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A rollover in finance is the process of transferring funds from one account or investment vehicle into another of the same or similar type, without triggering a taxable event. The term most commonly applies to retirement accounts, where you move savings from a former employer's 401(k) into an Individual Retirement Account to preserve the tax-deferred status of the funds. It also applies to futures trading, where a rollover means moving a position from an expiring contract to a later-dated one.
Think of a rollover like transferring water between two containers: the amount stays the same, and nothing spills, as long as you move it correctly.
When you leave a job, you have several choices for your 401(k) balance. You can leave it in the old employer's plan, cash it out, roll it into your new employer's plan, or roll it into an Individual Retirement Account. A rollover into an Individual Retirement Account is often the most flexible option because it gives you access to a wider range of investments and potentially lower fees than most employer-sponsored plans.
According to the IRS, most pre-retirement payments from a retirement plan or Individual Retirement Account can be rolled over within 60 days of receipt without incurring income tax. Rolling over preserves your retirement savings' tax-deferred growth.
Two methods exist for completing a rollover, and the difference between them matters for taxes.
In a direct rollover, your former plan administrator transfers the funds directly to the receiving account. You never take possession of the money. No taxes are withheld, and no clock starts ticking. This is the preferred method because it eliminates risk entirely.
In an indirect rollover, the plan sends a check made out to you. The plan is required to withhold 20 percent for federal income tax. You then have 60 days to deposit the full original amount, including the 20 percent that was withheld, into the new account. If you deposit only the net amount you received, the withheld 20 percent is treated as a taxable distribution. You will get the withheld taxes back as a credit when you file your return, but only if you fund the full amount within 60 days.
The IRS limits you to one Individual Retirement Account-to-Individual Retirement Account rollover per 12-month period, regardless of how many Individual Retirement Accounts you own. This limit applies in aggregate across all accounts, not separately per account. The rule does not apply to direct transfers between financial institutions or to rollovers from employer plans into Individual Retirement Accounts.
If you violate this rule by completing more than one rollover within 12 months, the excess amount is treated as a taxable distribution. If you are under 59 and a half, you will also owe a 10 percent early withdrawal penalty. Staying with direct transfers rather than indirect rollovers is the simplest way to avoid this problem entirely.
Most employer-sponsored retirement plans are eligible for rollover. These include 401(k) plans, 403(b) plans for employees of educational and non-profit organizations, 457(b) plans for government employees, and pensions. You can roll these into a traditional Individual Retirement Account or, if you are willing to pay income tax on the amount converted, into a Roth Individual Retirement Account.
After-tax contributions held in an employer plan can be rolled directly into a Roth Individual Retirement Account without additional tax. Pre-tax contributions roll into a traditional Individual Retirement Account tax-free, or into a Roth Individual Retirement Account with income tax due on the converted amount.
In the futures market, a rollover refers to closing a position in a contract approaching expiration and reopening the position in a contract with a later expiration date. Futures contracts have set expiration dates, and traders who do not want to accept physical delivery of the underlying commodity or financial instrument must roll their position before expiration.
The cost of rolling forward depends on market structure. In a contango market, the far-dated contract is more expensive than the near-dated one, so rolling costs money. In a backwardation market, the far-dated contract is cheaper, and rolling forward generates a gain. This distinction is especially important for commodity funds and exchange-traded funds that must roll contracts continuously to maintain their exposure.
Cashing out a 401(k) after leaving a job has significant costs. The full amount becomes taxable income in the year of withdrawal. If you are under 59 and a half, you also pay a 10 percent early withdrawal penalty. On a $100,000 balance in a 24 percent federal tax bracket, a cash-out could cost you $34,000 or more before state taxes.
Rolling over preserves the full value of the account, keeps your money growing tax-deferred, and gives you more investment choices. For most people leaving a job, a direct rollover into an Individual Retirement Account is the financially superior choice to cashing out.
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