How Does a Rollover IRA Work?

When you change jobs, you have several options for what to do with your employer-sponsored retirement account. For some people, rolling these funds into an individual retirement account, or IRA, may be the best approach.

While rolling over a 401(k) or other employer-sponsored retirement plan into an IRA is generally quick and relatively simple, there are some nuances to consider. Learning more about how rollover IRAs work can help you make the most of your retirement savings.

What is a rollover IRA?

A rollover IRA happens when you move funds from a workplace retirement plan into an IRA. Rollover IRAs are often a good solution for people wondering what to do with an old 401(k) or 403(b), particularly when compared to other options like leaving the money in an old employer plan, transferring it to a new workplace plan or withdrawing the funds.

How does a rollover IRA work?

A rollover IRA allows you to keep the special tax status of your employer-sponsored retirement plan. Assuming both your workplace plan and the IRA are traditional accounts, your funds will remain tax-deferred and only subject to taxes when you withdraw funds from your IRA. This is the same tax treatment as if you'd kept the 401(k) account intact.

Converting your 401(k) into a rollover IRA is straightforward, but there are some important factors to consider—particularly when it comes to how your funds are transferred.

First, you'll need to set up an IRA if you don't already have one. The process is relatively simple and can be done online in many cases. It can be helpful to set up a separate IRA that will hold only rollover funds and no other IRA contributions because this gives you the option to roll these funds into a future employer's 401(k) plan if allowed.

Once you've opened an IRA, funds can be rolled over. There are two types of rollover processes—direct and indirect. Choosing the right IRA rollover method is key to avoiding a potential tax bill.

Direct IRA rollovers

For most people, a direct IRA rollover may be the best option. Not only are direct rollovers typically easier, but they also leave less room for error.

With a direct rollover, the trustee or administrator of your workplace plan will transfer the balance of your account directly into your IRA or will issue a check that's payable to the new account. Because the money moves straight from one plan to another without going through you, direct rollovers are nontaxable events.

Indirect IRA rollovers

Indirect IRA rollovers, also called 60-day rollovers, require more steps to ensure you avoid potential tax issues. With an indirect rollover, the trustee of your workplace plan will issue a check to you rather than to your IRA. They're also required to withhold taxes on the rollover amount—typically 20%.

The challenge is that you're required to deposit the 80% check plus additional savings to cover the 20% withheld taxes into your IRA within 60 days. This 60-day clock starts when the money is withdrawn from your account, not the day you receive the check. If you successfully deposit the full amount within 60 days, the taxes your employer withheld will be returned when you file your taxes for the year.

However, if you only deposit the 80% check, miss the 60-day deadline or have already done a 60-day rollover within the past 12 months, all or a portion of your intended rollover funds will count as a distribution. And this distribution will be fully subject to federal and state income taxes and a likely 10% early-withdrawal penalty.

Can you convert a rollover IRA into a Roth IRA?

When you open a rollover IRA, you'll get to decide between a traditional and Roth version of the account. Traditional IRAs typically offer an immediate tax deduction for your contributions along with tax-deferred growth, while Roth IRAs generally provide tax-free growth and tax-free withdrawals.

Choosing a Roth IRA may offer significant long-term tax advantages, but unless you're rolling over a Roth 401(k), you'll have to pay current income taxes on the full amount of the rollover. This may result in a large tax bill and could even push you into a higher tax bracket. You also may be subject to a 3.8% net investment income tax.

Once your money is in a Roth IRA, however, qualified withdrawals are tax-free. You also won't have to take required minimum distributions—which can unnecessarily deplete your tax-deferred account—and turn those monies into taxable investments like you'd do with a traditional IRA.

Benefits of a rollover IRA

While the biggest advantage of rollover IRAs may be gaining more control over your money, they offer a variety of other benefits as well.

• A wider range of investment choices: Workplace plans tend to offer limited options when it comes to investing for retirement—typically a short list of mutual funds. With an IRA, you can invest in almost anything—including mutual funds, exchange-traded funds, individual stocks and bonds, and alternative assets.
• More low-fee investment options: With an employer-sponsored retirement plan, you're locked into both the plan fees and the fees charged by the funds included with your plan. With an IRA, you can specifically seek out low- and no-fee investments, which may help maximize returns over the long term.
• Easier account management: Having a single account for all of your old workplace retirement plans may make it easier to track and manage your investments. Plus, holding a larger balance within one account may give you increased access to lower fees and other possible benefits.
• More flexibility in naming beneficiaries: With an IRA, you'll have the freedom to name anyone you choose as a beneficiary. This differs from most workplace retirement plans, which may require you to obtain written consent from your spouse to name someone else as your beneficiary.
• More exceptions for penalty-free early withdrawals: The IRS offers several exceptions that allow people to take penalty-free early withdrawals from their retirement savings in specific circumstances—like if you're buying a home for the first time. IRAs generally offer more exceptions compared to workplace retirement plans.
• Easier wealth transfers for heirs: While the distribution rules for workplace retirement plans vary by employer, the rules may be quite restrictive in some cases. IRAs typically offer beneficiaries more options, depending on their status as eligible designated beneficiaries. Consolidating multiple 401(k) accounts may also help streamline your estate planning.

Drawbacks of rollover IRAs

Although rollover IRAs have many benefits, they do come with a few potential downsides compared to keeping your money in an employer-sponsored retirement plan.

• Limited access to institutional funds: Employer-based retirement plans may have access to institutional funds—exclusive investment vehicles for large institutional investors such as corporations, charities, governments and trusts—that aren't available to IRA holders. You may be able to find similar funds, but you may not be able to duplicate your workplace plan holdings in your IRA.
• Inability to borrow funds: The ability to borrow against your retirement savings—as opposed to simply withdrawing funds—is a key benefit associated with 401(k) accounts. Unfortunately, you can't take a loan against your IRA. If you have an outstanding 401(k) loan, you may need to repay it before rolling over your funds.
• Eligibility for penalty-free distributions: Employees with 401(k) plans who leave their jobs during or after the year they turn 55 may take distributions without incurring a 10% early-withdrawal penalty. With a traditional IRA, however, you'll typically need to wait until age 59 1/2 to withdraw funds penalty-free. If you're close to retirement age, learning more about IRA withdrawal rules can help ensure you're well-prepared to avoid any potential penalties.
• Potential tax consequences and penalties: If you choose an indirect rollover, you may need to contribute a large lump sum to balance the effect of withholding taxes and keep your rollover tax-free. Without this, you'll end up losing more of your money to taxes—including a potential 10% penalty.

Net unrealized appreciation versus IRA rollover

If you hold highly appreciated employer stock in your 401(k) and don't plan to sell soon, talk to a financial advisor before rolling it over into an IRA. Taking a distribution of the stock instead of rolling it over may allow you to benefit from the net unrealized appreciation, or NUA, tax strategy.

With NUA, you pay ordinary income tax on the stock's original cost basis, but any gains above that may qualify for long-term capital gains tax treatment when you sell. This can result in a lower tax rate on the appreciated portion, depending on your tax bracket and how long you hold the stock. In contrast, rolling the stock into an IRA keeps it tax-deferred, but all distributions will be taxed as ordinary income.

While NUA may offer tax benefits, it can be complex and requires meeting specific conditions to qualify. It's helpful to consult a tax specialist before pursuing this strategy.

What happens after an IRA rollover?

Once you roll funds into an IRA, you'll need to invest these funds. Taking the time to choose IRA investments based on your personal risk tolerance and long-term goals may help you make the most of your existing savings.

Can you contribute to a rollover IRA?

You can continue to grow your retirement savings by contributing additional funds to your IRA, but annual contribution limits apply. While there's no limit to the amount you can roll over from an existing workplace retirement plan, regular IRA contributions are subject to annual IRS limits—up to $7,000 in 2025 if you're younger than 50 and $8,000 if you're 50 or older.

Rollovers versus transfers

While rollovers and transfers sound similar, they're used for different purposes. A transfer is when you directly move retirement account assets between two similar accounts. For example, this could involve shifting a traditional IRA from one provider to another or moving assets from a previous employer's 401(k) plan to a new employer's plan.

The bottom line

Ultimately, your IRA rollover decision should be part of a larger retirement planning strategy that's tailored to your particular financial situation and goals. As you evaluate your options, it may be helpful to discuss them with a financial advisor. They can help you weigh the pros and cons of an IRA rollover and navigate the process if you decide to proceed.