IRA Rollovers Versus IRA Transfers: Learn the Key Differences

IRA rollovers and IRA transfers might sound like the same thing to those saving for retirement. However, it's important to know the differences between the two. With a little knowledge, you'll be able to understand when each is an appropriate action to take with your retirement savings and how to avoid common pitfalls that can turn into costly IRS tax penalties.

Understanding rollovers

The term rollover has many uses. But for the purposes of this article, a rollover is when you move assets from your employer-sponsored retirement plan into an IRA. Employer-sponsored plans include accounts such as a 401(k), 403(b) and pension plan.

There are two types of rollovers.

Direct IRA rollovers

With a direct IRA rollover, assets move from organization to organization. For example, if you're rolling over a 401(k) into an existing or new IRA, the 401(k) company would send those funds directly to your chosen IRA company and not to you. This is what makes the rollover direct.

With a direct IRA rollover, there are no tax implications and no required federal withholding because you never receive the funds personally. Also, the organizations prepare all the necessary paperwork for the IRS.

Indirect IRA rollovers

With an indirect IRA rollover—otherwise known as a 60-day rollover—the money being moved out of your employer-sponsored plan comes directly to you, the account holder, to be deposited into your personal account. You then roll the funds into an existing or new IRA within 60 days.

With indirect rollovers, you're taking a distribution from your employer-sponsored plan. This distribution could trigger a taxable event if you don't follow some specific IRA rollover rules. You're limited to one 60-day rollover every 12 months per person, and you'll need to redeposit the funds you receive from the distribution into an IRA within 60 calendar days from the date you receive the distribution. Any funds you don't roll over into an IRA will be included in your income, may be taxable and may be subject to a 10% early withdrawal penalty if you are younger than 59 1/2.

If you become the beneficiary of a retirement plan of someone who has passed away, it's important to understand your options regarding a direct rollover to an IRA and an indirect rollover to yourself. Keep in mind that elections as a beneficiary are irrevocable and can't be changed.

To initiate either type of rollover, you'll need to file paperwork directly with the retirement plan. You'll also need to set up your IRA or provide the information for an existing IRA if you choose to facilitate a direct rollover.

The basics of IRA transfers

Transfers are much simpler than rollovers. A transfer is when you directly move retirement account assets between two accounts of the same type. For instance, to move a traditional IRA at one organization into a traditional IRA at another organization, you'd transfer the assets. The same holds true when you move assets in an account like a 401(k) with a previous employer into a 401(k) with a new employer.

To initiate a transfer for an IRA, you'll need to obtain an asset transfer form from your existing IRA organization to provide to the organization to which you want to transfer the IRA assets. Your existing IRA organization will finalize the paperwork and forward it on your behalf.

Like a direct IRA rollover, there's much less that can potentially go wrong and cause a taxable event with transfers.

When to choose a transfer versus a rollover

There are a few reasons you might want to explore a transfer from like account to like account or move funds from an employer's retirement plan to an IRA through a rollover.

When a transfer might be right for you

• You take a new job. If you don't want to leave assets behind in a former employer's plan, you can facilitate a transfer to bring your assets with you to your new employer's plan if they allow the movement.
• You want to consolidate your accounts. If you have multiple IRAs or 401(k)s, you might want to manage just one of each account type. A transfer can help you combine your assets.
• You want better investment options. If your new employer or another IRA organization offers a better array of investment options, you can transfer assets into your new plan or another IRA.
• You're looking for lower costs. Your new employer's plan or another IRA organization might offer lower administration fees or investment options with lower management fees than your current plan or organization.

When a rollover might be right for you

• You prefer more control over your investments. Moving assets from an employer's plan with limited investment options to an IRA that offers more options could help you better achieve your financial goals.
• You need to take a partial distribution. If you have an urgent need for assets, an indirect IRA rollover—or 60-day rollover—can help you access some of your retirement funds early and still roll the remaining assets over into an IRA. While you may incur tax and early-withdrawal penalties on the funds you keep, you can still enjoy the tax-deferred status on the remaining funds you roll into an IRA.

Don't be afraid to ask for help from professionals who work with retirement accounts every day and know the IRA rollover and transfer rules. Your CPA or financial consultant can help you determine whether a transfer or rollover is the better option.

Avoiding common pitfalls

Knowing the errors people often make with IRA rollovers and transfers can help you avoid problems during the process.

With transfers, make sure you initiate your transfer with the receiving organization. Whether transferring to your bank, a new employer's plan or an online brokerage firm, use the forms your new organization provides to initiate your transfer.

With rollovers, make sure your current plan indicates that you're facilitating a direct rollover to an IRA on the plan paperwork. This is a common pitfall that's easy to avoid with some proofreading.

Make sure the check isn't being made payable to you directly, which would indicate an indirect or 60-day rollover and is reportable as a distribution by the plan. If your employer plan requires that proceeds from the plan are mailed to the address of record, make sure the check is made payable to the organization receiving the direct rollover funds. If possible, add FBO [your name] IRA—or for the benefit of [your name] IRA—or even the IRA account number so there's no question about the account to which funds should be deposited.

One potential way to avoid this pitfall is to have the direct rollover check from your previous employer's plan mailed directly to the new IRA organization. Even though the plan controls this decision, it's easy to ask for and can help you avoid an extra step in the rollover process.

Remember, you don't have to go through a transfer or rollover alone. Your banker or financial advisor will be happy to speak with you about your options before you initiate a transfer or rollover. It's possible that you don't need to do either one, as these options aren't right for every investor. There are pros and cons to each, and starting the conversation can help you make the best decision while keeping your individual financial goals in mind.