Understanding The Rollover IRA (And How It Can Help You Protect Your Retirement Savings)

Key Takeaways

  • A rollover IRA is a retirement savings account that provides individuals with the flexibility of transferring funds without facing taxes or fees.
  • There are at least 10 rules you should know in order to maximize the benefits of using a rollover IRA.
  • Although a rollover IRA and traditional IRA are similar, there is one crucial benefit that makes a rollover IRA unique from its counterpart.

Have you ever stopped working for an employer and wondered how to access your 401(k) savings? Or worse, have you ever withdrawn the money from your employer savings plan, only to get punished with taxes and early withdrawal penalties? To avoid these scenarios, find out how a rollover ira can be a smart solution that allows you to continue enjoying your tax-deferred benefits, even after you’ve switched employers.

What Is A Rollover IRA?

A rollover IRA (individual retirement account) is a type of retirement savings account that enables you to move funds out of a retirement plan that was sponsored by a previous employer. When you withdraw funds out of a retirement savings account, such as a 401(k) or 403(b), you may be subject to income taxes and early withdrawal penalties. However, by setting up a rollover IRA, you can transfer your savings between retirement accounts while preserving your tax-deferred status. In addition, it protects you from having to pay taxes and penalties.

Top 10 Rollover IRA Rules You Need To Know

When you leave a job, your employer will typically continue to sponsor your retirement savings plan over a grace period. Before this period ends, you will be required to dictate whether you will withdraw or transfer your funds, as well as provide instructions based on your decision. Consulting a financial advisor can help you avoid common mistakes that could ruin your retirement savings.

If you wish to continue growing your savings in a tax-deferred environment, a rollover IRA can be a great solution. Get to know the following rollover IRA rules to help you decide if it’s your best course of action:

  • Most employers won’t allow you to rollover funds while you’re still employed.

  • Retirement account distributions are subject to an automatic tax withholding of 20 percent, unless the funds are distributed directly into a rollover IRA account.

  • Funds can be transferred from one IRA account to another without any tax penalties, as long as no distribution was made payable to you.

  • You can also withdraw IRA funds tax-free, as long as you redeposit the funds into another IRA account within 60 days.

  • Using a rollover IRA, individuals can elect to move parts of (not necessarily all) funds between IRA accounts or company retirement plans.

  • Any funds inherited from a spouse’s traditional IRA can be rolled over into your own, or can be titled as an inherited IRA. Fidelity provides a deeper explanation of your options when inheriting an IRA from a loved one.

  • The IRS requires individuals over the age of 70 to take minimum withdrawals from their retirement accounts; these minimum distributions are not eligible for rolling over.

  • Make sure to carefully explain any IRA rollovers or transfers to your tax preparer, as they must be reported on your tax return as a non-taxable transactions.

  • A rollover account can be used to transfer after-tax funds into a Roth IRA, which allows for tax-free growth without minimum distribution requirements.

  • If you have shares of company stock through a former employer, you may be able to use a special tax rule called Net Unrealized Appreciation (NUA) to transfer the cash value of the stocks through a rollover IRA. Visit Investopedia to learn more about NUA rules.


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What is a rollover ira

Rollover IRA Vs Traditional IRA

Rollover and traditional IRAs are both individual retirement accounts used to grow retirement savings in a tax-deferred environment. A rollover IRA is unique from a traditional IRA in that it is used specifically to transfer retirement funds, and can be thought of as an account used on an interim basis. Maintaining a rollover IRA account separate from your traditional IRA provides the crucial advantage of transferring funds in and out of different types of retirement plans without having to pay taxes or penalties.

For example, let us say you were formally employed with Employer A for five years, during which time you accrued savings in a company-sponsored 401(k) plan. You plan to eventually transfer your savings into a new retirement plan when you find new employment, but you don’t want to pay any taxes or penalties when making the transfer. Here, you set up a rollover IRA, where you can hold your retirement funds while you look for employment. Once you secure a job with Employer B, you can then transfer your retirement funds out of your rollover account into your new 401 (k) plan without any penalties.

You might be wondering why an individual would not opt to permanently transfer their retirement funds into a traditional IRA instead. While company-sponsored retirement plans are federally protected from creditors and court judgements, traditional IRAs are not. In addition, you can start making penalty-free withdrawals if you leave or lose your job between the ages of 50 or 55, depending on if you have a 401(k) or 403(b). On the contrary, you cannot make withdrawals from a traditional IRA until the age of 59 and a half. For these reasons, many individuals prefer to use a rollover IRA on an interim basis, so that they may keep their retirement savings in company-sponsored plans as long as possible.

Rolling Over A 401(k)

Most individuals will have to decide what to do with their 401(k) funds at least once in their life. Although a financial advisor is best qualified to help you make these decisions, it’s still worthwhile to understand your options. For example, did you know that you can use a self directed IRA to invest in real estate?

Continue reading to learn more about some of the advantages and disadvantages of rolling over a 401(k) into an IRA account:

Pros

  • Sustain your tax deferral: A rollover IRA provides the same tax-deferred treatment you enjoyed through your former employer’s retirement account.

  • Increase your investment options: Employer-sponsored retirement plans can have limited choices. Setting up a rollover IRA gives you the flexibility of allocating any portion of your funds to other investment options, including real estate.

  • Lower your fees: Some employer-sponsored plans can have high administrative fees, while IRAs tend to offer lower fees. Individuals have the option of keeping their retirement assets in the same tax-deferred environment, but with lower fees, if they so choose.

  • Consolidation: According to the Bureau of Labor Statistics, an average worker holds twelve different jobs by the time they reach the age of 50. Managing retirement accounts through various employers can become confusing, and using a rollover IRA allows you to consolidate all of your retirement accounts into one place.

Cons

  • Limited borrowing: Individuals can only borrow from an IRA account once per year, and must pay themselves back within 60 days in order to avoid taxes and penalties.

  • Age restrictions: Penalty-free withdrawal benefits for IRA accounts don’t start until the age of 59 and a half, while those holding a 403(b) or 401(k) can start withdrawing between the ages of 50 and 55.

  • Less protection: Protections against bankruptcy and creditor claims are unlimited when you have your retirement savings in a 401(k), whereas IRA protections are limited.

  • Required minimum distributions: IRA accounts enforce minimum withdrawal requirements starting at the age of 70 and a half, regardless of employment status.

Summary

Hopefully by getting a better understanding of your retirement investment options, you can continue to protect and grow your hard-earned retirement savings. A rollover IRA is a great way to transfer, consolidate and expand your retirement savings portfolio without facing costly taxes and fees. As always, before you make any decisions on what to do with your retirement savings, be sure to consult your financial advisor.

Did you know that withdrawing your retirement savings early can result in costly penalties? Let us know your thoughts on retirement investment planning in the comments below.

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