What Is a Rollover IRA?

Many Americans do the bulk of their retirement saving through employer-sponsored retirement plans like 401(k) accounts. When you stop working for your employer, whether due to retirement or because you've decided to take a job elsewhere, you have the option to take your money out of your 401(k) plan. However, if you just take your retirement money and put it in a regular bank account, then you'll lose all of your tax benefits from the 401(k), and you can owe early withdrawal penalties. A rollover IRA lets you preserve the tax-deferred benefits of the retirement account, and as long as you go through the right process, a rollover IRA can offer more flexibility than most 401(k) retirement plans in letting you manage your investments.

Why rollover IRAs are smart

A rollover IRA is a retirement account that you create to receive money from 401(k) or other employer-sponsored retirement plan accounts. Done correctly, the rollover transaction lets you avoid having to include the amount you move from your 401(k) as taxable income, prevents you from having to pay a 10% penalty if you're younger than age 59 1/2, and preserves the tax deferral that the retirement plan account had.

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In addition, rollover IRAs have some advantages over IRAs into which you've made direct contributions. In some jurisdictions, the creditor protection for rollover IRAs is unlimited, while contributory IRAs have an upper limit on the amount one can shelter from creditors.

It used to be that setting up a rollover IRA was very important if you wanted to be able to move your retirement money back into a 401(k) plan at some point. When you start a new job, most companies allow you to take money you had in a previous 401(k) and roll it over into the new employer's 401(k) plan. But federal law used to require that rollover IRA money be kept separate from other IRA funds if you wanted to put the rolled over funds back in another 401(k) in the future. Now, the rules on moving money between IRAs and 401(k)s are much less strict, making it less important to keep separate accounts.

How to open a rollover IRA

There are a couple of ways you can open a rollover IRA. The best is to do what's called a direct transfer, in which your former employer sends the money directly to the financial institution you've chosen to manage your IRA. Typically, you'll have paperwork you have to fill out with your former employer and with the financial institution receiving the IRA funds. The benefit of the direct transfer is that you never have custody of the money, and so there's no chance that you'll make a mistake and end up having to pay tax and penalties on the rollover money.

The other method is to do what some call an indirect rollover. With this method, you actually receive a check from your previous employer, and it's up to you to take that check and deposit it with the financial institution that will have your rollover IRA within 60 days. If you don't, you'll be treated as having taken a taxable distribution of the full amount and potentially have to pay penalties as well.

The other downside with indirect rollovers is that your employer might withhold income tax on the 401(k) distribution, and if that happens, it's up to you to replace the withheld amount with money of your own. Again, if you don't, the withheld amount will be treated as a distribution with tax and penalty implications.

Look closely at rollover IRAs

Yet perhaps the biggest benefit from rollover IRAs comes from the investment flexibility they offer. Most 401(k) plans have limited investment options that can be expensive and prevent you from buying individual stocks. In an IRA, you can choose lower-cost mutual fund or ETF investments, buy individual stocks, or look at a wide range of other types of eligible investment options.

Using a rollover IRA rather than just taking a taxable distribution from your 401(k) or other employer sponsored retirement plan is a smart move. By making sure you get the mechanics done right, you'll make sure you don't get a nasty surprise from the IRS.

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