If there’s one thing you should know about IRAs in general, it’s that they’re not created equal. There are some similarities, however: IRAs are all retirement savings vehicles, and some of them have similar withdrawal rules.
Still, each type of IRA has some unique characteristics; here, we’ll take a look at the main differences between a rollover IRA and a traditional IRA.
What is a rollover IRA?
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.
What is a traditional 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.
What are the differences between a rollover IRA and a traditional IRA?
To compare the two is to compare apples and oranges. The “rollover” title has nothing to do with the tax status of the account; in fact, you could have both a rollover traditional IRA and a rollover Roth IRA. This would just mean that you rolled over funds from another tax-advantaged source into either of these accounts.
A traditional IRA, on the other hand, is meant to hold pre-tax dollars. This means you received some tax benefit when you deposited the money, and it’s now growing tax-deferred until you withdraw it on some future date. Only then will you pay tax on any amount withdrawn. Still, as described earlier, you can deposit after-tax money to traditional IRAs, but this can be complicated to track.
Your investment options for either account are generally the same since both are IRA accounts. You’ll be able to access single stocks, bonds, ETFs, mutual funds, and in some cases, even more esoteric investments like cryptocurrency.
You’ll often see the terms together, but the words “rollover” and “traditional” aren’t meant for direct comparison. Recall that you can have an IRA that’s both a rollover IRA and a traditional IRA!
Are there tax consequences when I roll money over?
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 tax-deferred 401(k), to a tax-exempt account, like a tax-free Roth IRA.
Taxes can be pretty easily avoided if you ensure you are moving money between accounts of “like-tax” status. 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.
This is why it’s extremely important that you understand the tax implications of any rollover before you attempt to start one.
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).
Once you hit your early 70s, you’ll be forced to take Required Minimum Distributions (RMDs) from your pre-tax retirement accounts on an annual basis. The IRS has calculators to determine how much you need to 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 be hit with both income tax and an early withdrawal penalty, in most cases.
There are some instances within the world of advanced financial planning when you might even roll money over to purposely cause a tax charge in a particular tax year, but in most basic situations you’ll want to avoid any extra taxes.
Key Takeaways
- A traditional IRA can be a rollover IRA, but it doesn’t necessarily need to be. A rollover IRA refers to any IRA that contains money transferred from another tax-advantaged source (most commonly a 401(k)).
- The name “traditional IRA” is really a reference to the tax status of the account; the name “rollover IRA” refers to the source of funds in the account.
- With any rollover, it’s smart to investigate the consequences (particularly the tax implications) of any action well in advance of taking it.
- If you have questions along the way, be sure to consult with a qualified financial advisor, like a Certified Financial Planner practitioner or a Certified Public Accountant with personal financial planning experience.
