Understanding Your Rollover IRA

A Basic Introduction to the Rollover IRA

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Simply stated, a Rollover IRA is an account that acts just like a regular brokerage account in all regards except that it is funded by transferring, or “rolling over”, money from a previous employer's retirement plan. It is subject to the same restrictions (for instance, you can’t make a withdrawal unless you pay your full tax rate plus a 10% penalty), but for the most part, it is far more flexible.

If you receive the proceeds of your 401(k) to invest in a Rollover IRA it is extremely important that you complete the process within 60 days. If you miss this deadline, you will be subject to substantial taxes.

In my own family, one of my relatives just left a job at a major airline and opened a Rollover IRA with Charles Schwab. She used the money to invest in shares of Berkshire Hathaway. That wouldn’t have been possible had she rolled over into the plan of her new employer, where she would have had to choose between the mutual funds offered by the new plan sponsor.

The process of opening a Rollover IRA is fairly straightforward, and there are many firms from which to choose. The reason we used Schwab was that they had a rollover specialist that took care of all of the details. Other brokerage firms offer cash incentives (in the past, I've seen a firm actually offer a $500 cash bonus for transferring a large 401(k) to a Rollover IRA).

What are the Disadvantages of a Rollover IRA Compared to a 401(k)?

With a Rollover IRA, there are tens of thousands of potential investments. For those with no financial background, this can be overwhelming. It can also present the temptation to frequently trade, which can result in substantial frictional costs and sub-par returns.

Also, you can only take advantage of the Rollover IRA once each year.

What You Can Do with your Retirement Plan Assets if You Quit or Lose Your Job

The lifetime employment our grandparents once enjoyed, sadly, no longer exists in today's competitive global economy. For the majority of the current and future workforce, the odds are good that at some point in their lives, they will leave their current employer due to company downsizing, outsourcing, termination, or in pursuit of new opportunities. It's even possible they'll quit just because they can't face the prospect of going to work anymore.  

If your employer offers a company retirement plan such as a 401(k), and you find yourself no longer employed due to reasons mentioned above, you have a few options regarding the assets you've invested throughout your employment. They are:

  • Cash out and take the money, incurring large tax penalties to the IRS. This is ordinarily a huge mistake because you also lose the tax shelter from investing in a protected account (e.g., if you made $500 in dividends from stocks held in a retirement account, you likely won’t owe any taxes on that money for decades, if ever, whereas if you held the stock in a regular non-retirement account, you would get hit with taxes each year).
  • Move the money from your current employer’s plan to your new employer’s 401(k) plan. On one hand, the transfer is relatively easy and it keeps your assets consolidated. On the other hand, you will be subject to the choices provided by your new employer. This can be a major disadvantage for investors that know which stocks they want to own, or if your new employer offers a collection of investment options that aren't quite as satisfactory as those offered by your former employer.
  • Open a Rollover IRA with a brokerage firm and have the funds from your old 401(k) deposited into the account. Not only will you continue to enjoy the tax protection of a qualified retirement account, but you will be able to invest in practically any stock, bond, mutual fund, real estate investment trust, or other security available through your broker.