IRA’s are special brokerage accounts designed to allow individuals to save money for their retirement and manage their portfolios. There are two types of IRA’s: Traditional or Roth. There are also two types of contributions to an IRA:
- rollover contributions and
- direct contributions.
These contributions can either be tax-deferred or not. This can get a bit complex since taxes and the IRS are involved, so let’s go over the similarities and differences.
To begin with, rollover contributions come from an investor’s 401(k), 403(b), or other retirement plan. There isn’t technically such a thing as a Rollover IRA; it’s actually a type of tax-free distribution from one retirement plan to another.
However many brokerage houses will designate new IRA’s that are created from a rollover so that the IRS knows that the new account contains assets that were transferred from another 401k, 403b, another IRA or some other qualified plan. Because rollover contributions come from an existing tax-advantaged retirement plan, the rollover contribution isn’t typically taxed or subject to the annual limitations of direct contributions.
A rollover Individual Retirement Account (IRA) is an account that allows for the transfer of assets from an old employer-sponsored retirement account to a traditional IRA. The purpose of a rollover IRA is to maintain the tax-deferred status of those assets. Rollover IRAs are commonly used to hold 401(k), 403(b) or profit-sharing plan assets that are transferred from a former employer’s sponsored retirement account or qualified plan.
Rollover IRA funds can be moved to a new employer’s retirement plan. Rollover IRA’s do not cap the amount of money an employee can roll over and they permit account holders to invest in a wide array of assets such as stocks, bonds, ETF’s and mutual funds.
What does ‘Rollover IRA’ mean?
By moving retirement plan assets through a direct rollover, in which the former employer’s plan administrator moves the assets directly to the rollover IRA, employees avoid having 20% of their transferred assets withheld by the Internal Revenue Service (IRS).
Alternately, assets can be moved using an indirect rollover, in which the employee takes possession of the plan assets and then places them into another eligible retirement plan within 60 days. With an indirect rollover, however, 20% of the account’s assets may be withheld and cannot be recovered until the employee files his or her annual tax return. If the movement of assets from a qualified employer-sponsored retirement plan to a rollover IRA is not handled correctly, the employee will face taxes. If he has not yet reached retirement age (59½), he will also pay early withdrawal penalties on those assets.
Most IRA programs allow a single rollover per year. Most rollover IRA’s are executed via direct (electronic) transfer or by check, though with the latter there may be a 20% withholding charge to ensure that the individual deposits the entire sum into the rollover IRA (essentially, a refundable tax charge). In the case of a transfer by check, the rollover check must be deposited within 60 days.
Rollover IRA Options
An alternative to rolling distributions into a rollover IRA is for the employee to roll them directly into a new retirement account with a new employer. Other options include rolling assets into a Traditional IRA, but this may have implications for transferring the funds to another employer’s retirement account in the future. The rollover money can also be converted into a Roth IRA, but taxes will be due since qualified employer retirement plan contributions are made pre-tax and Roth IRA’s can only hold post-tax contributions.
What Are the Disadvantages of a Rollover IRA Compared to a 401(k)?
With a Rollover IRA, there are tens of thousands of potential investments. For those with no financial background, this can be overwhelming. It can also present the temptation to frequently trade, which can result in substantial frictional costs and sub-par returns. Also, you can only take advantage of the Rollover IRA once each year.
What You Can Do With Your Retirement Plan Assets if You Quit or Lose Your Job
The lifetime employment our grandparents once enjoyed, sadly, no longer exists in today’s competitive global economy. For the majority of the current and future workforce, the odds are good that at some point in their lives, they will leave their current employer due to company downsizing, outsourcing, termination, or in pursuit of new opportunities. It’s even possible they’ll quit just because they can’t face the prospect of going to work anymore.
If your employer offers a company retirement plan such as a 401(k), and you find yourself no longer employed due to reasons mentioned above, you have a few options regarding the assets you’ve invested throughout your employment. They are:
- Cash out and take the money, incurring large tax penalties to the IRS. This is ordinarily a huge mistake because you also lose the tax shelter from investing in a protected account (e.g., if you made $500 in dividends from stocks held in a retirement account, you likely won’t owe any taxes on that money for decades, if ever, whereas if you held the stock in a regular non-retirement account, you would get hit with taxes each year).
- Move the money from your current employer’s plan to your new employer’s 401(k) plan. On one hand, the transfer is relatively easy and it keeps your assets consolidated. On the other hand, you will be subject to the choices provided by your new employer. This can be a major disadvantage for investors that know which stocks they want to own, or if your new employer offers a collection of investment options that aren’t quite as satisfactory as those offered by your former employer.
- Open a Rollover IRA with a brokerage firm and have the funds from your old 401(k) deposited into the account. Not only will you continue to enjoy the tax protection of a qualified retirement account, but you will be able to invest in practically any stock, bond, mutual fund, real estate investment trust, or other security available through your broker. (See Page: Top 10 Gold IRA Companies)
IRA Rollover Rules
There are subtle differences between what is considered an IRA rollover, and what is considered an IRA transfer. The important thing to know – with either one in order for the rollover to be tax-free, the funds must be deposited in the new account no later than 60 days from the time they were withdrawn from the old one. Below are ten frequently asked questions about how these IRA rollovers and transfers work, and what you can and cannot do.
1) Moving Funds While Still Employed
- Most company retirement plans do not allow you to move funds out of the plan while you are still employed. To find out if they do, you can call your plan sponsor, and ask if they allow what is called an “in-service distribution”. The plan does not have to allow this option.
- An in-service distribution is a different type of transaction than a loan or hardship withdrawal. An in-service distribution is a transaction where you can roll over a portion of funds in your plan into a self-directed IRA account while you are still employed. Only some plans allow this.
- Once you are no longer employed there, the rules change. At that time it may make sense to roll funds from your plan into an IRA account. To avoid tax withholding, you’ll want to choose what is called a direct IRA rollover where the check is made payable to your new financial institution as the new trustee or custodian.
- Although most people think of an IRA rollover as moving funds from a 401(k) to an IRA, there is also a reverse rollover where you move IRA money back into a 401(k) plan. If you have small IRA accounts in many places, and your employer plan offers good fund choices with low fees, using this reverse rollover option can be a way to consolidate everything in one place.
2) The Tax Obligations When Moving Funds From Employer Plan to IRA
- If an eligible rollover distribution is paid directly to you, 20% of it must be withheld for federal taxes. This is sent directly to the IRS. This applies even if you plan to roll over the distribution to a traditional IRA. You can avoid this mandatory tax withholding by choosing a direct rollover option, where the distribution check is payable directly to your new financial institution
3) Transfering Funds From One IRA to Another IRA
- An IRA transfer occurs when you move IRA funds from one financial institution directly to another. As long as there is no distribution payable to you, then the transfer is tax-free.
4) Using IRA funds Tax-free If Depositing Back into IRA
- If you withdraw funds from an IRA, and then subsequently redeposit them to your IRA within 60 days, the transaction would not be taxed. You can only do this type of IRA transfer once in any 12 month time period. This one-per-year provision does not apply to trustee-to-trustee transfers where the money is sent directly from one institution to another.
- You could use this 60-day provision to “borrow” funds from your IRA for a short period of time. However, if any portion of the distribution is not repaid within the 60 days, and you are under age 59 1/2, it would be considered an IRA early withdrawal, subject to taxes and penalties, unless you can qualify for an exception.
5) Using an IRA Rollover to Move Part of Account
- Luckily IRA rollovers are not an all-or-nothing proposition. You can use an IRA rollover to move a portion of your funds from one IRA to another, or once retired, to rollover part of a company retirement plan to an IRA.
6) Inheriting an IRA and Rolling Into Your Own IRA
- If you inherit a traditional IRA from your spouse, you can roll the funds into your own IRA, or you can choose to title it as an inherited IRA. There are pros and cons to doing it either way.
- If you inherit a traditional IRA from someone other than your spouse, you cannot roll it over or allow it to receive a rollover contribution. You must withdraw the IRA assets within a specified period of time according to the required minimum distribution (RMD) rules.
7) Rollover Required Minimum Distributions Requirements
Amounts that must be distributed during a particular year under the required minimum distribution rules are not eligible for IRA rollover treatment. However, you can distribute shares of investments from your IRA to satisfy the RMD requirements. These shares can then stay invested in a non-retirement brokerage account. Whether you distribute cash or shares, any amount distributed from your IRA will be reported on a 1099-R and is included on your tax return as income.
8) Reporting IRA Rollover Transactions On Tax Return
IRA rollovers are reported on your tax return but as a non-taxable transaction. Even if you correctly execute an IRA rollover, it is possible that your plan trustee or custodian will report it wrong on the 1099-R they issue to you and to the IRS. I have seen this occur many times in my career.
If your custodian reported the transaction incorrectly, and you hand off the documentation to your tax professional without explaining the transaction to them, it could get reported on your return incorrectly. To make sure you don’t pay tax on an IRA rollover or transfer, carefully explain any IRA rollover or transfer transactions to your tax preparer, or double-check all documentation if you prepare your own return.
9) Rollover After-Tax Funds to a Roth IRA
Recent tax rulings confirm that after-tax moeny in a qualified company plan can be rolled to a Roth IRA. This is a great option as Roth IRA money grows tax-free and you will not have required distributions from a Roth.
10) Transferring Company Stock From Plan to IRA
You may be able to use a special tax rule to distribute shares of company stock out of the plan once you are retired or no longer working there. This is a distribution option called Net Unrealized Appreciation (NUA). Some 401(k)’s may allow you to transfer existing shares directly to an IRA. Many institutions require the funds to go to your IRA as cash instead of as shares. Check with your 401(k) plan financial custodian to see what distribution options are allowed.
In a Traditional IRA, your money becomes subject to an RMD in the year you turn 70 ½. That means that after you turn 70 ½ you are required by law to start pulling money out of the Traditional IRA. In addition, you cannot start a new Traditional IRA account after 70 ½.
One major benefit of a Traditional IRA is that there is no income limit on contributions. Even if you make millions of dollars a year, you are still allowed to sock away contributions to a Traditional IRA and the earnings on that money will be tax deferred until withdrawal. However, your ability to deduct the contribution is phased out based on income and you or your spouse’s eligibility for a retirement plan at work.
Roth IRA’s do not have any age limits or a Required Minimum Distribution. You can open a new Roth IRA at age 85 if you want, and start saving for your “retirement.” However, Roth IRA’s have a very major restriction: you can’t contribute any money to a Roth IRA if your Adjusted Gross Income is above a certain amount. For single tax filers, that upper limit is $105,000 a year. For married people filing jointly, the upper limit is $167,000 as of tax year 2010.
You can rollover from a Traditional IRA to a Roth IRA by paying taxes on the funds in your Traditional IRA to equate their tax status with the funds in your Roth IRA. Converting from a Roth IRA to a Traditional IRA is generally not done—you’ve already paid taxes on your funds in your Roth IRA, why pay them again in retirement? Similarly, you can rollover a Traditional 401(k) into a Traditional IRA without paying taxes or a Roth IRA with paying taxes, but it would not make sense to rollover a Roth 401(k) into a Traditional IRA. From 2010 onwards, there are no income limits or restrictions on rolling over a Traditional IRA into a Roth IRA as long as you pay taxes on the “contribution”.
Feel free to view our page on the Best IRA Rollover Options for more information on how you can rollover any of your retirement plans to an IRA containing gold and physical precious metals.
Do you have any questions on what is an IRA rollover? Ask below!