Rollover IRA vs Traditional IRA [What is the Difference]

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Retirement planning is an important part of financial security, and there are various plan options available to provide you with the retirement savings you’ll need in your golden years. Are you looking to invest for your future but unsure of which IRA account is right for you? If so, you’re not alone. In this article, we’ll take a closer look at the key differences between a rollover IRA and traditional IRA accounts. We will dive into the annual contribution allotments, income limits, withdrawal rules, tax information, and more. 

By the end, you should have a better idea of which account type best suits your needs for investment planning. So let’s get started!

What’s An IRA? 

From a basic definition standpoint, an IRA stands for an individual retirement account. Here is the main difference between a rollover IRA and a traditional IRA. 

Rollover IRA 

A Rollover IRA is what it sounds like, a retirement plan that originated from another qualified retirement plan, such as 401(k)s or 403(b)s or other retirement accounts like IRAs. 

A Rollover IRA is ideal if you already have retirement savings from a previous employer’s plan or other qualified retirement plans, as it allows you to transfer those funds into the new account tax-free.

Pros: 

  • With an IRA, you have the ability to roll over all or part of your retirement funds from an employer-sponsored plan that was a 401(k) or 403(b) into a traditional IRA
  • You can choose investments based on your own preferences and risk tolerance.
  • The funds remain tax deferred until withdrawn.
  • You’ll potentially have more investment choices and fewer restrictions on withdrawals than with a traditional IRA. 
  • Rollover IRAs generally don’t incur any related fees and are penalty-free. 

Cons: 

  • Rollover IRAs can be complex, and there are hefty penalties if you don’t follow the rules exactly. 
  • You could be subject to harmful taxes and distribution penalties if you make a premature withdrawal.
  • You may end up paying more in investment fees than with an employer plan. 

Traditional IRA 

A Traditional IRA is an individual retirement account established directly between the account holder and the financial institution for retirement savings investments. 

Pros: 

  • The funds remain tax deferred until withdrawn. 
  • Your contributions may be partially or fully deductible, depending on your filing status and modified adjusted gross income (MAGI).
  • Traditional IRAs generally have low fees. 
  • There are several different investment options based on your own risk tolerance and preferences. 
  • These IRAs allow retirees greater flexibility with withdrawal options than other accounts, such as 401(k)s.

Cons: 

  • Withdrawals before age 59 ½ may result in taxes and steep penalties.
  • You may pay more in investment fees than with an employer plan.
  • Depending on your filing status and modified adjusted gross income (MAGI), you may not be able to make deductible contributions.

Contribution Limits 

Infographic of someone looking on a computer for investments of rollover ira vs traditional ira

When deciding which account best suits your retirement savings needs, IRA contribution limits play an important role.

Rollover IRA 

The contribution limit for a rollover IRA depends on your filing status, income level, and the type of retirement plan in which the funds rolled over. 

Generally, you may make up to $6,000 in annual contributions with no income limit restrictions if you are employed and have wages allocated to a 401(k), 403(b) or other employer-sponsored plan. 

If you are not employed and do not have access to a former employer-sponsored retirement plan, then the IRS imposes a maximum contribution amount of $3,000 for 2022. 

You can also roll over any eligible distributions from another qualified retirement plan into your rollover IRA with no contribution limit restrictions. Contributions can be in the form of cash or other eligible assets, including stocks, bonds, mutual funds and ETFs.

Traditional IRA 

The contribution limit for a traditional IRA is $6,000 in 2022, with an additional catch-up contribution of $1,000 if you are age 50 or above. Also, your total contribution cannot be more than the amount of your taxable compensation for the tax year. 

The IRA deduction may also be limited or eliminated, depending on your filing status and modified adjusted gross income (MAGI). 

Single filers with MAGI over $65,000 and joint filers with MAGI over $104,000 will have their IRA deductions reduced or eliminated. If your MAGI exceeds $75,000 for single filers and $124,000 for joint filers, then you are not eligible to make any traditional IRA contributions.

Withdrawal Rules

When it comes to withdrawals from retirement accounts, an investor must know the differences between a Rollover IRA and a Traditional IRA. 

Rollover IRA 

Typically, withdrawals from a rollover IRA are tax-free as long as the funds were rolled over from another qualified retirement account within 60 days. However, if the funds are not withdrawn or rolled over within that 60-day period, income tax and an additional 10% penalty will be imposed on the withdrawal amount. Additionally, required minimum distributions (RMDs) must begin at age 72 for rollover IRA holders.

Traditional IRA 

Generally, withdrawals from a traditional IRA are considered taxable income, and there is an additional 10% early withdrawal penalty for those below age 59-1/2 if not used for certain qualified medical or educational expenses. In other words, if you are under 59 and a half, you will pay taxes. 

Required minimum distributions (RMDs) must begin at age 72 unless contributions were made after reaching this age. It is important to be aware that some states may have their own taxes and withdrawal rules related to traditional IRAs. If you are unsure, it is always best to consult your tax specialist. 

Taxes 

Here is where the IRA accounts start to differ vastly. Both types of accounts offer potential tax savings in the form of tax deferment, but it’s important to understand which option best meets your financial goals first before making a final decision.

Generally, Rollover IRAs allow tax-free transfers from one custodian to another. You will not pay any taxes when rolling over, but as soon as you withdraw any money, you will.

Traditional IRAs are subject to income tax and may be applicable for tax deductions. 

Income Limitations 

Are you curious to learn more about the income limitations for both retirement accounts? We’ve got you covered. 

Rollover IRA 

There are income limits on rollover IRAs. Your eligibility for making a rollover IRA contribution depends on your filing status, income level, and the type of retirement plan in which the funds rolled over. 

Generally, if you are employed and have wages allocated to a 401(k), 403(b), or other employer-sponsored plan, then you may be eligible to make a rollover contribution with no income limit restriction. 

However, if you are unemployed and don’t have access to an employer-sponsored retirement plan, then the IRS imposes an income limit of $193,000-$203,000, depending on your filing status.

Traditional IRA 

Traditional IRA contributions may be limited or reduced depending on your filing status, retirement plan participation and/or income level. If you are covered by an employer-sponsored retirement plan and have a Modified Adjusted Gross Income (MAGI) of more than $65,000 for single filers and $104,000 for joint filers, the tax deduction is reduced. 

Additionally, if your MAGI exceeds $75,000 for single filers and $124,000 for joint filers, then you are not eligible to make any traditional IRA contributions.

Deciding which IRA is Best for you 

The right type of IRA for your individual retirement goals will depend largely on the tax bracket you fall into. 

A Rollover IRA is the option most beneficial to those who expect to earn more income after retirement, as taxes are only paid when withdrawals are made rather than during contributions. 

On the contrary, Traditional IRAs offer tax benefits while you are making contributions, making it more advantageous for those who anticipate a lower tax bracket in their older years. Whatever your situation may be, it’s always a good idea to consult with a financial advisor for professional advice about which type of IRA is best for you.

You might also be interested in: 8 Different Types Of Investment Accounts To Consider

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