A rollover IRA is a little different from other types of retirement plans. It operates much in the same way the likes of 401(k) and 403(b) plans do. It is also a tax-advantaged retirement plan. And account holders can invest in many of the standard securities like stocks, bonds, mutual funds and ETFs.

The big difference between a rollover IRA and other retirement plans is how and why it’s established…

Figuring out how a rollover IRA can make money

If someone has a defined contribution plan set up with their employer and leaves that job – but does not to retire – a rollover IRA can come in very handy. This offers the most control and investment opportunities. And it helps the account holder avoid costly penalties and an increased tax burden. Here’s why…

If you have a 401(k) set up with your employer and leave the job, there are basically four options to choose from:

  • Cash out the 401(k)
  • Keep the old 401(k)
  • Consolidate the old 401(k) into a new one (with a new employer)
  • Move the assets of the 401(k) into a rollover IRA.

All of these have merits for the account holder. But some have more merits than others. Next, we’ll look at the pros and cons of each of the four opportunities outlined above.

Skipping the Rollover IRA and Cashing Out a 401(k)

This is very seldom the most sensible choice. For starters, when all of the money that’s accrued in a retirement account is cashed out, it’s treated the same as income. And that can turn into a big tax burden. Before going down this road, be sure to find out what the early distribution costs will be.

On top of the tax burden, there are some hefty penalties to consider as well. If you’re under the age of 59 1/2 and cash out, under most circumstances, there’s a 10% penalty. That means if there is $50,000 in the account, the IRS takes $5,000. With $100,000 in the account, the IRS collects a free $10,000. And if you’ve managed to sock away $1 million, the taxman gets a $100,000 handout. If at all possible, don’t give the IRS the chance to sink its hooks into your money.

This option should be reserved for emergencies only. And even in an emergency, the best course is to cash out only what is absolutely needed… and put the rest into a rollover IRA. But there are other options…

Keep the Old 401(k)

This is the path of least resistance. And again, it’s not without its merits. But not all employers allow account holders to keep funds in their 401(k) after leaving the company. So it’s crucial to make sure this is actually an option.

Even if it is, there are other factors to weigh, though. How has it been performing? Do you want more control over the account? Does your new job offer a retirement plan? If so, is it any more or less advantageous? When changing jobs, it’s certainly possible to land a new gig with a more restrained retirement plan that has fewer investment opportunities. If the old account has been outperforming the market and the new job’s retirement plan doesn’t offer the bells and whistles you’re looking for, this is a perfectly suitable choice.

Consolidate 401(k) Plans

For someone who’s changed jobs and landed a new one with a solid 401(k) plan, this is a perfectly fine choice. Just make sure this is actually an option first – not all employers allow immediate rollovers into their retirement plans.

It’s important to look into the details of the new plan in order to see how it stacks up against the previous one. Does the new plan offer the same amount of investment options or more? How does it stack up historically against the performance of the old plan? If the old plan has been regularly outperforming compared with the greater markets, it might make sense to just let the old one ride.

It’s also important to look at the fee structure of the new plan. If the new plan has high maintenance costs, that can significantly eat away at your nest egg. Also, find out whether the new plan has a company match. If there isn’t one, this could be another reason to simply let the old plan continue on its own. Even though you won’t be able to contribute to it any longer, it will still compound and grow over the years.

Move 401(k) Assets Into a Rollover IRA

Most retirement plans – especially 401(k)s – are limited in the funds investors can choose from. With very few exceptions, IRAs aren’t nearly as confining. An IRA allows the account holder to invest in any mixture of stocks, bonds, mutual funds, ETFs or REITs, among others

On top of this expansion of investment choices, an IRA comes with fewer fees than most 401(k) plans. Unless a 401(k) is administered by a financial institution, it is not FDIC insured. This usually results in an insurance fee that can eat away at 3% of your annual returns or more. If you set up a rollover IRA through a financial institution, you don’t have to worry about those fees. Your account will have the full protection of the FDIC’s $250,000 deposit insurance.

If you decide to open up a rollover IRA account, you’ve still got one more decision to make. Do you want to set up a traditional IRA or a Roth IRA?

A Traditional IRA

With a traditional rollover IRA, deposits are tax-deductible (to a certain level). And you deposit the money pre-tax. That means you won’t have to pay taxes on it until you withdraw it after retirement. This is particularly beneficial for those who will be in a lower tax bracket when they retire. And it’s mandatory to begin withdrawing funds by the age of 72. This is known as a required minimum distribution.

A Roth IRA

With a Roth rollover IRA, all of the funds deposited into the account are treated as taxable income. This means you’ll pay taxes federal and state income taxes on them. So you’ll have to have the funds available to pay taxes on this in order to go this route.

But if you maintain the account for at least five years, contributions and any earnings made from investments can be withdrawn after retirement tax-free. On top of this, there are no minimum distribution requirements. The account can continue to grow tax-free in perpetuity.

This type of account can also be left to heirs. The only catch is the inheritor must withdraw funds over a 10-year period after taking it over.

Of the two types of rollover IRA accounts, this one is preferable for those that will be in a higher bracket after retirement. It’s also the preferred choice for those that won’t need the money in retirement and plan to pass the holdings of the account along to someone else.

Rollover IRA Plans: The Bottom Line

A rollover IRA is an ideal choice for those leaving a job with a defined contribution plan in place. But it’s not possible with all retirement plans. Those with an employee stock ownership plan don’t have this option.

However, for most other types of retirement plans, this is a relatively easy way to continue growing your nest egg. All you have to do is pick a brokerage, bank or other financial institution and open an IRA with them. Then you just let the administrator of the old account know where the new account has been opened.

From there, you can choose a direct rollover or an indirect rollover. A direct rollover consists of an electronic transfer of funds from one account to the next. An indirect rollover involves a check being mailed to the account holder and then that person needs to deposit it into the IRA. Of the two, a direct rollover is usually preferable. This will ensure that deposit delay penalties are avoided. If the check from the old account isn’t deposited into the IRA within 60 days, the account holder can be subject to penalty fees and taxes.

Now, obviously, a rollover IRA isn’t for everyone. If you’ve been steadily employed for years and have a healthy retirement plan, you’re good to go. But if you’re looking for additional ways to financially prepare for retirement, we suggest signing up for our Wealthy Retirement e-letter below. By doing so you’ll get valuable wealth-building advice delivered to your inbox daily.