts allow employees to save and invest for the future in a tax-advantaged way, sometimes with the added benefit of employer contributions.
But what happens when an employee who has been contributing to their employer-sponsored 401(k) leaves the company? That’s where a rollover IRA can come in.
What is a rollover IRA?
A rollover IRA is simply an individual retirement account (IRA) that is used to receive, or roll over, existing 401(k) funds after an employee leaves their job. Rollover IRAs can be brand new accounts, opened just for this purpose, or existing accounts that are used to accept other eligible retirement funds.
When considering a rollover, an existing IRA can be used or the employee can choose to open a new “rollover IRA” just for this purpose. A rollover IRA can be either a traditional or Roth IRA.
The type of IRA chosen for the rollover will impact what accounts can be rolled into it. A traditional 401(k) can only be rolled into a traditional IRA, while a Roth 401(k) needs to be rolled into a Roth IRA. Exceptions may be allowed, depending on the 401(k) plan rules, though rolling from a traditional 401(k) to a Roth IRA will also trigger a taxable event, as Roths are funded with after-tax dollars.
Why would someone use a rollover IRA?
When an investor leaves a workplace where they currently have an employer-sponsored retirement savings account, they are able to do one of three things:
- Leave the money where it is (if allowed, though this can mean higher fees and lower returns),
- Withdraw the savings in cash (though this can trigger serious tax and penalty implications, if the account holder is younger than retirement age), or
- Roll those savings into a new retirement account.
The latter can be the most cost-effective option for many employees. Within this option, there are two paths.
- Roll the funds into a new 401(k), sponsored by their new employer, or
- Roll the funds into an individual retirement account (IRA), which is not tied to an employer.
By rolling funds from a 401(k) plan into an IRA or another 401(k), employees are able to move their savings from their old workplace accounts without incurring the typical early withdrawal penalties that come with taking money out before age 59 ½. The stipulation, however, is that the funds are moved within the first 60 days of leaving the employer, and that they are moved into an eligible account.
Benefits of a rollover IRA
This rollover IRA offers many benefits to employees:
- Funds go with the investor. Rather than being tied to a specific employer, IRAs are owned by the individual (as their name suggests). This means that investors have total control over how and where those funds are invested, and they can take them with them no matter where their career goes.
- Wider range of investment options. When investing in a 401(k) through an employer, individuals are limited to the investment options chosen by the company. After moving those funds into an eligible IRA, though, they may be invested in any number of available funds or even used to buy and manage real estate.
- Rollovers can exceed typical contribution limits. While the current IRA contribution limit is $6,000 per year (or $7,000 if you’re age 50 or older), that’s intended for new contributions. Any money rolled over into an eligible IRA isn’t subject to this limit. This can allow investors to put more money into their IRAs without incurring penalties.
- Reduced fees are possible. IRAs allow individuals to select funds and financial institutions themselves. With this control, they can optimize for lower fees than might be available with 401(k)s.
How to set up a rollover IRA and roll funds over from 401(k)
Generally, any eligible funds will need to be rolled over from a 401(k) into an IRA within the first 60 days after leaving an employer. However, if there are extenuating circumstances, the IRS does allow for some exceptions to this rule.
Before the rollover can occur, a new “rollover IRA” must be set up (unless an investor wishes to use an existing IRA). Once the account is opened with a particular financial institution, employees can then transfer their existing retirement savings over. This process depends on what the employer’s plan administrator offers. There are two different ways this process can occur:
- It can be a direct rollover. With a direct rollover, the plan administrator makes the payment directly from the existing retirement account to the new account. This often involves writing a check to the new account, and mailing it either directly to the new account administrator or to the account holder. If the latter, the account holder must then mail to the new account within 60 days. Taxes generally aren’t withheld when distributing funds in this way.
- It can be a typical 60-day (indirect) rollover. With this route, distributions from the existing retirement account are paid to the account holder first, minus a mandatory 20% tax withholding on the distributed amount. These funds—in full or in part—can then be deposited into a new rollover IRA within 60 days. Since taxes were withheld, employees will then need to use funds from other sources to contribute the full amount into the new rollover IRA, if they want to avoid additional income taxes.
Here’s how indirect rollovers can work in practice. If a former employee has $20,000 in their 401(k) and opts to do an indirect rollover, their 401(k) administrator will write them a check for $16,000 (this is $20,0000 minus a 20% withholding). However, they will need to deposit the full $20,000 into the new rollover IRA in order to prevent that $4,000 from being counted as taxable income. This means that they will need to find $4,000 elsewhere—perhaps from a savings account.
If they do so, they can report the full $20,000 as a nontaxable rollover. If they only deposit the $16,000, however, they will need to pay tax on the $4,000 (added to their taxable income for the year), and will also be subject to a 10% early withdrawal penalty if they are not over age 59 ½.
Direct rollovers skip the need for withholding, because the funds never land in the hands of the account holder—they go right from one retirement account to the next.
Rollover IRA Rules
In addition to the 60-day limit, there are some important rollover IRA rules to keep in mind.
Only one IRA rollover is allowed per year. Funds can be rolled from a 401(k) into an IRA, but they can also be rolled from an IRA into another IRA. If rolling from IRA to IRA, investors are bound to the one-rollover-per-year rule from the IRS. They also aren’t able to roll funds out of an IRA that received 401(k) funds in the first year that those funds were rolled over.
Future contributions may be limited. Depending on whether the rollover IRA was a traditional or Roth IRA, employees may be limited in terms of how much money that can continue putting into that account.
For instance, all IRAs are currently limited to $6,000 in annual contributions ($7,000 if you’re over age 50), excluding contributions made through a rollover. This means that employees can’t put as much in their IRAs each year as they can put in other types of retirement accounts, such as 401(k)s.
Roth IRAs also have income limits. So, if the account owner makes too much money, they can no longer contribute to this type of account.
Owners may be subject to required minimum distributions. Once certain retirement account owners reach age 72, they are required to begin taking distributions from their account. This applies to owners of traditional IRAs, SEP-IRAs, SIMPLE IRAs, 401(k) and 403(b) accounts, and profit-sharing plans. However, distributions from Roth IRAs are not required until after the account owner passes away.
FAQs about Rollover IRA
Can I combine multiple 401k accounts into a rollover IRA?
A rollover IRA can be used to combine multiple 401(k) plan funds into one. This could mean using an existing IRA for future rollovers, or opening an account to combine multiple retirement savings balances that are currently held by former employers.
What is the difference between a rollover and a transfer of assets?
A transfer of assets occurs when funds move from one type of account into another account of the same type. This could mean moving money from one traditional IRA into another traditional IRA. With a rollover, however, funds are moving from one type of account into a different type, such as when savings are rolled from a 401(k) plan into a traditional IRA.
What types of retirement plans can I rollover into a rollover IRA?
Depending on the type of account the rollover IRA is (traditional vs Roth, etc.), there are many different retirement plans that can be rolled. This IRS chart shows exactly what can be moved where, but in general, a combination of 401(k)s, 403(b)s, 457(b)s, Roth IRAs, traditional IRAs, SIMPLE IRAs, SEP-IRAs, and qualified plans can be rolled over.
How do I know if I am eligible for a rollover?
The eligibility requirements for a rollover depend on a number of different factors. It’s important to check with the plan’s administrator to see what is allowed and any limitations that may exist. In general, though, sponsored retirement accounts can be rolled into an IRA without penalty or taxes, as long as the employee moves those funds within 60 days of leaving the employer.
The bottom line
A rollover IRA allows an individual to move funds from one retirement account to another. Using one can limit retirement savings fees, open the door to new investment options, and keep that money close by even when leaving an employer. As long as they meet the requirements of this process, they can do so without taxes or penalties. Working with not only plan administrator(s) but also a trusted financial professional can help ensure that all rules are met, and the process goes smoothly.