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Updated on October 4, 2024
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Not all IRAs are created equally. While they’re all retirement savings accounts and they have similar withdrawal rules, there are many different type of IRA to choose from.
Here, we’ll look at two types: the rollover IRA and the traditional IRA. First thing to know: They’re not always separate things.
Let’s dive into some more clarifying details.
A rollover IRA is an IRA (Individual Retirement Account) that contains money transferred to a brokerage or financial institution from another tax-advantaged source, typically an employer-sponsored retirement plan — like a 401(k) or 403(b). Sometimes money “rolled in” to an IRA can come from another IRA, like a traditional or Roth IRA.
If you’ve ever left a job and moved on to a new employer, there’s at least a decent chance that you’ll want to take your previous employer’s retirement account with you. If it’s a 401(k) savings plan, you might consider rolling the money to a traditional IRA — in this case, you’d have a traditional IRA that’s also a rollover IRA.
Recall that a rollover IRA account contains money that’s been transferred from another tax-advantaged source. If you open up a traditional IRA on your own and start making IRA contributions (within the contribution limits) from your checking account, you’d be well within your rights to do so but the account wouldn’t be considered a rollover IRA.
A traditional IRA is a tax-advantaged retirement account that’s established outside of your employer. Some traditional IRAs are rollover IRAs (if money has been previously transferred to them), but some traditional IRAs have simply been self-funded over the years and would not be considered IRA rollover accounts.
Traditional IRAs are subject to specific rules that determine whether you can deduct any contributions on your tax return. Generally speaking, if you earn more than $76,000 as a single taxpayer — or $125,000 as a married couple — you won’t be able to deduct contributions on your tax return. Annual contributions for 2021 are limited to $6,000 per individual, and there are also deductibility restrictions if you are covered by a retirement plan at work.
Most traditional IRAs are funded with tax-deductible contributions, but you can have a traditional IRA that contains “non-deductible” contributions. This simply means that you didn’t receive any tax benefit from putting the money into the account, which can occur if you funded the IRA with after-tax dollars or if you earn too much to receive any immediate tax benefit.
Comparing rollover IRAs and traditional IRAs is like comparing apples and oranges. The word “traditional” describes the tax structure, while the word “rollover” describes its funding source. Fun fact: You could have both a rollover traditional IRA and a rollover Roth IRA, if you had employer-sponsored plans of both tax type to roll over.
Both traditional and rollover IRAs usually have similar investment options, like stocks, bonds, ETFs, mutual funds, and sometimes, depending on your IRA custodian, alternative asset classes like cryptocurrency.
What’s more, both are governed by the same early withdrawal penalties and, in general, the same IRA contribution limits (though the rollover itself doesn’t count toward the maximum). You could even have an IRA that’s both a rollover IRA and a traditional IRA at the very same time.
It depends. You’ll only owe tax on a rollover if you move money from a “pre-tax” retirement account, like your former employer’s traditional 401(k), to a tax-exempt account, like a Roth IRA. (You’d also pay taxes if you moved funds from a traditional IRA into a Roth IRA, a process known as sa Roth IRA conversion.)
So long as you’re moving money between accounts of “like-tax” status, you won’t face any additional tax burden as part of the rollover. For instance, if you were to roll over money from a tax-deferred account, like a 401(k), to a traditional IRA, you wouldn’t owe any taxes. (You’d also enjoy tax-deferred growth on the assets.)
No one loves a surprise at tax time, which is why it’s important to understand this ahead of time. As an example, if you were to do a direct rollover from a pre-tax 401(k) to a Roth IRA, you’d be charged ordinary income tax on the entire transfer amount. This is because you’re actually performing a Roth conversion, which causes an additional tax charge. Worse, untimely Roth conversions can push all of your income into a higher tax bracket (you’d pay a higher tax rate). (The same is true for a Roth IRA conversion, by the way.)
Once you hit your early 70s, you’ll be required to take Required Minimum Distributions (RMDs) from your traditional retirement accounts on an annual basis. The IRS has calculators to determine how much you must remove based on your age, and, in less-common scenarios, how you acquired the IRA account.
If you voluntarily take money out of a pre-tax retirement account before age 59.5, you’ll likely be hit with both income tax and an early withdrawal penalty, not to mention missing out on more tax-deferred growth. So do yourself a favor and leave it be!
If you roll over funds from an old workplace retirement plan, you’ll likely be prompted to open a new rollover IRA in which to do so. While you could technically then transfer money from the rollover IRA into an existing IRA of the same tax type, there are a few reasons to consider keeping them separate.
For one thing, maintaining a separate rollover IRA—and not making new contributions to it—could make it easier to roll the funds over into a new employer plan in the future, if you wanted to. Additionally, rollover IRAs are protected in the event you declare bankruptcy, whereas funds in a non-rollover IRA are protected only up to $1.51 million. Hopefully you don’t have to worry about bankruptcy, but just in case, it’s nice to know.
If you’re moving to a new job that doesn’t offer a 401(k) or striking out on your own as a freelancer, a rollover IRA can help you manage your retirement funds and maintain an active retirement planning strategy regardless of your work situation. Additionally, IRAs often have more diverse investment choices than 401(k)s do, so even if your new employer does offer a plan, you may want to open an IRA at a financial institution of your own choice.
As mentioned above, if you make a rollover between two accounts of the same tax type—i.e., traditional to traditional or Roth to Roth—according to the rollover rules, you won’t pay any additional income tax on the rollover itself in the short term. Of course, all funds are taxed at some point. The main question is when. With a traditional account, you’ll pay taxes later, when you make retirement withdrawals; with a Roth account, you pay taxes now, but enjoy tax-free retirement income down the line.
Rollover IRAs and traditional IRAs aren’t really comparable, and in fact, many rollover IRAs are traditional IRAs. “Traditional” refers to the tax structure of an account, whereas rollover accounts are those specifically designed to catch funds that are transferred from another account of a similar type. It may sound complicated, but we promise it’s pretty simple!
Still have questions? Capitalize is here to help—and to ensure your retirement is as bright and stable as possible. We can help you find old 401(k)s and seamlessly roll them over into an IRA so you can keep up with your retirement planning without the hassle.
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