Rollover IRA: What is it and How Does it Work?

February 14, 20236 min read
Rollover IRA: What is it and How Does it Work?
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Key Takeaways

  • Rollover IRAs receive funds from individual 401(k) or other employer retirement plan.
  • A rollover IRA permits investors to skirt taxes and penalties that normally accompany 401(k) withdrawals.
  • Rollover IRAs have contribution and income limits.

When leaving a job that has a retirement plan, a rollover individual retirement account (IRA) can be a good option for several reasons. Chief among these are continued tax advantages and more diverse investment choices. Whatever the case, it is important for such rollovers to be handled carefully and with forethought.

The following is about rollover retirement accounts, how they work, and where to establish them.

What is a Rollover IRA?

A Roth or traditional rollover individual retirement account accepts funds from a former 401(k), pension, or other workplace retirement plan. Such an account permits investors to avoid the taxes and penalties that usually come with 401(k) withdrawals. Note that an IRA rollover may only be used once annually.

Why Rollover?

A rollover IRA essentially allows individuals to shift funds from a 401(k) without losing the benefit of deferring taxes until retirement. While both IRA and 401(k) accounts provide pre-tax savings, employers make 401(k) investment decisions. IRA investment choices are nearly unlimited since most brokers offer a broad range of options.

How Does a Rollover IRA Work?

Any kind of IRA can be used as a rollover account. An individual may establish a new account or utilize an IRA they already own. A common way to rollover funds is by seeking a direct transfer from the old 401(k) plan. The former employer will transfer the funds straight to the financial institution where the rollover IRA has been opened.

When Should Perform an IRA Rollover?

When one leaves their job, either for a new one or to work on their own, they must decide what to do with the money in their employer-sponsored plan. A rollover IRA could be a wise move if goals include lower fees, tax benefits, and increased investment options.

How Does One Transfer an IRA?

The process is largely straightforward and basically involves:

  • Selecting a rollover account type. The most popular types of IRAs are traditional IRAs and Roth IRAs. It can be helpful to consult with a financial advisor to help choose between them.
  • Select a provider. An online broker might work best for those who wish to manage their investments themselves, while a “robo-adviser” could be ideal for investors who would rather have someone else manage their money.
  • Shifting funds. Nearly all rollover IRA providers offer help with the rollover process. The basics, though, include contacting the former employer’s plan administrator, filling out some forms, and requesting that a check for the account balance be sent to the new account provider. The provider will give the investor instructions in terms of what information to include on the check, etc.

Considerations for Rollovers

Factors to consider when rolling over an IRA include:

  • Taxes. With direct rollovers – funds never touch investors’ hands – there are no taxes involved until money is withdrawn in retirement.
  • The 60-day rule. With an indirect rollover – a check is made out to the investor – the money must go into an IRA within 60 days of receipt of the distribution. The plan administrator will withhold 20% from the account balance to pay distribution taxes.
  • Eligible distributions. Most payments received from a retirement plan may be rolled over into an IRA.
  • Eligible rollover amounts. There is no limit to the amount of money that can be rolled over to an IRA, but there will be limits to future contributions. For 2023, that limit is $6,500 annually, or $7,500 if the investor is age 50 or older.

What are the Benefits and Downsides of Rollover IRAs?

Benefits include:

  • Continued enjoyment of the tax shelter provided by a qualified retirement account.
  • Investment freedom beyond what was available with the old 401(k) account. Participants can invest in almost any stock, bond, mutual fund, or other security available.
  • More ability to track funds, reduce fees, and better plan ahead.

Drawbacks include:

  • A potentially overwhelming number of investment options.
  • Temptations to trade frequently, which could result in sub-par returns.
  • The inability to borrow against an IRA, and the likelihood that any money withdrawn before age 59.5 will be subject to penalty.

Which IRA Should I Choose?

It is generally advisable to roll a plan over into an account that has an equal tax status. For example, a traditional 401(K) can be rolled into a traditional IRA with no taxes owed. Similarly, funds can be shifted tax-free from a Roth 401(k) into a Roth IRA.

Retirement Alternatives

Those leaving an employer largely have three choices. They can:

  • Leave the funds where they are. This is likely not ideal since Human Resources isn’t around to help, and there may be higher 401(k) fees for former employees.
  • Roll the funds into a retirement plan. For many, this is the wisest choice for all the benefits mentioned, including the possibility of investing in alternatives. Such assets are gaining in popularity since they have low correlation with volatile public markets.
  • Cash out. Most experts agree this is the worst choice due to substantial penalties and taxes.

How to Start a Rollover IRA

Investors have options, in terms of starting a rollover IRA. One option calls for adding alternatives to retirement portfolios, a strategy that historically has been fraught with complications and involved high fees.

That is changing. The alternative investment platform Yieldstreet, for example, allows investors to easily diversify their holdings with private-market alternatives. With a Yieldstreet IRA, such assets traverse a variety of classes, including art and real estate.

The overarching goal is to render retirement portfolios less dependent on a stock market that is volatile by nature. After all, diversification does not end with taxable accounts.

Diversification and Alternatives

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

Exclusive asset classes were once limited to wealthy investors with high minimum investments. Yieldstreet now offers a range of alternative investments for all, democratizing access to real estate, legal finance, art finance, and more.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

To help realize the full potential of one’s retirement portfolio, the best move might be to go beyond stocks and bonds toward private market alternatives. With a Yieldstreet IRA, such returns can grow tax-free or tax-deferred.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.