IRA rollover vs. transfer: Which option is best for your wallet?

IRA rollover vs. transfer: What are the big differences?

The main difference between a rollover and a transfer is that a rollover allows you to change investment account types entirely, while a transfer just swaps the IRA’s custodian. A custodian is a financial institution that carries your IRA and reports contributions and earnings to the IRS.

The most significant differences between how IRA rollovers and transfers affect you are taxation and flexibility.

• Taxation: Rollovers can have tax consequences, especially when moving funds from a traditional IRA to a Roth IRA (more on that below). In contrast, transfers are always tax-free (when you follow the rules), making them an attractive option for simplifying your retirement portfolio without incurring additional tax liabilities.
• Flexibility: Rollovers offer greater investment flexibility since you can choose how to invest your funds in the new IRA or retirement account. Transfers typically maintain the same investments, limiting your ability to make significant changes to your portfolio. However, Roth accounts allow you to keep the same ETFs or even trade to a different portfolio. If you self-direct the IRA (pick and choose the individual investments, not just adhere to the standard investment strategy) then you have control over where the funds go.

It’s important to note that even though transfers and rollovers are different, they’re not mutually exclusive. You can complete transfers and rollovers, and in some cases, a combination of the two might be best. This could happen when you’ve already completed a direct rollover and still want to move assets, or if you want to shift assets without hitting a contribution limit through a rollover.

Beware of these tax implications.

IRA transfers don’t have any tax implications, making them a nice option to reorganize or rearrange your funds if you have multiple IRAs, or if you want to try out the investments offered by another firm. This is called a “trustee-to-trustee transfer” and it’s why IRA transfers don’t have tax implications, since the money goes directly from one custodian to another.

Rollovers are another story.

IRA rollover rules can penalize you for rolling over too often (more than one rollover within 12 months), not rolling over fast enough (the 60-day rule), or mishandling funds.

If you indirectly rollover multiple IRAs within a 12-month period, there could be tax consequences, like:

• Including the rollover amount in your gross income for the year, inflating your taxable income.
• Paying a 10% early withdrawal tax on the rollover amount on top of income taxes.
• Paying a 6% excess contribution tax on the rollover amount for each year it remains in an IRA.

However, you can do as many direct rollovers and transfers as you want, as long as they don’t impact the same IRA.

If you roll over a traditional IRA to a Roth IRA (also called a backdoor Roth conversion if you roll the entire IRA into a Roth), you’ll owe taxes on any pretax contributions you made to the original account.

These tax consequences can stunt the growth of your retirement savings, so think carefully before moving forward with a rollover. It will give you greater control over your portfolio, but if you won’t be in a higher bracket in the future or if you’re paying taxes on a large transfer amount, that could inhibit your future growth.

Now that we’ve covered the differences and tax implications of rollovers and transfers let’s dig into how each works.

What does it mean to roll over an IRA?

An IRA rollover is a pre-retirement switcheroo allowing you to move funds from one retirement account to another. A distribution is taken from an existing retirement account (typically an employer-sponsored 401(k), profit-sharing plan, or another IRA) and invested in a new retirement plan or another IRA.

Rollovers are a way to move your retirement funds into different accounts without incurring taxes on the payout (since you haven’t yet pocketed the funds).

Say you’ve been steadily contributing to your 401(k) to take advantage of your employer’s matching contributions. Now, you’ve decided to change jobs.

Instead of leaving your 401(k) funds to sit without receiving new contributions or cashing it out (which can lead to hefty taxes and penalties – a no-no for optimal wealth growth), you can opt for an IRA rollover. You open an IRA and transfer the funds from your old 401(k) to preserve your retirement savings and grant yourself more investment flexibility.

There are a few types of IRA rollovers:

• Direct rollover: When rolling over from a non-IRA retirement plan, you can ask your plan administrator to direct your payout to an IRA or another retirement plan without it ever entering your hands.
• Trustee-to-trustee: This is similar to a direct rollover. When you’re rolling over from an IRA to another IRA or a retirement plan, the IRA custodian (the administrator who holds your plan) can pay the new administrator directly.
• 60-day rollover: This is also called an indirect rollover. When you receive a payout directly from an IRA or retirement plan, you have to roll those funds into a new IRA or plan within 60 days to avoid tax penalties. The administrator will withhold taxes from your payout, so you’ll need to dip into other funds to complete the full rollover.

Rollovers where you never take possession of your funds are all direct, while rollovers that require you to redeposit your funds are indirect.

Rolling over your IRA comes with potential pros and cons that should impact your choice:

The IRS has certain IRA rollover rules that state you can only complete a rollover once a year. However, this rollover limit doesn’t apply to Roth conversions where you transform a traditional IRA to a Roth.

What’s an IRA transfer?

An IRA transfer is when you move funds from one IRA to another IRA of the same account type – traditional to traditional or Roth to Roth – without ever taking possession of the funds yourself.

Unlike a rollover, a transfer never involves taxation or penalties because you never touch the funds during the transfer period. It’s a straightforward way to change IRA custodians or consolidate accounts.

Suppose you have two traditional IRAs with different financial institutions, and you’d like to streamline your retirement accounts so you can manage them in the same place. So, you initiate an IRA transfer.

Your IRA custodians communicate directly with each other to move the funds, preserving the tax-advantaged status of your savings. You avoid any taxable events, and you keep the same IRA type with no hassles involved.

Transferring an IRA has some pros and a couple of cons, too:

If your financial report card doesn’t quite have an A+, that’s OK! IRA transfers can help you streamline your retirement accounts, so they’re more manageable, which in turn helps you grow toward your long-term financial goals.

So, how do I make the best choice for my retirement?

Choosing between rollovers and transfers doesn’t have to be hard. You can even do both, depending on your growth goals and the amount of IRAs or retirement accounts you have.

Think about factors like:

• Your retirement goals. Are you looking for more investment control than you can get in a 401(k) or other employer-sponsored plan? In that case, a rollover is your best option. If you’re just looking to consolidate your accounts, a transfer may be best for you since it has fewer negative consequences.
• Potential tax consequences. Rollovers come with a few negative tax implications if mishandled. You want to be very careful about your timelines and how much you’re rolling over since you will quickly be penalized for rolling over too much or too often.
• Personal investment preferences. What kinds of funds do you want to hold in your IRA? If you want the ability to choose more independently, you’ll want to choose a rollover. This is because you’re moving from an employer-sponsored plan to an IRA with more investment options. Transferring is much simpler if you don’t care as much about specific funds and are just looking to streamline.

Don’t leave old IRAs to collect dust.

Managing your IRA strategically is essential for building a robust nest egg and retiring early. Because of that, an IRA transfer will be easier for most people to manage with fewer tax consequences that eat into your wealth growth and slash your gains.

You don’t have to be a rocket scientist to be smart about your savings, though. Playbook makes proactive financial decisions easy by taking into account your goals and scaling along with you and your life changes. With Playbook’s help, you can reach your financial goals faster, minimize long-term regret, and reach freedom from money stress.