What is a Rollover IRA? - Definition, Rules & Sample Video

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  • 0:00 Rollover IRA
  • 0:34 The Rules of Rollovers
  • 3:13 But How Does It Really Work?
  • 4:54 Lesson Summary
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Lesson Transcript
Instructor: Michael Cozad

Michael is a financial planner and has a master's degree in financial services.

This lesson will define a rollover IRA, or an individual retirement account. This lesson will also explain the rules associated with a rollover IRA and a sample will be given.

Rollover IRA

Have you ever seen commercials for a rollover IRA? Perhaps you've heard friends or family members talk about moving their traditional 401(k) plan once they retire or stop working for their current employer. A rollover IRA is a transfer of monies from a retirement plan to a traditional IRA or a Roth IRA. The transfer is typically called a rollover, and can either be via a direct rollover or an indirect rollover. These terms will be explored in more detail in this lesson.

The Rules of Rollovers

Have you left your job and wondered what happened to your 401(k) or 403(b)? It's still there. The account value may have changed, but you have options. One of those options is to move your retirement plan to an IRA. For purposes of this lesson, there are two types of IRAs that accept the funds that were in the retirement plan. One is a traditional IRA rollover, the other is a Roth IRA rollover.

Traditional 401(k) and 403(b) plans are similar to a traditional IRA in that the employee has not yet paid income taxes on the contribution. Upon distribution, however, income taxes will be owed. Employees typically choose to move traditional 401(k) and 403(b) plans to rollover traditional IRAs. This maintains the tax status.

A Roth 401(k), however, is similar to a Roth IRA in that the employee has already paid income taxes on the contribution. Upon distribution, if certain guidelines are met, the distribution can be completed tax-free. Employees with Roth 401(k) plans can choose to move their assets to a rollover Roth IRA. Again, this maintains the tax status.

Traditional 401(k) and 403(b) rollovers to Roth IRAs may be permissible, but the amount moved or converted from the traditional to the Roth will be taxable in the tax year of the conversion. Now that you understand the differences in a traditional IRA rollover and a Roth IRA rollover, how do you actually complete the transaction?

As mentioned, there are two types of rollovers: direct and indirect. A direct rollover is when the delivering or existing custodian of the money writes the check directly to the new custodian. When this is done, there is no mandatory tax withholding, as the tax status of the assets is maintained.

An indirect rollover is when the delivering or existing custodian writes the check directly to the individual, who subsequently deposits the check in the account with the new custodian. When this is done, there is a mandatory 20% federal tax withholding, and state tax withholding if required by the state of residence. If the indirect rollover is completed within 60 days, the individual must deposit the entire distribution, including the federal tax withholding, to maintain the tax status. If not done within 60 days, the rollover cannot be completed. It's extremely imperative to deposit the check to the account with the new custodian within 60 days, as IRS guidelines are strict. IRS guidelines state that you cannot make more than one rollover from the same IRA within a one-year period.

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