A 401(k) rollover IRA may help you move your retirement assets into a new account from a previous employer’s sponsored retirement plan without incurring taxes or other penalties.
- Using a rollover IRA may help you avoid taxes and penalties associated with early withdrawals, helping to ensure that you retain the benefits of tax-deferred retirement assets.
- There are two types of rollovers – direct and indirect – which differ based on who is involved in moving your money, either a retirement plan administrator or an investor.
- Many 401(k) rollover IRAs, direct or indirect, must be made within 60 days to avoid any penalties set by the IRS.
When changing jobs, you may wonder how to move your retirement assets from your employer’s 401(k) plan into another retirement account, like an IRA. One way to do this is with a rollover IRA, which allows you to protect your retirement assets from additional taxes or penalties when transferring your funds. But what is a rollover IRA, and how does it work?
What Is a Rollover IRA?
Rollover IRAs are accounts that allow you to transfer assets held in a former employer’s employer-sponsored retirement plan into a traditional IRA. The main purpose of a rollover IRA is to maintain the tax-deferred status of those assets and ensure the safe transfer of your retirement assets.
A rollover IRA is often used to hold 401(k) or 403(b) assets transferred from a previous employer’s sponsored retirement account or retirement annuities.
There are no limits to the amount of money you can roll over or in how you choose to invest that money.
How Does a Rollover IRA Work?
Not all IRA rollovers are alike. How they work will depend on the method used to roll the funds over and the type of account being used.
Choosing Between a Traditional and Roth IRA
When choosing a method for IRA rollovers, eligibility is key.
Traditional IRAs typically allow anyone with earned income to contribute, although tax deductibility is reduced for those on higher incomes. Roth IRAs have income caps that limit the amount you can contribute.
One of the benefits of Roth IRAs is tax-free growth and withdrawals, which appeal particularly to individuals in higher tax brackets during retirement. However, traditional IRAs offer tax relief through tax-deductible contributions and taxes deferred until the funds are withdrawn in retirement. This type of tax relief could be beneficial for those looking for more immediate tax deductions.
To decide which option is better for you, consider weighing your current and future income levels, retirement timeline, and tax status.
Direct vs. Indirect Rollovers
When an employee leaves a company, many IRA rollovers are made directly to protect funds from losing their tax-deferred status or early withdrawal penalties. Direct rollovers work by requesting the employer’s retirement plan administrator to transfer the funds directly into another retirement account.
However, another option is the indirect rollover, which involves transferring funds from a tax-deferred account to an investor. That investor then deposits the funds into another tax-deferred account.[1]
Key IRS Rules & Timelines
Two important rules to note are the 60-day rollover and the one-rollover-per-year rule.
As long as you complete a rollover of funds into another retirement or IRA account within 60 days, you can avoid penalties for early withdrawals.
The one-rollover-per-year rule is that you usually cannot make more than one rollover from the same IRA within a one-year period. However, this limit doesn’t apply to all types of rollover.[2]
Exempt types of rollovers include:
- Rollovers from traditional IRAs to Roth IRAs
- Trustee-to-trustee transfers to another IRA
- IRA-to-plan
- Plan-to-IRA
- Plan-to-plan
Tax Implications
If you have not yet reached retirement age, manually moving the money held in your employer-sponsored retirement account may be considered a withdrawal. As a result, you could face taxes or early withdrawal penalties – even if you’re simply moving the money into another retirement account.
However, using a rollover IRA allows you to perform a direct rollover, where a plan’s administrator can transfer the assets directly to a rollover IRA. This means that when employees leave a company, they won’t be penalized for moving their retirement funds, nor will they incur taxes or potentially have 20% of their transferred assets withheld by the Internal Revenue Service (IRS).[3]
Benefits of a Rollover IRA
Rolling over a 401(k) to an IRA comes with tax and investment benefits both in the long and short term.
Tax Advantages
By using a rollover IRA when an employee leaves a job, they may avoid taxes or penalties associated with early withdrawals. They also may not have to pay tax on potential growth until it’s time to make withdrawals.
Broader Investment Options
A rollover IRA generally provides more options for choosing your own investments than a traditional employer-sponsored retirement plan.
Consolidation and Simplicity
Consolidating previous employer-sponsored retirement plans under one IRA account may make retirement planning and accessing funds later on in life easier.
Alternatives To a Rollover IRA
A rollover IRA isn’t the only option available. Alternatives to managing your retirement funds when you leave a job include:
Leaving Money in Your Former Employer’s Plan
While it may depend on your employer’s retirement plan, some people choose to simply leave the funds in their old employer’s 401(k) accounts rather than move them. This keeps things consistent and helps to avoid tax or penalties while maintaining its tax-deferred status.
However, this option may limit your investment options and make accessing the money more difficult. There may also be a minimum account value required to keep the plan.
Rolling Over to a New Employer's Plan
Some instead choose to let their funds roll over to a new employer’s plan. This is typically managed by the administrator from your previous employer and ensures that your funds maintain their tax-deferred status, avoiding taxes or penalties. The pros and cons of this option may largely depend on the type of plan your new employer offers.
Taking a Cash Distribution
Another option is a cash-out from your plan, giving you access to the money immediately. However, unless you’re 59½ or older, you may face penalties and income tax, which could deplete a large portion of your retirement assets, leaving you with less later on in life.
Receiving this cash lump sum could also push you into a higher income bracket, leading to higher taxes on your overall income.
Frequently Asked Questions about Rollover IRAs
Some common questions we hear about rollover IRAs include:
Can You Contribute to a Rollover IRA?
Yes. Even when you roll over your funds to a new IRA, you will still be able to make contributions to your account to further grow your money.
Is There a Limit to How Much You Can Roll Over?
No. IRA contribution limits do not apply to rollover contributions.[4]
Can You Have More Than One Rollover IRA?
Yes, but you can only make one tax-free rollover IRA within a one-year period. However, this limit doesn’t apply to traditional Roth IRA rollovers.
What if You Have Both Pre-Tax and After-Tax Funds?
If your 401(k) account balance has both pre-tax and after-tax contributions, a distribution usually includes a pro rata share of both.[3]
Final Thoughts
A rollover IRA may be a good option for anyone leaving a workplace, as it allows them to avoid taxes and penalties when moving their retirement funds. Moving from a previous employer’s 401(k) to a rollover IRA may also open up greater opportunities to manage your investments and consolidate your retirement assets.
If you are unsure of the best option for you, it’s always worth seeking professional advice to help you assess your options. PNC offers a way to move your money safely while making the most of your tax-deferred status. Learn more about PNC Wealth Management Rollover IRAs.
