What is a rollover IRA?

coins in a jar labeled savings

A rollover IRA is an Individual Retirement Account that is funded by closing a 401(k) (or similar account) at a previous job and moving those funds to the new individual retirement account (IRA).

The key factor is that by classifying this as a rollover, not a distribution, it doesn’t trigger any taxes or penalties that usually result from pulling money from a retirement account early.

A rollover IRA has the same tax advantages that you get with any IRA; your investment grows tax-deferred, so you end up with more in retirement than if you invested for retirement in a standard brokerage account.

Contributions to traditional IRAs are tax deductible, up to a limit, and with restrictions based on your income. You don’t need to worry about those limits and restrictions for a rollover.

If you have money in a traditional 401(k) you can roll the entire amount over into a rollover IRA and it doesn’t count towards the contribution limits, and it isn’t limited by the income restrictions.

If you leave a job,it’s best to handle the transfer quickly if you decide to move your 401(k) funds away from your old company. Your old company may distribute your 401(k) funds to you without giving you a choice so don’t delay.

It’s also very important to handle the transfer the right way. The simplest way is to initiate a direct transfer. Select an IRA provider (there are many options, most brokerages of any size offer a Rollover IRA) and get instructions from them on how to transfer your funds in. Then contact your 401(k) provider from your prior job and give them instructions on how to make the transfer. Usually, you don’t want to take a distribution from your 401(k) and then put that money into the new IRA later. 20% will be withheld in taxes, and you’ll be subject to a 10% early withdrawal penalty if you don’t get that money correctly deposited into a qualified retirement account quickly (usually 60 days).

It is much, much simpler to do a direct transfer, and it’s a process that the company your new IRA is with will have clear instructions on how to get it done.

Finally, make sure you make invest the funds when they hit your new IRA account. In almost every case, the securities you held in your 401(k) aren’t transferred. They are sold, and the resulting cash is what is transferred. Make a note of what your investments were in your 401(k) and you can probably find similar options, if not the identical funds, in your IRA if you want to keep things basically the same.