When you’re no longer eligible to participate in a workplace retirement plan, like a 401k or 403b, one of the ways you can preserve the tax-deferred status of your assets and maintain the potential for tax-free growth is to rollover your funds to a rollover IRA.

A rollover IRA is a type of IRA that allows you to rollover your funds from your employer-sponsored plan into an IRA. After the transfer, you can continue to invest and manage your retirement savings and avoid potential taxes and penalties associated with cashing out the original retirement account.

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How does a rollover IRA work?

When you leave your job, retire, or become ineligible to participate in your employer-sponsored retirement plan, you have three options for what you want to do with the assets in your plan.

  1. Leave it alone: Some employers will allow you to keep your assets in your old 401k plan, without requiring you to remove them. However, this may not be the best option for you since the HR team is no longer able to assist you with any plan related questions, and you may have to pay higher fees as an ex-employee.
  2. Withdraw the funds: Cashing out early from a retirement plan comes with penalties, taxes, and eliminates the ability to keep compounding your money with tax-free growth. Making an early distribution from the plan before you reach the age of 59 ½ will trigger an early distribution penalty of 10% plus income taxes owed on the amount withdrawn.
  3. Roll it over into a different retirement plan: Rolling over your funds to another retirement plan like a rollover IRA is usually the most sensible option. Transferring the assets to a rollover IRA can avoid early distribution penalties, taxes, and keeps your assets in a tax-deferred status.

If you choose to transfer your assets into a rollover IRA, you simply need to choose a rollover IRA provider, open an account, choose whether you want to open a traditional or Roth account, and then transfer the funds.

Difference between a traditional IRA and Roth IRA

A traditional IRA is funded with pre-tax income and gives you a tax deduction on your contributions. Investments grow tax-deferred and withdrawals in retirement are taxed as regular income.

A Roth IRA is funded with post-tax income and doesn’t give you any tax deductions on your contributions. Investments grow tax-free and withdrawals in retirement are also completely tax-free.

Rolling over assets from a pre-tax 401k account into a traditional IRA is tax and penalty free. But because a Roth IRA is funded with post-tax income, rolling over assets from a pre-tax 401k into a Roth IRA would require you pay income taxes on the transferred amount. Assets in a Roth 401k account can be transferred into a Roth IRA tax and penalty free.

Also read: Roth vs Traditional IRA

Difference between a rollover IRA and a regular IRA

In terms of investment options, rules for withdrawals, and tax treatment of contributions and earnings, there is generally no difference between a rollover IRA and a regular IRA. The key distinction lies in the source of the funds and the purpose for which the account is initially created.

A rollover IRA is specifically created to receive funds from an employer-sponsored retirement plan, like a 401k or 403b, when you leave your employer, retire, or are terminated. Rolling it over into an IRA preserves the tax-deferred status of your assets and allows you to keep compounding your money tax-free. You get to choose whether you want your rollover IRA to be a traditional IRA or a Roth IRA

There is essentially no difference between a regular IRA and a rollover IRA, besides the source of the funds contributed to the account when it’s opened. A regular IRA is not specifically designated for rolling over funds from an employer-sponsored retirement plan. However, a regular IRA is still able to receive rollovers from other retirement plans.

Can’t I just rollover the funds into an existing IRA I already own? Why should I choose to rollover to a rollover IRA instead?

Yes, you can roll over the funds from an employer-sponsored retirement plan into an existing IRA you already own, as long as it is the same type (traditional or Roth) as the retirement plan funds. However, there might be reasons to consider creating a separate rollover IRA for the funds:

Easier to track the source of funds: Rolling over your funds into a separate rollover IRA can make it easier to track the source of the funds, which can be helpful for record-keeping purposes or in the event of a future rollover to another employer-sponsored plan.

Rollover to a new employer plan in the future: If you think you might want to roll over the funds from your old employer-sponsored plan into a new employer’s plan in the future, keeping the funds in a separate rollover IRA can make the process easier. Some employer-sponsored plans may only accept rollovers from other qualified plans or rollover IRAs, but not from IRAs that have been mixed with personal contributions.

Protection from creditors: In some cases, funds rolled over from an employer-sponsored plan to a rollover IRA may have greater protection from creditors under federal bankruptcy law compared to a regular IRA. This protection varies depending on federal and state laws.

Are there any limits on how much I can rollover?

There is no limit on how much you can rollover, and they do not affect your yearly contribution limits. You could rollover as much as you want from your employer-sponsored retirement plan and still have the full contribution room available for the tax year.

The contribution limit of a rollover IRA is the same as a traditional or Roth IRA. For 2023, you can contribute up to $6,500 if you’re under 50 years old, or $7,500 if you’re 50 years of age or older.

How to transfer your 401k to a rollover IRA

Transferring your assets from a 401k plan to a rollover IRA is simple. Choose a rollover IRA provider, choose which type of IRA you want to open (traditional or Roth), and then rollover the funds from your employer-sponsored plan to your new rollover IRA.

There are two types of rollovers you can choose to do: Direct and Indirect.

Direct rollover

In a direct rollover, the funds are transferred directly from your employer-sponsored retirement plan to the rollover IRA, without you ever taking possession of the funds. This type of rollover is not subject to mandatory withholding or penalties.

Indirect rollover

In an indirect rollover, the funds are distributed to you, the account holder rather than being sent directly to the rollover IRA. An indirect rollover is often called a 60-day rollover because you are given 60 days to deposit the funds into your rollover IRA. 

While you’re in possession of the funds, you’re allowed to use the funds however you wish, as long as you’re able to fund the account in full before the 60-day deadline. If the funds are not deposited within the 60-day window, the distribution may be subject to taxes and a 10% early withdrawal penalty. 

Additionally, a 20% mandatory withholding for federal income tax applies to the distribution. In other words, your 401k plan provider withholds 20% of the requested transfer funds, which you must come up with from other sources in order to deposit the full amount. If you successfully deposit the money in full to your new account, the withheld amount gets returned to you in the form of a tax credit the next time you file your taxes.

Also read: IRA vs 401k Differences

How long does a 401k rollover take?

How long it takes to rollover a 401k to a rollover IRA depends on whether you choose a direct or indirect rollover.

A direct rollover is the faster option and usually takes between 3 to 7 business days, depending on the speed of your plan provider.

An indirect rollover can take 60 days or longer, since the funds are sent to you first, and you’re given 60 days to deposit the full amount into your rollover IRA.