What is a Rollover IRA and do I need one?

Financial people and publications talk about Rollover IRAs or just Rollovers all the time—like everybody knows what they are. Yet, when you go to contribute to an IRA or other retirement accounts, rollovers are never one of your choices.

Bear in mind that rollovers can be made into various types of retirement accounts, not just IRAs. It’s just that rollover IRA accounts are frequently used because they can accommodate many other types of accounts.

Basic Primer on IRAs

So first let’s back up a little and talk about IRAs in general. Individual Retirement Arrangements (IRAs) are accounts you can use to set money aside for retirement. You can do these on your own, as opposed to many other types of retirement accounts that employers make available to employees.

IRAs come in essentially 3 types—traditional deductible IRAs, traditional non-deductible IRAs, and Roth IRAs. One of the main differences lies in the tax treatment of each. (Visit the IRS Web site for more information concerning IRAs.)

Traditional Deductible IRAs

Before Roths were invented, there were only traditional IRAs. They are still very much used today. With this type, you can contribute up to a given amount of money per year into your IRA account. Then, when you file your taxes for that year, you can deduct the amount you contributed on your tax return and not pay taxes on that amount.

Traditional Non-Deductible IRAs

Some people (or their spouses) are also covered by retirement plans where they work. Depending on how much they make (a calculation called Modified Adjusted Gross Income), they may not be able to deduct any of their IRA contribution, or they may be able to deduct only part of it. They can still contribute up to their given limit, but they can’t deduct any non-deductible portion on their tax return.

You might wonder who would want to do that, to contribute to an IRA but not be able to deduct the contribution. Well, your money is still allowed to grow tax-deferred. Once it’s inside the traditional IRA, whether you deducted the contribution or not, you don’t pay taxes on it until you take it out.

Roth IRAs

Roth IRAs have different tax features from traditional IRAs. You are not allowed to deduct your contributions to a Roth IRA. Whatever you contribute, you go ahead and pay taxes on that amount. However, when you take your money out of a Roth IRA, if it’s done in accordance with the rules, you will owe zero taxes on what you take out. However, in the years that your Modified Adjusted Gross Income is too high, you may not be eligible to contribute anything to your Roth IRA account, or you may be able to contribute only a reduced amount.

So what about Rollovers?

Rollovers come into play when you need to switch your money out of one retirement account and into another. Typically, you don’t want the money to come straight to you because of the taxes and penalty that can be triggered, and also because you might spend it

Say you’re changing jobs and you need to do something with your retirement account. (Sometimes you may be allowed to leave you money in the old plan, but even if you can, you may or may not want to do that.) If the money gets distributed directly to you and you don’t get it back into a qualified account within 60 days, you’ll owe taxes on it and possibly an additional 10% penalty. This is where a rollover account comes into play to avoid this tax and/or penalty issue:

  1. Direct rollover—you establish another retirement account with perhaps a mutual fund company, brokerage firm, bank, or your new employer’s plan. Then you request the plan administrator from your old plan to transfer the funds directly to your new account or to make a check payable to your new account and not to you directly. No taxes will be withheld from your transfer amount.
  2. Trustee-to-trustee transfer—perhaps you have an IRA and want to change the institution that’s holding it. You go open another IRA with the new institution and then ask that your funds be transferred directly from the old institution to the new. Again, no taxes will be withheld from your transfer amount.
  3. 60-day rollover—sometimes your old plan doesn’t give you a choice and pays the money in your retirement account or IRA directly to you. You have 60 days to deposit the money in a new qualified account without having to pay taxes, but there is a catch with this option. Your old retirement plan administrator will withhold 20% to apply toward taxes. In order for you to get the entire amount into the new account, you’ll have to come up other funds out of pocket to make up for the 20% withheld. Then when you file taxes for that year, you can get your money back. Ideally, you wouldn’t choose this option if either of the other two options are available to you.

Rollovers of Retirement Plan and IRA Distributions

All that money you’ve been setting aside will come in handy, once you reach retirement. That’s when a rollover of your funds will come in handy as well. While Rollover IRAs are popular, the type of rollover that’s appropriate for you will depend on the type of existing account your have. Not all retirement accounts are compatible, just like you can’t mix oil and water. Click on this Rollover Chart from the IRS which shows the allowable rollover transactions.

Say that you’ve reached retirement day and are ready to start making withdrawals. You may not be allowed to leave your money in your previous employer’s account. Or you may desire other investment options than what are available to you presently. You pick where you want your money to go and set up the appropriate rollover account with them. Then you have your funds transferred over to your new account using one of the three methods listed above. With rollover accounts, you’re allowed to transfer over the entire amount, although there are some exceptions. You’re not limited to the yearly contribution amount.

You’ll want to learn everything that applies to your situation and your account before you initiate a rollover. You want to avoid paying taxes and penalties! Consult your existing and future account administrators and your tax professional. Be sure to visit the IRS Web site concerning Rollovers for more information.

Here’s my disclaimer: I am NOT a tax professional, and this article is for general informational purposes only. It may or may not be the information you need for your situation. Very little about taxes is simple or straight forward. There are all sorts of exceptions. Retirement plans can vary in type and in how they are set up with the employer. You should always seek out competent professionals who know about your specific retirement plan and your specific situation.

You can find more information on retirement accounts as well as other personal finance topics in my book, Money For Life. It’s available on Amazon as either a paperback or an e-book download for Kindle. [Note: you do NOT need a Kindle to read it. Amazon has a free reader download that allows you to read Kindle books on your computer.]