IRA rollovers: What they are & how they work

Chances are that you'll work for several employers throughout your career. As a result, your retirement assets can get complicated over time. You may find you have money in a previous employer's plan or have multiple individual retirement accounts (IRAs).

When you leave a job where you have participated in an employer-sponsored retirement plan, it's wise to take the retirement savings you've accrued and roll them over into a traditional IRA. This is because consolidating your assets can help streamline your finances and give you greater control over your investments.

Here's what you need to know about IRA rollovers so you can better understand whether putting different accounts together is the right move for you.

IRA rollovers involve moving funds from another tax-qualified account into your IRA. For instance, you can roll the money you have from a previous employer's retirement plan—whether it's a 401(k), 403(b) or 457(b) plan—into an IRA once you leave your former job.

When you roll over a retirement account, you generally won't need to pay taxes. Any retirement plan distribution—other than qualified Roth distributions—are subject to taxes. Taxes will not apply if the amount is rolled directly to another retirement plan or traditional IRA. If you receive a check made out to you instead of the receiving account, that check must be deposited within 60 days of the distribution to avoid ultimately paying the mandatory taxes. It's best to request a direct rollover to avoid mandatory tax withholding.

A properly performed rollover allows you to retain the tax-deferred status of your retirement plan money. You'll still pay income tax on your withdrawals in retirement, but your investments grow tax-deferred until withdrawn.

It's important to note that the terms "rollover" and "transfer" in the context of retirement plans and IRAs aren't interchangeable. They're similar, but they describe different processes.

"Rollover" is used when you are withdrawing all of your money from one kind of retirement account and putting all of it into another kind of retirement account without tax implications. The IRS has rules about what kinds of accounts can roll into others and when.

"Transfer" is a term for moving some or all of the money between like-typed accounts without tax implications. For example: IRA to IRA, or from one employer-sponsored plan to another employer's plan. If you're moving money between Roth and non-Roth accounts—which does have tax implications—it'll be handled as a "conversion."

When you roll over funds from a traditional 401(k)-style plan or IRA, you don't have to move them into a pre-tax IRA. Instead, you have the ability to move them into a Roth IRA, which has a couple of potential benefits of its own.

If you expect to be in a higher tax bracket later in life, putting your retirement assets in a Roth account could result in a lower overall tax liability. In this case, the money you roll over would be taxed at your ordinary rate in the year you perform the transaction. But there's a big potential upside. With a Roth IRA, after five years from the conversion and you are at least 59½ the account earnings will be distributed tax-free. This often works to the advantage of younger workers whose earnings will likely rise substantially by the time they hit retirement.

Another reason to roll your retirement money into a Roth IRA is the potential ability to avoid required minimum distributions. With the passage of the recent SECURE Act 2.0, you have to start taking mandated distributions when you hit age 73 (the cut-off will increase to 75 in 2033). Roth IRAs are the exception. If keeping more retirement assets for your beneficiaries is a priority for you, performing a Roth conversion—or moving your Roth workplace funds to a Roth IRA—is something you may want to consider. (Note, though, that if you're at an age where you have to take RMDs, your RMD for the tax year in which you're doing a Roth conversion cannot be part of the conversion.)

If you have money in a retirement plan sponsored by your previous employer, you have several options:

• You can leave the money in your previous employer's plan.
• You can transfer the funds to your new employer's plan.
• You can roll the money into an IRA.
• You can take a cash distribution.

Withdrawing your funds gives you immediate access to your money. But money in a traditional 401(k) or similar plan is taxed as ordinary income when you take a distribution. And if you're younger than age 59½, you also typically face a 10% penalty on the entire amount of the withdrawal (one exception is if you leave your job in the year you turn 55 or thereafter, in which case you can withdraw 401(k) funds without the early withdrawal penalty).

In most cases, that makes an early distribution the least advantageous of the options. If in doubt, talk to a financial advisor about which option makes the most financial sense for you.

Rolling your retirement assets into an IRA can make sense for a variety of reasons. These are some of the potential benefits:

• Simplifying your finances. The average American will have more than 10 jobs in their adult life, which means you'll likely acquire multiple employer plans. Moving them into a single IRA can help you better understand your complete retirement picture and allocate your money wisely.

• Gaining greater control over your investments. When you invest in a 401(k)-style plan, you're often limited to a small menu of investment options chosen by your employer. IRAs tend to offer a much larger selection of choices.

• Avoiding penalties and taxes. If you leave a job and have a retirement balance of less than $5,000, the plan administrator may cut you a check and terminate your account. If you simply cash that check, the amount is subject to ordinary income taxes in the year it was received and, potentially, a 10% early withdrawal penalty. Rolling that money into an IRA avoids those consequences.

• More flexibility with your money. The IRS allows you to tap IRAs for certain non-retirement purposes—such as purchasing a first home or paying qualified education expenses—without incurring the 10% early withdrawal penalty. You can also use IRA distributions to help pay for the birth or adoption of a child. However, you may still have to pay income tax on any distributions from a non-Roth account.

However, IRA rollovers may not be the best option in certain circumstances. For example, moving money from a previous workplace plan to a new employer plan may give you the option to take out plan loans with no tax consequences (if you pay back the loan on time).
Additionally, if you have company stock in your previous employer's plan, rolling that portion into a traditional IRA may result in a larger tax bill when you make distributions in retirement. Before deciding what to do with those funds, be sure to understand the terms of your employer plan, evaluate fees and talk with a tax professional who can advise you on the potential implications and advantages.

There are two ways to roll over retirement assets into an IRA: directly and indirectly.

A direct rollover is the simplest way to consolidate your retirement balances. Your retirement plan administrator sends your funds directly to the receiving IRA custodian. In some cases, the plan administrator may mail a check to you, which you then forward to the IRA custodian. While you physically handle the check, it doesn't count as a distribution and doesn't result in an early withdrawal penalty.

To perform a direct rollover, contact the IRA provider that will be receiving the retirement plan funds and ask for instructions. Your former employer may have forms you need to complete in order to release the funds on your behalf. The IRS allows you to perform as many direct rollovers in a year as your former employer permits.

You can also roll over retirement assets that were distributed directly to you as long as funds are deposited to the receiving IRA custodian within 60 days of receiving those funds. Failure to comply with this 60-day window means the money is treated as a taxable distribution.

Keep in mind that employer retirement plans have to withdraw 20% of the account balance for taxes before cutting you a check. If you plan to roll that money into an IRA, you have to come up with that extra 20% out of pocket.

The 20% rule only applies to money from a qualified employer plan. Money that you withdraw from an IRA—including any amount you intend to roll over to another IRA—isn't subject to this tax withholding. However, you can't make more than one 60-day IRA-to-IRA rollover in a 12-month period.

Navigating your rollover options is easier with expert guidance. Connect with a financial advisor for all your retirement planning needs. Doing your rollovers right can produce big benefits in the years to come, so don't hesitate to reach out for a helping hand.