Which Rollover IRA Option is Right for You?

A rollover IRA allows you to consolidate all of those old accounts into one new one, making it easier to manage your investment options and plan for retirement.  In addition, most rollover IRA accounts offer a wider range of investment opportunities than your old employer’s plan, including things like stocks, ETFs and bond funds.  With these new options available, you may be able to earn a much higher rate of interest on your retirement funds.

Saving for your retirement is vitally important.  In fact, most financial advisors recommend making this a priority over funding other accounts – like your child’s college savings fund – because your future is depending on your having sufficient funds to meet your needs.

Chances are you’ve already begun to save for retirement.  But if you’re like most Americans, you likely have a scattered series of 401k and 403b accounts from old employers, gathering dust while they grow according to the limited investment options you once chose from.  There’s a better way to manage your retirement funds – with a rollover IRA.

Performing an IRA rollover transfer is easy, although the steps you’ll need to follow depend on whether you’ve invested in a Traditional or Roth 401k or 403b plan in the first place.  Let’s look at each situation:

401k Rollover to Traditional IRA

Most 401k and 403b plans are traditional retirement plans – meaning that the money that funded your contributions was taken from your paycheck on a pre-tax basis.  Any future contributions or capital gains used to fund your account are allowed to grow tax free until you withdraw them in retirement.  At this point, you will owe taxes on your distributions, although the assumption is that you’ll be in a lower tax bracket as you’re no longer employed.

Traditional IRA accounts operate in the same way.  Any funds you add to these accounts (including any that you rollover from previous retirement accounts) will grow tax free until distribution.  And, as long as you set up an IRA direct rollover (where the money moves directly from your old retirement account to the new IRA account), you won’t owe any taxes or penalties on the transfer.

401k Rollover to Roth IRA

A Roth IRA is a slightly different beast than a traditional IRA, as Roth account contributions are made on an after-tax basis.  In this situation, you’re taking care of your tax liability up front – meaning that the distributions you take in retirement won’t be subject to personal income taxes.

If your old retirement funds were invested in a Roth 401k or 403b account, you can transfer them directly to a Roth IRA with no penalty as long as you meet certain income requirements.  However, this situation is rare, as few employers offer the Roth 401k as an option.  That doesn’t mean you’re out of luck, though.  If your funds are in a traditional retirement account and you’d like to invest them in a Roth IRA, perform a traditional IRA rollover first.  Later, you’ll be able to convert the funds into a Roth IRA account, although you will owe income taxes on any funds you convert.

As an added bonus, the IRS IRA rollover rules have recently changed to allow more people to take advantage of the benefits of a Roth IRA.  First, if you’re converting funds from a traditional IRA to a Roth, you won’t need to meet the typical income retirements beginning in 2010.  In addition, this new legislation enables you to spread the taxes due on your conversion over two years, making it easier for more people to get involved with Roth IRA investing.

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