What is an IRA Rollover?
Find out how to move assets between retirement accounts tax free.
You probably know that you’re typically not allowed to take money out of a retirement account, like a 401(k) or a traditional IRA, without paying taxes or an early withdrawal penalty if you’re younger than age 59½. But I’ll tell you how to use a rollover to move money or property between most types of retirement accounts so you avoid those pesky taxes and penalties.
What is an IRA Rollover?
A rollover is a tax-free transfer of cash or other assets from one retirement account to another. The most common reason for doing a rollover is when you leave a job and want to take your retirement funds with you instead of leaving them in your old employer’s account. You can’t roll over funds from a workplace plan while you’re still employed—you have to wait until you say goodbye to your old job. Here are 2 examples:
Sally decides to leave her teaching job to relocate out of state. Though she still has control over her 403(b) retirement funds, she wants more investment options than the plan allows. She decides to roll over the account balance into a traditional IRA where she can choose from thousands of investments and continue to make monthly contributions.
John is an attorney who leaves his company and starts working for a new firm. After 60 days he’s eligible to participate in the firm’s 401(k) and he’s really impressed with it. He decides to roll over funds from his old 401(k) directly into his new 401(k).
Both of these situations can take advantage of a rollover so money is transferred without triggering any taxes or early withdrawal penalties.
Different Types of Rollovers
You can roll over funds from and to most types of retirement accounts, as long as you don’t mix pre-tax and post-tax contributions. Remember that contributions to regular or traditional retirement accounts are not taxed, but contributions to Roth accounts are. So you can roll over a pre-tax 401(k) into a traditional IRA, but not into a Roth IRA, without paying income tax on the rollover amount.
You may have heard of a Roth conversion. That’s when you roll over all or a portion of a traditional IRA into a Roth IRA. There’s no restriction on your income to make a Roth conversion; however, there is an annual income limit for making contributions to a Roth IRA each year. So, when you make too much money you become ineligible to contribute to a Roth IRA (but there’s no income restriction for making contributions to a traditional IRA).
As I mentioned, you must pay income tax on any amount you convert from a traditional IRA to a Roth IRA that wasn’t previously taxed. But doing a conversion allows you to avoid the 10% additional penalty for early distributions.
IRA Rollover Rules
One of the most important rules to know about making a retirement rollover is that there’s a strict time limit to complete it once you receive a distribution check. You must make your rollover or conversion contribution within 60 days (including weekends and holidays)—otherwise it’s considered an early withdrawal and will be subject to ordinary income tax plus a penalty if you’re younger than age 59½.
So always treat a rollover distribution like a hot potato and be ready to forward it to your new account right away!
How to Roll Over Your Retirement Account
When you’re ready to do a rollover simply download a request form from your online retirement account, or get one from your account custodian or the benefits administrator at work.
You can receive a check made payable to you or one made payable to your new retirement account, which is called a direct rollover. I strongly recommend that you always make a direct rollover.
Here’s why: When you receive rollover funds in your name there’s an automatic 20% withholding penalty applied—even if you intend to complete the rollover later. Let’s say you want to roll over $10,000 from your 401(k). The custodian must withhold 20% for taxes and you’ll only get a check made payable to you for $8,000.
You can add funds from other sources to equal the amount withheld. For instance, if you have $2,000 in a savings account, you can deposit those funds in your retirement account to replace the missing amount of rollover withholding.
If you complete the rollover, you’ll eventually receive a refund for the withholding when you file taxes. But the refund could take many months and you lose potential investment gains every day that those funds aren’t under your control. With a direct rollover—where the distribution is made payable to the new retirement account—there’s no withholding, so that’s always the best option.
At the end of the year, you’ll receive Form 1099-Ropens PDF file or Form 5498opens PDF file from your account custodian to document the rollover. You can’t deduct a rollover distribution from your taxable income, but you have to include it on your tax return.
So, instead of cashing out an old retirement account and paying unnecessary taxes and penalties, use a rollover to move the money into a new retirement account. That will give you more investment options and allow you to continue making tax-advantaged contributions so you build your retirement nest egg as quickly as possible.
To learn about my recommendations for the best places to open up your rollover IRA, head over to SmartMovesToGrowRich.com to watch a video with more information on this topic.
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Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
