What is the difference between a Rollover IRA and a Roth IRA?

Question

Previous Question.

I have decided to roll my 401(k) into a Roth IRA. I use ThinkOrSwim as my broker currently, so I plan on opening an IRA with them. When opening the account I'm presented with the choice between a Rollover IRA and a Roth IRA. The description for the Rollover IRA says its for rolling over a retirement account. My question is: What is the difference between the two? Can I not just open a Roth IRA and roll the funds into that account?

Answer 1

If you have the cash on hand to pay the tax on the amount you are transferring I recommend moving to a Roth IRA

An IRA is tax-deferred. You put in pretax contributions in to an IRA, and you are taxed on that money (your contributions and interest earned) when you withdraw it at retirement, age 59 1/2.

The idea being that you will be taking less out per year in your retirement years, putting you into a lower tax bracket. The major problem is most people draw out as much or more a year in their retirement years than when they were working.

A Roth IRA grows tax free You put after tax contributions into a Roth IRA, you have paid taxes on the contributions, and you are never taxed on the growth. When you draw the money out at retirement you don't pay any income taxes on that money.

Let me give you an example:

For this example we will use the following information for both scenario:

• You are in the 25% fed tax bracket
• Your mutual fund investment will average 12% a year.
• You will invest from age 25 to age 65.

We will invest $400 per month for a total of $4800. The current maximum is $5000 if you are under 50 years old

Roth IRA

$400 dollars after taxes is $300

Invest $300 a month, at age 65 you have 3,529,432

You owe no taxes on this money, it doesn't matter how much you take out a year.

IRA

$400 dollars a month is taken pretax out of your paycheck.

Invest $400 per month, at age 65 you have $4,705,909 You owe taxes of 25% as you draw that out for at total tax of 1,176,477

4,705,909 - 1,176,477 = 3,529,432 cash in your pocket

The problem is if you draw out more than $82,400 (current 2010 filing single) per year you will be pushed to a higher tax bracket and take more of your money away.

If you decide to buy a vacation home and you take out $250,000 to pay for it, that's counted as income for that year any you will be in the 33% tax bracket.

Even if you can keep yourself to a low income the government forces your hand and makes you draw out more money at age 70, based on their tables, forcing you into a higher tax bracket

Answer 2

A rollover IRA is a traditional IRA. Your rollover contributions are not taxed and rollover or counted against your annual limit, which is income dependent.

A Roth IRA is one where your contributions will be taxed going into the IRA. Note that there are adjusted gross income maximums for contribution to a Roth IRA (see here), and as far as I can tell those income maximums also determine whether or not you can rollover to a Roth IRA.

Answer 3

Adding to justkt's answer. The big difference to you during the rollover is that moving the money to a Roth IRA, unless it was a Roth 401K, is going to require you pay a lot of taxes on the money you move. I'd suggest not doing that without guidance from a financial advisor.

Answer 4

For reporting purposes, most IRA firms prefer that you roll the 401(k) funds into a Rollover or Traditional IRA and then convert to the ROTH from there. The mid-air conversions (401(k) directly into a ROTH) can get tricky when you go to do your taxes the following year if the 1099 form from the releasing custodian and the 5498 form from the accepting custodian have different numbers due to the conversion amount and taxes withheld if any.

Answer 5

I saw this confusion with Fidelity and called up their customer support. With Fidelity, Rollover IRA is the same as Traditional IRA. If you are looking to rolling over into a Traditional IRA and a ROTH IRA, you would need to open the two respective accounts - 1 Rollover/traditional and 1 ROTH.