What is an IRA rollover?
A rollover IRA is an account that allows you to transfer funds from previous employer-sponsored retirement plans like 401(k)s to an IRA. If done correctly, an IRA rollover has the advantage of keeping the money tax-deferred without triggering taxes or early withdrawal penalties.
In comparison to a 401(k), which may have a limited list of investment possibilities and higher administrative fees, rollover IRAs can provide a larger selection of investment options and lower expenses.
Options For a 401(k) Plan That is No Longer Active
When it comes to leaving a job, you generally have three options regarding your 401(k) — all of which offer advantages.
- Allow it to be. You can leave your money with your ex-employer if they agree. This isn’t ideal because you won’t have access to an HR staff to answer problems, and you can be charged higher 401(k) costs as an ex-employee.
- Put it into your retirement plan. For many people, this is the ideal option. You may opt to put your money into an IRA or a new employer’s retirement plan.
- Make a withdrawal. This is almost definitely the worst choice available to you. Cashing out not only jeopardizes your retirement, but it also comes with a slew of IRS fines and taxes. You’ll have to pay a 10% early withdrawal penalty as well as regular income taxes on the amount disbursed. That implies you might fork up as much as 40% of the money right away.
Taxes on Rollover IRAs: Two Things to Keep in Mind
You’re good to go if you conduct a direct rollover. You won’t have to worry about taxes until you start taking funds in retirement.
If you conduct an indirect rollover, which means you get a check written out to you, follow these criteria to avoid facing a large tax bill:
- The 60-day rule states that something must be done within 60 days. You have 60 days from the day you receive the distribution to transfer the funds to an IRA if you do an indirect rollover. If you miss that date, the IRS will most certainly consider it an early withdrawal. In that case, you might incur a 10% early withdrawal penalty in addition to income tax. Take into consideration as well that there is an SEP IRA set up deadline. This is another time table that you’ll want to keep track of.
- Taxes are deducted. In most cases, an indirect rollover from a company retirement plan will result in a check for the amount of your 401(k) balance minus 20%. The 20% is withheld by the plan administrator to pay taxes on your dividend. This is unless your money was in a Roth 401(k). If you have a standard 401(k) and wish to rollover into a Roth IRA, you will have to pay extra taxes.
To get your money back, you must deposit the whole account amount into your IRA, including any taxes deducted.
Consider the following scenario: your total 401(k) account balance was $20,000, and your former employer sent you a cheque for $16,000 (the complete account value minus 20%). If you don’t want to go the Roth route, you’ll need $4,000 to deposit the entire $20,000 into your IRA.
When it comes time to file your taxes, the IRS will see that you rolled over your whole retirement account and will reimburse you the amount withheld in taxes. You’ll also avoid a 10% penalty. If you only put $16,000 into the IRA, however, the IRS will consider it an early withdrawal of the remaining $4,000. On that $4,000, you’d face the early withdrawal penalty plus, believe it or not, income tax.
Tax Consequences of a 401(k) Rollover to an IRA
You can delay taxes on your rollover IRA if you meet the regulations for rolling over your retirement plan to a rollover IRA. Alternatively, some people may desire to convert all or part of their retirement assets to a Roth IRA. As a result, they must pay ordinary income taxes on the amount converted to a Roth. Unlike standard IRAs, where taxes are deferred, Roth distributions are tax-free if the account has been open for at least five years.
Make a Rollover IRA Contribution
You can contribute to your rollover IRA up to the IRA contribution limitations if you continue to work. You can donate up to $6,000 per year in 2019, as long as you earn that much. Those over the age of 50 can make a $1,000 catch-up payment, bringing the total to $7,000 every year. If you don’t have access to a company-sponsored retirement plan, you can deduct your conventional IRA payments from your federal income tax.
