Understanding Your Rollover IRA

A couple working with a financial advisor in an industrial office.
••• kate_sept2004 / Getty Images

A rollover IRA is just like a regular brokerage account except that it is funded by transferring, or “rolling over," money from a previous employer's retirement plan. A rollover IRA is subject to the same terms as other retirement accounts. For instance, with certain exceptions, you can’t make a withdrawal before the age of 59 ½ without paying a penalty. But in other ways, it is far more flexible.

If you receive the proceeds of your 401(k) to invest in a rollover IRA, it is very important that you complete the process within 60 days. If you miss this deadline, you will be subject to taxes.

It's fairly straightforward to open a rollover IRA. There are many firms from which to choose. Some brokerage firms, such as Schwab, have specialists who can execute your rollover to align with tax law as well as with your retirement goals. Other firms, such as TD Ameritrade, offer cash incentives.

What to Do With Your 401(k) Funds When You Leave a Job

If your employer offers a company retirement plan such as a 401(k), and you wind up leaving the company, you have a few options for what to do with your retirement funds. 

Cash Out

You could cash out and take the money. However, there are two problems with that method. First, you will likely incur large tax penalties from the IRS if you withdraw your funds before it's time to retire. One exception is if you elect to take Substantially Equal Periodic Payments (SEPP, also known as IRS rule 72t), which requires you to continue withdrawals for five years or until you turn 59-1/2, whichever is longer.

For instance, if you made $500 in dividends from stocks held in a 401(k) or similar retirement account, you likely won’t owe any taxes on that money for decades. But if you instead hold the stock in a regular brokerage account, you'll get hit with taxes each year.

Transfer to a New 401(k)

Another option is to move the money from your current employer’s plan to your new employer’s 401(k) plan. The transfer is relatively easy and it keeps your assets consolidated. But you need to know that you will be limited to the choices offered by your new employer.

This can be a major drawback if you have certain stocks in mind, or if the plan options offered with your new job don't measure up to the ones you had under your old plan.

Open a Rollover IRA

Your third (and often best) option is to open a rollover IRA with a brokerage firm and have the funds from your old 401(k) moved into the account. This should be pretty simple to do. But you have to make sure that you follow all the right steps so you retain the tax benefits and don't get hit with surprise penalties.

You can use any type of IRA as a rollover IRA. So if you already have a Roth IRA or traditional IRA, you can use one of those, or open a new one.

What Are the Benefits of a Rollover IRA?

A rollover IRA lets you keep enjoying the tax shelter of a qualified retirement account. If you roll over your funds in the proper time frame, you won't be taxed as having taken a withdrawal from your old 401(k).

You have 60 days from when you receive the distribution from your old 401(k) to roll into an IRA. Or you can arrange for a direct rollover or a trustee-to-trustee transfer. If you choose one of those methods, no taxes will be withheld from your account.

Also, you can exceed the typical IRA limits for this one event, because you'll be moving over the total amount of your 401(k). That may be much more than the yearly $6,000 limit.

Another perk of using an IRA: You'll enjoy much more freedom than you had with your old 401(k). You will be able to invest in nearly any stock, bond, mutual fund, real estate investment trust (REIT), or other security available through your broker. That means you can fine tune your choices to work best for you.

Lastly, moving all your retirement money into one place can give you a much clearer picture of where you stand. It can also help you better track your funds, find and reduce costly fees, and plan ahead.

What Are the Drawbacks of a Rollover IRA?

Although you do have the freedom to choose any of thousands of investment options with an IRA, so much choice can be overwhelming. You also might be tempted to trade often, which can result in frictional costs and sub-par returns. Plus, many of the assets you can buy may come with fees or sales loads, which can eat into your returns as well.

You can't borrow against your IRA like you can with a 401(k). And if you take money out before age 59 1/2, you may get hit with a penalty.

Lastly, you can only take advantage of the rollover IRA once each year. So you need to plan if you think you might need to use this feature more than that.