Distinguishing account types while retirement planning can feel overwhelming. Besides the 401(k), 401(a), 401(b), and the traditional IRA, which are the most commonly known accounts, there are also the Rollover IRA and the Roth IRA.
Though they have similar names, these accounts have different purposes and tax implications that can impact your retirement savings down the line. In this article, we highlight the difference between Rollover IRA and Roth IRA, as well as the pros and cons of each.
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Rollover IRA vs. Roth IRA: What's the difference?
Rollover IRA and Roth IRA are both individual retirement accounts (IRAs). The key difference between them is that the former combines funds from different accounts, while the latter works as a retirement savings account.
Here's a breakdown of each characteristic:
Rollover IRA
A Rollover IRA is a retirement account that allows you to consolidate your retirement savings from a previous employer-sponsored retirement plan, like a 401(k). While some employers may let you keep your sponsored account in place indefinitely, many won't—and it can be convenient to have your portfolio all in one place after switching jobs. That's what a rollover is for.
Technically, a rollover isn't a type of IRA on its own. “Depending on the tax treatment you choose, your rollover IRA can be either a traditional IRA or Roth IRA,” says Bill Ryze, certified Chartered Financial Consultant (ChFC) and board advisor at Fiona.
Usually, a rollover IRA is set up as a traditional IRA due to its immediate tax benefits in comparison to a Roth IRA, especially for those moving funds from a 401(k). Similarly to a 401(k), a traditional IRA grows your money tax-deferred and withdrawals after retirement are taxed as current income.
With a Roth IRA, your money grows tax-free and withdrawals after retirement are free of income taxes. So, if you decide to rollover funds from a 401(k) to a Roth IRA, it's likely that you'll have to pay taxes over all the pre-tax contributions made.
Traditional IRA
A traditional IRA is an individual retirement account that allows you to contribute with your pre-tax income. For this reason, the funds become tax-deductible and you can write them off on your tax return, lowering your taxable income and total tax bill.
Because you contribute to a traditional IRA with pre-tax dollars, your contributions and earnings grow tax-deferred. Once you start making withdrawals in retirement, the amounts will be taxed as current income.
The minimum age to start withdrawing your retirement savings from a traditional IRA without triggering the IRS 10% penalty is age 59 ½—whether or not it's a rollover IRA. If you decide to keep the money untouched for a couple more years, keep in mind that currently, once you reach age 73 you’re required to make required minimum distributions (RMDs) from a traditional IRA (including rollovers).
Roth IRA
A Roth IRA is a type of individual retirement account where you make contributions. This type of IRA is tax-advantaged, allowing you to contribute with your after-tax income and grow it tax-free. In your retirement, you don't pay tax on the withdrawn contributions and its returns.
While you have to wait until you turn 59 1/2 to withdraw your contributions to other retirement accounts, with a Roth IRA you can withdraw it at any time without penalty. However, it only applies to the contributions, not the earnings. If you withdraw the earnings, you'll pay taxes unless the account is open for at least five years, starting from January 1st of the year you made your first contributions.
Roth IRAs don't require you to make required minimum distributions (RMDs), which means there's no maximum age to withdraw money from the account, and you can leave it there indefinitely.
Roth IRA vs. Rollover IRA: Pros and cons
Both accounts have pros and cons regarding taxation, requirements to open the account, and potential penalties for withdrawing before retirement age. Here's a list of each one's pros and cons:
Pros of Rollover traditional IRA
- Tax-deferred growth. If you set up your rollover as a traditional IRA, your contributions grow tax-deferred “until withdrawals,” Ryze says.
- This type of IRA is flexible. According to Ryze, you can roll it into other employer sponsored plans subsequently, if you need to.
- The rollover is penalty-free. If done correctly, either through a direct or indirect rollover, it doesn't count as an early withdrawal and you're free from the 10% penalty.
Cons of Rollover traditional IRA
- Withdrawals are taxable income. If you roll your money into a traditional IRA, your withdrawals during retirement “are taxed as ordinary income,” Ryze says, so you'll have to account for that in the future.
- Age limit to start RMDs. Your assets can't stay in a rollover traditional IRA indefinitely. According to the IRS, the maximum age to start making withdrawals is 73 years old, if you don't start earlier.
- Employer-sponsored plans are required. You must have an employer sponsored retirement plan to be eligible for opening a Rollover IRA.
Pros of Roth IRA
- Tax-free withdrawals. Since contributions to a Roth IRA are post-tax (meaning they come from your after-tax paycheck), when it's time to withdraw your contributions and earnings, it'll be tax-free.
- No age limit to start RMDs. The IRS doesn't impose the 73-year-old rule on Roth IRAs. This means your assets can stay in your account for an indefinite period during your lifetime.
Cons of Roth IRA
- No immediate tax-benefit. Because you make the contributions with after-tax dollars, Ryze says, you won't gain any tax benefit immediately, only after your retirement (when you'll be able to withdraw money without paying income taxes.)
- Contributions are limited. “The contributions are limited based on your income,” Ryze says. According to the IRS, for 2024 the amount you contribute to a traditional IRA or Roth IRA can't exceed $7,000 ($8,000 if you're age 50 or older).
FAQs
Is a Rollover IRA the same as a Roth IRA?
Yes and no. A Roth IRA is an account you use to save for your retirement, while a Rollover IRA is an account you can use to move funds from an employer-sponsored plan, like a 401(k), to another account, which can be either a Roth IRA or a traditional IRA.
Is a Rollover IRA better than a Roth IRA?
Not necessarily—both can be advantageous depending on your financial situation and goals. “A Rollover IRA is a better option if you want to defer taxes and roll the funds into another employer’s plan,” Ryze says. “On the other hand, a Roth IRA is beneficial if you prefer tax-free withdrawals in retirement and do not want to deal with RMDs.”
Should I convert my Rollover IRA to a Roth IRA?
Not necessarily. Depending on your financial goals and situation, keeping a rollover as a traditional IRA may be the best for you. However, you should consider converting it to a Roth IRA under three circumstances, Ryze says:
- If you expect to move to a higher tax bracket in retirement
- If you can afford to pay the conversion taxes from external sources
- If you have a long time horizon to grow tax-free earnings
Why use a Rollover IRA instead of a traditional IRA?
A Rollover IRA isn't a specific type of IRA account. It's an account you open to transfer and consolidate the funds of employer-sponsored plans after switching jobs. When you open a rollover, it has to be set up either as a Roth IRA or as a traditional IRA, with later being the most common choice due to its tax-benefits.
“Generally, people prefer a Roth IRA because of its tax-free withdrawals and lack of RMDs,” Ryze says. “However, much depends on your current tax situation, your future income expectations, and your retirement goals.”
For instance, if you'd like to maximize your earnings, a traditional IRA could be a better option, since contributions are pre-tax, which allows you to invest more and only pay income taxes during retirement. The best thing to do is consult with a financial advisor to determine the ideal strategy for you.