Both Rollover IRA and Roth IRA are individual retirement accounts (IRAs). A Roth IRA is a retirement savings account where you make contributions with after-tax dollars, which can be withdrawn later without paying taxes. A Rollover IRA can be either a Traditional IRA or a Roth IRA where you transfer assets from a previous employer-sponsored retirement plan such as a 401(k) plan.
What is the difference between Rollover IRA and Roth IRA?
A Rollover IRA is either a pre-tax IRA (Traditional) or a post-tax IRA (Roth) where you deposit money from an employer-sponsored retirement plan. While a Roth IRA is an after-tax account for individual retirement savings.
Eligibility
To be eligible for a Rollover IRA, you must have funds in a qualified employer-sponsored retirement plan such as a 401(k) or 403(b). You can simply open an IRA at a financial institution of your choice to receive those funds.
If you already have a Traditional IRA or a Roth IRA, you can choose to transfer assets from the employer plan to the existing IRA, effectively making this account function as a Rollover IRA. However, this option may lead to complications in the future. For example, if you want to eventually move the rolled-over funds to a new employer-sponsored plan—such as in the case of getting a new job—it may be better to keep the Rollover IRA separate instead of merging the funds with the existing IRA. This is because making contributions to the Rollover IRA after the transfer itself may prevent you from moving the funds to an employer-sponsored plan in the future.
Roth IRA eligibility depends on whether you are rolling over assets or not. If you are rolling over funds to a Roth IRA, you can do so without worrying about income restrictions. But if you want to make direct contributions to a Roth IRA, you will need to meet income requirements based on your modified adjusted gross income (MAGI). For the year 2022, the full contribution is $6,000 for individuals, plus an additional $1,000 contribution if you are 50 years old or older.
Taxes
If you follow the rules for moving money from an employer plan to a Rollover IRA, the transaction generally does not trigger any taxable events, even if you later receive a tax form explaining the transaction.
For example, you can avoid a taxable event by making a direct rollover, where the sponsored plan sends your money directly to your IRA provider. You may want to seek assistance from your current plan provider in this process.
If you do an indirect rollover, such as having the sponsored plan send you a check with tax withholding, you must deposit that money into an IRA within 60 days. You will also need to “make up” your deposit with the amount withheld for taxes so that you roll over the full amount to avoid further taxes. If you do not roll over the full amount, including the withheld taxes, the withheld amount will be considered taxable income (even though you can still claim that amount as taxes paid in that year). Additionally, you typically have to pay a 10% penalty on the amount that was not rolled over.
Your Rollover IRA structure is also tax-related. A Traditional IRA allows tax-deductible contributions, and you’ll pay taxes on your withdrawals in retirement. A Roth IRA, whether used for conversion purposes or on its own, involves after-tax contributions, which can later be withdrawn without paying taxes if certain conditions are met, such as reaching age 59 and a half.
Required Minimum Distributions
Traditional IRAs require Required Minimum Distributions (RMDs), generally starting at age 72. There are no RMDs in Roth IRAs. Therefore, whether Rollover IRAs have RMDs depends on whether you are rolling funds into a Traditional IRA or a Roth IRA.
Note: If you are age 72 or older and wish to transfer assets from an employer plan to an IRA, you still need to take an RMD for that year.
The Five-Year Rule
One of the requirements for withdrawing earnings from a Roth IRA without paying taxes is that the account must have been open for at least five years, starting from January 1 of the year you made your first contribution. The same five-year rule applies to Roth IRAs whether you opened the account for direct retirement contributions or for rolling assets from an employer plan.
Note: The five-year rule applies only to Roth IRA earnings. You can always withdraw your contributions, regardless of how long you have held the account.
However, Traditional IRAs do not require a specific time frame, as withdrawals are taxable regardless. So a Rollover IRA may or may not have to follow the five-year rule, depending on whether it is a Traditional IRA or a Roth IRA.
Conclusion
Rollover IRAs and Roth IRAs can overlap, such as rolling assets from an employer plan into a Roth IRA. However, rolling into a Traditional IRA will have very different rules, especially concerning taxes.
In some cases, both types of accounts can be used. For example, if you leave your employer, you might roll your 401(k) into a Traditional IRA to consolidate your assets and have more control over them. If eligible, you may also open a Roth IRA for additional retirement savings, especially if you plan to get a new job with access to a new employer-sponsored plan.
Options regarding the use of retirement account types depend on factors such as:
- Employer plan rules regarding how your assets can continue in the plan after you stop working
- Access to a new employer-sponsored plan
- Your income and tax status
Given the complexity of this situation, you may want to speak to a professional to determine what works best for your circumstances.
Frequently Asked Questions (FAQs)
Are Rollover IRAs and Roth IRAs the same thing?
Some Rollover IRAs are Roth IRAs, but not all Roth IRAs are Rollover IRAs. The difference is that Rollover IRAs can be either Traditional IRAs or Roth IRAs used to transfer assets from a qualified employer-sponsored retirement plan to an individual account. Roth IRAs can also be used for direct contributions to retirement, subject to income restrictions.
What are the tax implications of Rollover IRAs versus Roth IRAs?
Rollover IRAs can trigger taxable events if the rules concerning the transfer process are not followed. One way to avoid this is by directly transferring from the employer plan to your IRA provider. Additional taxes depend on the account structure. For a Roth IRA, whether used for asset conversion or direct contributions, distributions are made using after-tax funds, which can later be withdrawn without taxes if the relevant conditions are met.
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Sources:
- Fidelity. “Rollover IRA,” see footnote 1.
- IRS. “Amount of Roth IRA Contributions That You Can Make for 2022.”
- IRS. “Rollovers of Retirement Plan and IRA Distributions.”
- Charles Schwab. “Roth IRA Withdrawal Rules.”
- IRS. “Retirement Plan and IRA Required Minimum Distributions FAQs.”
- IRS. “Publication 590-B (2020), Distributions From Individual Retirement Arrangements (IRAs).”
Source: https://www.thebalancemoney.com/rollover-ira-vs-roth-ira-5270163
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