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What is a rollover IRA? How to transfer funds from your 401(k) to an IRA and avoid taxes

If you have an employer-sponsored plan like a 401(k), you might wonder what happens to your money when you leave the job — either for a new gig, to work on your own, or to retire early. 

A rollover IRA is one alternative. It could be a smart choice if you’re looking for more investment options, lower charges, and significant tax benefits.

What is a rollover IRA?

A rollover IRA is an individual retirement account that can accept funds from a former employer-sponsored retirement plan. Most rollovers happen when people leave a job and want to transfer funds from their 401(k) or 403(b) account into an IRA, but it can also apply to most any pension or workplace plan. 

When you transfer — roll over, in IRS-speak — you avoid early withdrawal penalties (if you’re under 59½) and maintain the tax-deferred status of your assets. That means they’ll continue to grow in the account free of income tax.

What’s more, you’ll likely end up with a broader range of investment options and lower charges than you had with the 401(k).

Any type of IRA can be, or become, a rollover IRA. You can set up a new account, or use an IRA you already own. If it’s the latter, for this one deposit you aren’t bound by the usual annual IRA contribution limits: You can invest the total amount of your old account.

How to set up a rollover IRA 

Ready to roll over your employer-sponsored plan into an IRA? Here’s how to do it, step by step:

1. Decide which type of IRA account you want. 

A rollover IRA can be either a traditional IRA or a Roth IRA. You can roll tax-deferred (traditional) accounts into Roth accounts, but not vice versa.

It’s generally better to move like to like — roll over a plan into an account with the same tax status. If you have a traditional 401(k), you can roll it into a traditional IRA without owing any taxes on the amount (you pay taxes later when you withdraw funds, usually after you retire). Likewise, you can move a Roth 401(k) into a Roth IRA tax-free. 

However, if you roll money from a traditional 401(k) into a Roth IRA (aka a Roth conversion), you’ll be on the hook for income taxes for that sum — because the 401(k) was funded with pre-tax money, remember, and a Roth is funded with after-tax dollars. But after that, the money will grow tax-free, and you won’t owe any taxes on withdrawals during retirement.

2. Open the account. 

Visit your bank or brokerage firm’s website to fill out an application online. If you don’t have an existing brokerage, be sure to consider investment options, IRA custodian charges, trading costs, customer service, and research tools before making a decision. 

Of course, they vary, but since it’s a competitive business, often the custodial costs will be lower than the management expenses your 401(k) plan sponsor charged. 

3. Move your money. 

The best (and safest) way to roll over funds is to request a direct transfer from your old 401(k) plan. Your former employer will send the money directly to the brokerage (or other financial institution) where you opened the IRA. 

Alternatively, you can do an indirect rollover, where you receive a check from your previous employer, and then deposit it yourself with your IRA provider. The indirect transfer is a riskier option: If you don’t complete the transfer within 60 days, the IRS could treat the money as a taxable distribution — that is, as a regular withdrawal from the account. 

Translation: You could owe taxes on the entire amount, plus a 10% early withdrawal penalty.

4. Invest your funds. 

The last step is to select your IRA investments. “Rolling over one’s funds from a company retirement plan to an IRA certainly opens up the world of investment options,” says financial advisor Sam Davis, a partner with TBH Global Asset Management.

With your 401(k), you were limited to the funds (or the fund families) offered by the plan’s manager. With an IRA, you can invest in any mutual fund or exchange-traded fund out there — not to mention individual stocks or bonds, too. 

Many investors opt to work with a trusted financial advisor or planner. “If one prefers an advisor to manage those funds, research their track record, compensation model, client references, and investment philosophy,” Davis recommends. “If an investor doesn’t want to have those funds professionally managed, I would encourage [them] to use low-cost index funds, or maybe even a target-date fund. It’s going to reduce the probability of a negative outcome.”

IRA rollover rules to consider 

What sort of rollover you can do depends on the type of workplace plan the money’s coming from, and the sort of retirement account it’s going to.

If you’re considering a rollover IRA, keep these other factors in mind:

  • The Employee Retirement Income Security Act (ERISA) protects 401(k)s and other employer-sponsored plans from creditors. In general, IRAs don’t offer the same level of protection.
  • Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, you can withdraw up to $100,000 from your employer-sponsored plan during 2020 without penalty if you have been affected by COVID-19. If you think you might need funds, keeping the 401(k) might be the better course. 

Rollover IRA alternatives

Advantageous as the rollover IRA can be, you do have three other options:

  1. Leave your money in your former employer’s 401(k). Of course, this is the simplest course. And if you have a robust plan with lots of fund choices that’s performing well, why change it? 
  2. Roll the money into your new employer’s 401(k). “If one is young and working with a small balance, rolling the old retirement funds into the new employer’s plan can make a lot of sense,” says Davis. “This often reduces charges, ensures the person is prudentially invested, and consolidates accounts versus having small accounts scattered at various firms.”
  3. Cash out your account. In general, it’s not a good idea to empty and close your 401(k). If you do, your employer will withhold 20% for income taxes, and you may owe a 10% penalty — unless you are older than 59 ½ or qualify for an exception. 

The financial takeaway

When you leave a job with a retirement plan, a rollover IRA can be a good option, especially if:

  • Your new employer doesn’t offer a 401(k) plan
  • Your new employer’s 401(k) plan has high charges or limited investment options
  • You’ll be self-employed
  • You want more diverse investment choices
  • You want to consolidate your financial accounts (especially good if you change jobs often)

In transferring the funds, a direct rollover — with the retirement plan administrator directly depositing the money into the IRA is the preferred way to go. Since you don’t ever touch the funds, you can’t make a costly mistake.

Keep in mind that you do have some time to weigh your options. According to FINRA, the government-authorized overseer of broker-dealers, “By law, you must have at least 30 days to decide what to do with your 401(k) when you switch jobs.” 

Take the time to choose carefully — after all, your retirement nest egg is at stake. Making a smart decision now helps ensure you will be adequately prepared for a comfortable retirement. 

First Midwest Bank has ideas to help you get started. Visit to FirstMidwest.com/IRA to learn more. 

This article was written by Jean Folger from Business Insider and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.