IRA Rollover: Overview, Types, Special Considerations

What Is an IRA Rollover?

An IRA rollover is a transfer of funds from a retirement account, such as an employer-sponsored plan, into an individual retirement account (IRA). The purpose of a rollover is to maintain the tax-deferred status of those assets.

IRA rollovers are commonly used to hold 401(k), 403(b), or profit-sharing plan assets that are transferred from a former employer’s sponsored retirement account or qualified plan. An IRA rollover can also occur as an IRA-to-IRA transfer.

Understanding IRA Rollovers

IRA rollovers can occur from a retirement account, such as a 401(k) into an IRA, or as an IRA-to-IRA transfer. Most rollovers take place when people change jobs and wish to move 401(k) or 403(b) assets into an IRA, but IRA rollovers also happen when retirement savers want to switch to an IRA with better benefits or investment choices.

The are different types of IRA rollovers: direct and indirect. It’s crucial to follow Internal Revenue Service (IRS) rules to avoid paying taxes and penalties.

Direct IRA Rollover

In a direct rollover, the transfer of assets from a retirement plan to an IRA is facilitated by the two financial institutions involved in the transfer. To engineer a direct rollover, you need to ask your plan administrator to send the funds directly to the IRA. In IRA-to-IRA transfers, the custodian from the old account sends the rollover amount to the custodian of the new IRA.

Indirect IRA Rollover

In an indirect rollover, the assets from your existing account or plan are liquidated and the custodian or plan sponsor mails a check made out to you or deposits the funds directly into your personal bank or brokerage account. This route leaves it up to you to redeposit the funds into the new IRA.

To be considered a tax-free rollover, the money must be deposited in the IRA within 60 days. If you miss the 60-day deadline, then the withdrawal will be considered a distribution in the eyes of the IRS, and some of it may be subject to income tax as well as an early withdrawal penalty. In general, withdrawals before age 59½ from a traditional IRA trigger a 10% penalty. If you withdraw Roth IRA earnings before age 59½, a 10% penalty usually applies. Roth contributions are not subject to the penalty. The same rules apply if you are doing an IRA-to-IRA rollover.

The IRS requires your previous employer to withhold 20% of your funds if you receive a check made out to you, which cannot be recovered until you file your annual tax return. But if the check is made out to the IRA, then you will not subject to withholding. Custodians will withhold 10% from IRA distributions that you intend to roll over unless you elect out of withholding.

Special Considerations

IRA Rollover Limits

The IRS limits IRA-to-IRA indirect rollovers to one every 12 months. The one-year calendar runs from when you made the distribution and applies to traditional IRA-to-traditional IRA rollovers or Roth IRA-to-Roth IRA rollovers.

The limit on IRA-to-IRA indirect rollovers does not apply to distributions from employer-sponsored retirement plans or rollovers from traditional IRAs to Roth IRAs. The latter is known as a Roth conversion. Direct IRA-to-IRA rollovers are also not subject to the one-year rule.

Tax Traps

Pay strict attention to which type of IRA or other retirement account you are transferring from—and which type you are transferring to. You can easily roll over funds from a Roth IRA or a Roth 401(k) to a new Roth IRA. The same is true if you’re rolling over monies from a traditional IRA or a standard 401(k) to a traditional IRA. Anything else has significant tax consequences that you need to work through carefully before you do the rollover. Traditional IRAs and 401(k)s contain pretax funds, while contributions to Roth IRAs and 401(k)s are made with after-tax monies.