Difference Between a Rollover IRA & a Traditional IRA

Planning for retirement can be complicated. Since it seems far away, new couples frequently neglect to plan for it, but beginning early is the secret to a large retirement fund later on. Retirement accounts include several types of IRA accounts. Understanding the differences between retirement accounts is an important step in selecting the right type of savings and investment account for you. Even more important, it can keep you from making expensive mistakes along the way.

Basics of an IRA

An IRA, or Individual Retirement Account, is a tax-advantaged way to save and invest for retirement. IRAs follow rules and regulations issued by the Internal Revenue Service. In all IRAs, money within the account grows tax deferred until withdrawal. This means that no capital gains taxes or taxes on interest accrued are due each year.

How a Traditional IRA Works

A traditional IRA offers qualified taxpayers an income tax deduction for contributions made to the account. Taxpayers who do not qualify for the deduction can still make nondeductible contributions to an IRA, up to $6,000 per year, or $7,000 if you are over 50. These nondeductible contributions must be documented fully because no additional taxes should be paid on them.

401(k) Account Basics

Many people get their start investing for retirement via a 401(k) plan or other employer-sponsored retirement plan at work. Typically, contributions to these plans are made with pretax dollars. All growth within the plans occurs on a tax-deferred basis. A 401(k) or other retirement plan may be transferred into an IRA account under certain circumstances, usually when the employee changes employers.

How an IRA Rollover Works

Transferring a retirement account into an IRA account is known as a rollover. A rollover is a special type of transfer that is tax-free. In the case of certain employer-sponsored retirement plans, like a 401(k), that money can be rolled back into another 401(k) at a later date. However, only money from a previous retirement plan may be transferred in this way.

A rollover IRA is the same as a traditional IRA, except that only funds rolled over from a previous retirement plan are held in the account. By segregating the monies in this way, a rollover IRA ensures that the funds can be rolled back into a 401(k) plan should the opportunity ever arise. If you contribute money into your rollover IRA, it will cause headaches if you try to convert it back to a new employer-sponsored 401(k). So if you want to invest money into your retirement while between employer-sponsored plans, it's best to set up a separate, traditional IRA or Roth IRA.

A rollover IRA has the same tax rules on withdrawals, conversions to Roth IRAs and required minimum distributions as a traditional IRA. Most IRA programs allow a single rollover per year.

Advantages of a Rollover IRA

Once you've moved a 401(k) into a rollover IRA, keeping it that way may appeal to some savvy investors. A rollover IRA usually offers more investment opportunities than what is in a company 401(k) plan. Investment costs are often lower. Your new company may charge higher fees. Also, there is more withdrawal flexibility and better estate-planning options than an employer plan typically offers.

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