Rollover IRA vs. Traditional IRA: Differences to know

“Rollover” just describes how the account was started—with a rollover from an employer-sponsored retirement account or different IRA. It’s common to transfer money from an employer-sponsored account when you leave a job, and a rollover IRA is a smart way to maintain your tax-deferral status. 

The main difference from other IRAs is that you directly fund a traditional IRA with contributions. You likely opened the account as part of your overall retirement strategy and make regular direct contributions. 

It’s a simple difference that can affect your tax liability. Learn more about a rollover IRA vs. a traditional IRA and their eligibility requirements below. 

Rollover IRA

A rollover IRA is just an IRA you created with funds rolled over from another retirement account. A direct rollover means you transfer between providers and never hold the money yourself, so it’s not considered a withdrawal and you don’t owe taxes. 

A rollover IRA can be a traditional IRA or Roth IRA, depending on where you’re transferring the funds from. When rolling over a traditional 401(k), you can choose between a traditional or Roth IRA. If you roll over a Roth 401(k), you have to use another Roth account. 

Why choose a rollover IRA?

Rollover IRAs are a popular way to maintain retirement funds when you switch jobs, but that’s not the only reason to open a rollover IRA. Here are some common reasons people choose to rollover an employer-sponsored retirement plan into an IRA:

• Leaving a job: Once you leave an employer, you can’t continue contributing to their employer-sponsored retirement. Instead, you should transfer it to a new employer’s retirement plan or open a rollover IRA with the existing funds to preserve your tax advantages. 
• Avoid taxes and penalties: If you don’t transfer or rollover funds to a new retirement account and opt to withdraw the money instead, you’re subject to any owed income taxes and early withdrawal penalties if you’re younger than 59½ years old. 
• Diversified investment options: Investors have more control and available investment options with an IRA than a 401(k), so a rollover IRA is a good choice for flexibility.
• Account consolidation: Managing multiple accounts can be time consuming and costly. Instead of leaving old 401(k) accounts open with previous employers, you can consolidate your retirement savings into a rollover IRA to continue making contributions and easily track your savings.   

If you’re deciding between a new employer’s 401(k) and an IRA, consider that IRAs have a few benefits over 401(k)s:

• Lower administrative fees
• Increased investment options

Alternatively, you can leave your old 401(k) money alone and stop contributing, or cash out early with a penalty fee (we wouldn’t recommend it). 

Eligibility differences

IRA contribution limits are the same regardless of if it’s a traditional, Roth, or rollover account. Annual contribution limits are set at $7,000 in 2024 ($8,000 for people aged 50 and older), and it’s cumulative. So opening a new IRA won’t increase how much you can contribute each year. 

However, your rollover assets are exempt from these contribution limits. You can open a rollover account and transfer any amount from an old 401(k) to kickstart your IRA, and that doesn’t count towards the annual contribution limit. 

Typical IRA rules do apply to all direct contributions, however. So if you continue to fund the account, keep an eye on your annual contribution limit. 

Rollover rules and penalties

There are two types of rollovers: direct and indirect. Direct rollovers transfer assets directly from one account custodian to the next, and you never hold the money yourself. This is ideal to avoid costly mistakes that could make you liable for taxes and penalties. 

Indirect rollovers are when you take a check for the account balance with the intent to reinvest it in a new account within 60 days. 

Rollovers are a great way to manage your multiple retirement assets, but you can only make one indirect IRA rollover every 12 months without a penalty. Exceptions to this rule include conversion rollovers between traditional and Roth IRAs and rollovers involving employer-sponsored retirement plans (to or from an IRA).

There are also tax consequences to indirectly rolling over multiple IRAs within a year, including:

• Increased taxable income: Your rollover balance is counted as part of your gross income.
• 10% early withdrawal tax: Tax applied to your total rollover amount. 
• 6% excess contribution tax: Tax applied to the rollover amount for every year it remains in an IRA. 

Not rolling over within 60 days or mishandling the funds also carries consequences like early withdrawal penalties and owed income taxes. But the IRS may waive the 60-day requirements if you can’t meet the deadline due to uncontrollable circumstances.

Can you contribute to a rollover IRA?

Yes, you can continue making direct contributions to a rollover IRA. At this point, your contributions are treated the same as a traditional or Roth IRA, with a: 

• $7,000 annual contribution limit
• Possible tax deduction for contributions to a traditional IRA (income limits apply)
• Restrictions on Roth contributions based on income 

Does a rollover IRA earn tax deductions?

Rollover IRAs aren’t typically eligible for tax deductions. You already earned a tax benefit from the original tax-advantaged account, so the IRS isn’t about to give you a deduction on top of it. So the transaction itself isn’t tax-deductible.

However, depending on your income and 401(k) status, you might qualify for tax deductions when you make additional direct contributions.

IRA

You can open a traditional or Roth IRA anytime and contribute with earned income from wages, tips, and other sources. This account isn’t a rollover IRA unless you move assets into the account. 

IRAs are open to anyone regardless of age and income, though your income might impact tax deduction eligibility and Roth IRA contribution limits. It’s an individually owned account, so it’s not managed in any way by your employer. 

Transferring a 401(k) to an IRA

Transferring an old 401(k) into an IRA is pretty straightforward. You just have to follow these steps. However, we recommend connecting with a financial advisor to avoid any penalties or heavy taxes that might offset your retirement strategy. 

1. Choose your IRA account

Your first step is to choose an IRA to transfer your retirement funds to. You can roll over into an existing IRA if you don’t plan to transfer the money again, or you can choose a rollover IRA if you might transfer the funds to a future 401(k) or other tax-advantaged account.

• Rollover IRAs are best if you need a temporary place to store funds between jobs or if you want to continue with an independent account. 
• You can also transfer into an existing traditional or Roth IRA without impacting contribution limits.
• Consider a Roth IRA if you expect you’ll be in a higher tax bracket when you withdraw. You’ll owe income taxes when you make the transfer on any pre-tax funds.
• Choose a Roth IRA if you’re rolling over from a Roth 401(k).

2. Find an IRA provider

Next, decide what type of provider is right for you. If you’re rolling over to an existing account, you can skip this step. 

Otherwise, your plan provider selection is an opportunity to shop around and find a provider with low fees and strong resources to support your investments. There are two primary types of brokers to choose between:

• Robo-advisors automatically manage your investments, considering your risk tolerance and goals. They’re great for those with less investment experience and/or desire to actively manage their portfolio.
• Brokers allow you to manage your own assets as you see fit. Live brokers, online or in-person, are ideal for experienced investors who want control, and you can find providers with zero account fees and great service. 

3. Make your move

Finally, you can rollover your funds into the new IRA account. Your IRA provider and previous employer can help with much of the heavy lifting.

But first, you should know the difference between direct and indirect rollovers.  

• Direct rollovers: The plan providers complete paperwork and transfer the funds between their accounts without you ever holding the money. 
• Indirect rollovers: The original plan administrator sends the money to you to deposit into a new account within 60 days. Failure to follow all guidelines and deposit the money in 60 days can rack up expensive fees and taxes. 

We strongly recommend you complete a direct transfer to avoid unnecessary tax complications. Follow these steps:

• Gather transfer instructions from your new plan provider, including who to address the check to, where to send it, and other important details. 
• Connect with your 401(k) administrator to fill out the appropriate transfer forms and send the balance to your new provider. 
• Wait for confirmation that the direct transfer is complete. 

Other 401(k) options

‍A rollover IRA is a good idea to avoid the tax implications of a withdrawal while continuing to earn returns with your invested funds. But you have other options. Generally, there are three choices when managing an old 401(k). 

• Leave it in the existing account: If your employer allows it and you have at least $5,000 invested, you can keep your funds in your previous employer’s 401(k) plan. You can’t contribute to the account, but it will continue to earn returns. 
• Rollover to a new 401(k): If you’re starting a new job with 401(k) benefits immediately, you can choose to transfer your funds into the new employer’s 401(k). This way, you can continue to contribute and earn returns. 
• Cash out: While we recommend against it,  you can withdraw your 401(k) funds. You’ll owe taxes and early withdrawal fees, and lose out on future growth. This can also derail your retirement strategy, but it's an option if you’re in a financial bind. 

The Playbook take: Consider a rollover IRA to keep retirement funds growing

Switching jobs and managing old 401(k)s doesn’t have to be complicated. Rollover IRAs are just individual accounts that you roll existing retirement funds into, avoiding contribution limits and taxes on early withdrawals. But it’s not the only way to keep your retirement accounts organized. 

Want to supercharge your tax strategy and save more for retirement? Learn how Playbook can help you compare your tax advantages and make a plan to keep more money in your pocket this year. 

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