Setting Up a Rollover IRA

If you’re leaving your job and don’t know what to do about your 401(k) account, you may want to choose a rollover IRA. It’s the one alternative that’s always available if you want to keep your assets and any future earnings tax deferred until you withdraw them from your account. A rollover IRA also offers you the most flexibility in choosing investments. And it gives you the most control over withdrawals when you’re ready to start using the money.

Rollover IRAs have some unique qualities. You can move any amount into your account, provided you’re moving it from an employer-sponsored retirement plan. In other words, you’re not limited to the annual ceiling on traditional and Roth IRA contributions.

And you may be able to move money out of a rollover IRA into a new employer’s plan without owing any income tax or penalty if the new plan accepts rollovers. Check with your financial or tax adviser about any potential pitfalls that you can avoid by planning ahead. For example, you can’t roll after-tax contributions into a new employers plan.

To start the rollover process, you fill out an application provided by the financial institution to which you plan to transfer your money to open a rollover IRA. Then you use your IRA account number to complete the rollover request form provided by your old plan administrator. If you have an existing rollover IRA, you can use that rather than opening a new account.

When you turn in the request form, the administrator of your plan liquidates your assets and transfers the cash value to your rollover IRA, either electronically or by check. If you have a traditional employer plan, you can rollover to a traditional IRA, and if you have money in a Roth 401(k) or Roth 403(b) you can rollover to a Roth IRA.

In addition, you can convert the assets from a traditional 401(k) or 403(b) to a Roth IRA and pay the income tax that’s due on the contributions and accumulated earnings. As of January 1, 2010, there’s no longer an annual cap on how much you can earn and qualify to roll into a Roth.

For conversions in 2010 only, you can elect to pay the tax that’s due when you file your 2010 IRS return, or you can split what you owe, paying half when your 2011 taxes are due and the other half when your 2012 taxes are due. Ideally, you’ll pay the tax with money you don’t have to withdraw from your tax-deferred assets.

IRA CUSTODIANS

The financial institution where you have your rollover IRA is known as the custodian of your account. As custodian, the institution is responsible for making the investments you authorize, keeping track of the paperwork, and reporting investment performance and account balances to you.

But in most IRAs, the custodian doesn’t make investment decisions on your behalf. Nor does it have fiduciary responsibility for the investments you choose or the way your investments perform. This means if you decide to put all your money into a risky investment, your IRA custodian isn’t responsible for advising against it. The same is true if you keep all your money in a low-interest savings account.

In choosing a custodian, though, you’ll want to confirm that you’ll be able to make the types of investments you plan to make through your account. The alternatives available through an IRA you establish at a bank may be different from those available through an IRA you set up at a brokerage firm. The only investments that aren’t permitted in any IRA are coins, artwork, and other collectibles.

Your custodian may charge an annual fee for handling your account — often as little as $10 a year, and rarely more than $50. And if your account balance reaches a certain amount, which the custodian sets, the annual fee may be waived.

THE IRA ADVANTAGE

A traditional rollover IRA shares the advantages of a traditional deductible IRA. Your principal and any earnings accumulate tax deferred, which means your account value has the potential to grow more quickly than a taxable account with the same rate of return.

Unlike employer plans, which normally allow you to begin withdrawing only after you retire, you can begin taking money out of your rollover IRA without penalty when you turn 59 1/2, even if you’re still working. And you can postpone withdrawals until April 1 of the year after you turn 70 1/2. With most employer plans, you’re required to begin taking retirement income when you retire.

Similarly, a rollover Roth IRA shares the advantages of a regular Roth IRA. Withdrawals are tax free after 59 1/2 if your account has been open at least five years. One advantage a Roth IRA has over a Roth 401(k) or 403(b) is that there are no required withdrawals. Another is that you can continue to contribute in any year you have earned income no matter how old you are. You can’t contribute to a traditional IRA after you turn 70 1/2, though you can do a rollover at any age.

ROLLING DOWN THE FEES

Though you might not choose an IRA just to save money on fees, lower administrative costs are often a bonus of rolling over your 401(k). While there are sales charges on certain transactions, such as commissions on stocks you buy or sell, or annual asset-based fees on mutual funds you own, you can shop around for the combination of advice and expense that suits your investing style.

ONE AT A TIME

Keeping money in a rollover IRA isn’t a long-term commitment, even if saving for retirement is. You can use a rollover IRA for a brief period between jobs, until you qualify to roll the money into a new employer’s plan if it accepts rollovers, or for as long as you’re satisfied with the investments you can make through the account.

If you never move your rollover IRA into a new employer’s plan, it continues to work the same way as any other IRA.

PLAY BY THE RULES

You’ve got lots of leeway with a rollover IRA, but there are still some rules you have to follow.

Withdrawals before you turn 59 1/2 may result in a 10% penalty in addition to the income tax that is due. You can’t borrow against the value of an IRA account, which is often possible with a 401(k). And you can’t postpone required withdrawals from a traditional IRA if you’re still working when you turn 70 1/2, as you can with an employer-sponsored plan.

You should also check with your tax adviser about whether it’s a good idea to combine assets from a former employer’s plan with an IRA to which you make annual contributions, especially if you think you might ever want to roll the IRA into a new employer’s plan. Some custodians may insist you keep those accounts separate.


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