Individual retirement accounts (IRAs) are some of the most popular tools available to help workers save and invest for retirement.

It’s important to understand what each type of IRA is, how they work, and how best to take advantage of them.

Traditional IRA: An overview

A traditional IRA is a type of individual retirement account that allows workers to contribute pre-tax dollars. When you save in a traditional IRA, your contributions may be tax-deductible. You can write them off on your taxes, lowering your taxable income and total tax bill.

Any investment growth in your traditional IRA is tax-deferred, meaning you won’t pay current income taxes or capital gains taxes on your earnings. Once you start taking distributions from the IRA, you’ll pay taxes on those dollars.

In 2024, you can contribute up to $7,000 to a traditional IRA, up from $6,500 the year before. If you’re 50 or older, you can also make a $1,000 catch-up contribution, bringing your total contribution limit to $8,000.¹

Technically, anyone with earned income can contribute to a traditional IRA. However, there are limits as to who can deduct their contributions. If you have access to an employer-sponsored retirement plan, your ability to deduct your contributions is limited once you reach a certain income level.

Traditional IRAs have some key advantages, including their upfront tax savings and tax-deferred investment growth potential. However, remember that you’ll pay taxes on your withdrawals.

Read more: The advantages of an IRA

Rollover IRA: How it works

A rollover IRA is an individual retirement plan that you’ve rolled money into from an employer-sponsored plan. A rollover IRA isn’t technically its own type of IRA. Instead, you can use a traditional IRA or Roth IRA as a rollover IRA.

A rollover IRA can be a traditional IRA, meaning it has the upfront tax advantage. However, a rollover IRA can also be a Roth IRA.

Rollover IRAs have some key advantages. First, they allow you to move money from your employer-sponsored retirement plan to an IRA. Rather than keeping funds in multiple retirement plans as you leave jobs, you can keep all of your retirement dollars in one place.

Additionally, many investors find IRAs to be preferable to 401(k) plans as they typically have lower administration fees and a wider variety of investment options. Many IRA providers have no annual administration fees, meaning the only fees you pay are those that apply directly to your investments. Additionally, rather than being limited by the investment menu your employer provides, with an IRA, you can choose from nearly any investment your IRA provider offers.

Rollover IRAs also offer all of the same benefits as traditional and Roth IRAs. Once you have one open, not only can you roll money into the account from other retirement plans, but you can also continue contributing up to the annual contribution limit.

Read more: Can I contribute to a 401(k) and an IRA?

Key differences: Rollover IRA vs. traditional IRA

There are a couple of key differences between rollover IRAs and traditional IRAs, including their tax treatment and their eligibility.

Tax treatment

One of the important differences between contributing to a traditional IRA and rolling your 401(k) balance over into an IRA is the tax treatment.

When you contribute to a traditional IRA, you may get a tax deduction for your contributions, which reduces your taxable income and tax liability. But if your contributions to your 401(k) were also made pre-tax, because you’ve already received your tax benefit, you won’t get a tax deduction when you move the money into your rollover IRA.

However, once the money is in the account, traditional and pre-tax rollover IRAs have the same tax rules.  Any investment growth will be tax-free until withdrawal. You won’t pay taxes again until you take distributions, which will be subject to ordinary income taxes.

Eligibility and contribution limits

Another important difference between traditional and rollover IRAs is their eligibility requirements. To contribute to a traditional IRA, you must have earned income. Your contributions are limited to $7,000 or 100% of your earned income, whichever is lower.

There are no such eligibility requirements to complete an IRA rollover. Because you’ve already received the tax benefits for the dollars in your 401(k), you can roll over your eligible balance, regardless of your income level.

However, if you choose to contribute directly to the IRA after your rollover, you’ll be subject to the eligibility requirements.

Options for an old 401(k)

Because we’re discussing rollover IRAs, it’s important to give the full picture of your options for an old 401(k) and how a rollover IRA fits into those options.

Leave it be

Depending on the requirements of your plan, you may have the option of leaving your 401(k) balance in your existing plan when you leave your job. However, there can be several downsides to this choice.

First, not bringing your retirement dollars with you can make it difficult to keep track of them. It may seem like a minor administrative item when you leave one job, but once you have several jobs behind you, it could become easy to lose track of where all of your retirement dollars are.

Another downside of leaving your 401(k) balance with your former employer is the level of service you may get. Because you no longer work for the company, you likely no longer have access to HR for support as you did as an employee. Additionally, 401(k) plans may have limited investment options with higher fees when compared to IRAs.

Roll it into a retirement plan

As we’ve mentioned, when you leave your job, you can roll your 401(k) balance over to another retirement plan. It can be a rollover IRA, but it doesn’t have to be. You could also choose to roll your 401(k) balance over to the retirement plan offered by your new employer.

Rolling over your retirement funds may be the best option for many people. Whether to roll over to a new 401(k) or a rollover IRA can depend on several factors.

First, consider the quality and cost of your new employer’s 401(k). You may also consider whether you already have an IRA or whether you’d need to open a new one. If you already have an IRA, then a rollover to that account might be the best option. However, if you don’t have an IRA, then you might be better off rolling over to your new employer’s retirement plan.

Read more: 401(k) rollover options

Cash out

The final option for your 401(k) balance when you leave a job is cashing it out. While cashing out your 401(k) might seem beneficial — you get a lump sum of money in your bank account — it has some major downsides.

First, 401(k) distributions before you reach age 59 ½ or meet other requirements are subject to a 10% early withdrawal penalty.² And that’s in addition to the ordinary income taxes you’ll pay on the money. Between income taxes and the penalty fee, your losses could be upwards of 40% if you’re a high earner.

Additionally, if you cash out your 401(k) each time you leave a job, you’ll be starting at square one for retirement savings with each new job. And as you near retirement, you may find that you don’t have enough savings to leave the workforce.

How to transfer a 401(k) to IRA

If you’ve decided to use a rollover IRA for your 401(k) balance, there are just a few simple steps you’ll need to follow:

Step 1: Choose a rollover IRA account type

When you decide to move your 401(k) balance to an IRA, you must first decide the right type of rollover IRA for you. This decision depends partially on the type of 401(k) you have. If you have a Roth 401(k), you can only roll it into a Roth IRA. If you have a traditional IRA, you can choose to roll it over to either a traditional or a Roth IRA.

Moving a Roth 401(k) balance to a Roth IRA has no tax impact, nor does rolling a traditional 401(k) balance into a traditional IRA. However, if you roll your traditional 401(k) balance into a Roth IRA, taxes will apply, which we’ll discuss later.

When deciding whether you roll over to a traditional or Roth IRA, consider the tax benefit you want both now and in the future. If you want to avoid a current tax obligation, then rolling your pre-tax 401(k) to a traditional IRA might be the way to go. However, you may find the upfront tax bill worth it to enjoy the tax-free benefit of a Roth IRA down the road.

If you aren’t sure which is the best financial decision for you, consider enlisting the help of a financial professional. They can run numbers and different scenarios to help you determine which type of IRA is most beneficial for your situation.

Step 2: Choose a rollover IRA provider

If you already have an IRA, you can roll your 401(k) into the existing account. But if you don’t have an IRA open yet, you’ll need to choose a provider and open an account.

When choosing an IRA provider, you have many options. There’s not necessarily one right answer for everyone. The best IRA provider is the one that best fits your needs.

Step 3: Move the money

The final step of a 401(k) rollover is actually moving the money. There are a couple of different options to choose from:

• Direct rollover: Using a direct rollover, the plan directly transfers or makes your rollover payable to your IRA provider and no taxes are withheld.
• Indirect rollover: You can choose to have the plan send a check payable to you for your balance, and you’ll then deposit it into your IRA. However, this method would require that taxes be withheld. Additionally, you only have 60 days to deposit the full amount into your IRA before it’s considered taxable and possibly an early withdrawal.

Taxes for rollover IRAs

An IRA rollover can result in some complex tax consequences, and it’s important to understand how those work before you begin the process.

Direct vs. indirect rollovers

As we mentioned, taxes are handled differently whether you use a direct or indirect rollover. When you opt for a direct rollover, no taxes are withheld from your withdrawal. Instead, the money goes directly from one pre-tax account to another.

If you choose an indirect rollover, however, income taxes are withheld. However, that doesn’t mean you actually owe taxes on the rollover. As long as you deposit the full amount into your IRA within 60 days, the transaction isn’t taxable and you can expect to get that withheld amount back on your tax refund.

If you fail to complete the rollover within 60 days, it will be considered a taxable distribution and possibly an early withdrawal and there will be tax consequences:

• You’ll owe income taxes on the distribution
• You’ll owe a 10% early withdrawal penalty on the distribution if you are under age 59 ½.
• To put the money back in a pre-tax account, you’ll have to make a new contribution subject to applicable contribution limits.

Pre-tax to Roth rollovers

If you roll over your pre-tax 401(k) to a traditional IRA, there are no tax consequences. You’re moving money from one pre-tax account to another account with the same benefit. However, if you roll over your money from a pre-tax 401(k) to a Roth IRA, you’ll have to pay taxes on any pre-tax dollars included.

This is necessary because you’re converting your pre-tax contributions to Roth contributions. Because you’ll enjoy the Roth tax benefit later on, you essentially have to pay back the traditional 401(k) tax benefit you’ve already received.

The bottom line

If you’re saving for retirement, then you may have already taken advantage of a rollover IRA or traditional IRA at some point. A traditional IRA is one of the most popular tax-advantaged investing tools. Meanwhile, a rollover IRA isn’t technically a separate type of IRA. Instead, it’s either a traditional or Roth IRA that you’ve used to rollover funds from an employer-sponsored retirement plan.

If you want to roll over your 401(k) balance or aren’t sure how a rollover or traditional IRA might benefit you, consider consulting a financial advisor. They can take a thorough look at your financial situation and help you decide what retirement plans best fit your needs and goals.