Starting up a new rollover IRA is relatively simple … but if you’re not careful about following the steps, it’s just as simple for you to make costly mistakes.
As I pointed out with detail here in my recent story, When Is a Rollover NOT a Rollover IRA?, the primary purpose of a rollover IRA is to receive assets from an employer-sponsored retirement plan, such as a 401k.
Although this definition is about as straightforward as it gets, rollover IRAs have a bit of a strange and somewhat complex history, which is what you might expect from the Internal Revenue Service.
Fortunately this article on rollover IRAs was not written by someone associated with the IRS, and it simplifies what otherwise might do more to confuse the topic than keep it simple, which is what rollover IRAs should be.
With our introductions out of the way, let’s get into the steps to start up your new rollover IRA.
1. Choose the Custodian to Receive the Rollover IRA
In almost any endeavor you may choose, the first step is almost always the most important, and rollover IRAs are no exception. The custodian is the financial firm that will hold your assets. In simpler terms, it’s the brokerage firm or mutual fund company where you will open your new retirement account.
Notice I didn’t mention banks or insurance companies. It is possible to open an IRA with these financial entities, and it is even possible to open them with those that are better known for their credit cards, such as Capital One Investing. However, a general tenet of prudent financial management is to use your financial tools for the purpose for which they were designed.
Therefore, use insurance companies for insurance, banks for banking, and credit card companies for credit cards. For rollover IRAs, choose a good discount broker such as Charles Schwab (SCHW), TD Ameritrade (AMTD), or Scottrade, or use a reputable mutual fund company, such as Vanguard Investments or Fidelity Investments, that offers dozens of high-quality, low-cost mutual funds, plus thousands of non-proprietary funds, as well as individual stocks and ETFs.
2. Open the Rollover IRA
You won’t be able to roll over your 401k assets without an established IRA to receive them. This may seem extremely elementary, but people get this wrong more often than you might think. But, when those who have overlooked this step fill out their 401k distribution request forms, it’s then that they see the form requires the name and address of the custodian where the 401k is to be rolled over, and the respective account number of the rollover IRA.
But, when you go to open your rollover IRA, don’t be surprised if your chosen custodian’s form to establish the account doesn’t have a check box for “Rollover IRA.” If it doesn’t, just check the box that says “Traditional IRA.” A rollover IRA is simply a type of traditional IRA.
3. Complete the 401k Distribution Request
There’s only one way to initiate a transfer of your 401k assets to your new rollover IRA, and that’s through your former employer. Most employers provide information about requesting 401k distributions upon termination of employment. But, if you don’t receive this information, a good place to find it is your former employer’s human resources department.
The 401k distribution request form will typically list at least three basic benefit payment options: lump sum, rollover, and annuity payout. The rollover choice is often worded something like this: “Direct rollover of my vested account balance to the IRA designated in section X below.”
You’ll then provide the name and contact information of the brokerage firm or mutual fund company where you opened your rollover IRA, along with the account number.
The other sections of the form will ask for things that you already know, such as your name, date of birth, Social Security number, address, and so on. You’ll also need to sign and date the 401k rollover form.
4. Research Investments
After you’ve submitted your 401k rollover paperwork, it’ll probably take at least a few weeks before you’ll see the assets hit your rollover IRA. While your request is being processed, it’s a great time to search for the best investments to hold in your rollover IRA.
Fortunately, we’ve put together a few useful articles, such as 7 Best Funds for a New Rollover IRA Portfolio and 10 Stocks to Buy for Your Rollover IRA, to get you started.
You might also try online research tools at Morningstar.com or LipperLeaders.com.
It’s often helpful to use the tools provided by the brokerage firm or mutual fund company where you established your new rollover IRA. You’ll need to verify that the investments you choose are offered there, and you’ll want to find out if there are any transaction fees to trade those respective securities.
When doing your research, keep in mind that it is generally better to hold investments such as bonds, bond mutual funds, and dividend-paying stocks (all of which kick off interest or dividends) in your rollover IRA, and to keep more tax-efficient holdings such as growth stocks and index funds in your taxable account, if applicable.
5. Purchase Your Selected Investments
This is another step in starting up a new rollover IRA that appears to be a no-brainer, but you have a few choices about how to purchase your new investments.
When investing a large sum of cash, consider economies of scale and the timing of purchases. For example, if you’re buying mutual funds at Vanguard, it might be wise to consider cheaper share classes of the best funds. Vanguard’s Admiral share class funds typically require a $10,000 minimum initial investment, but they charge lower expenses than their Investor share class counterparts. You get the same funds, but they’re cheaper and, therefore, more beneficial in the long run.
As for the timing of purchases, you can choose to buy all of your investments immediately or dollar-cost average into them over a select period of time. Which is best for you? Generally speaking, if you don’t plan on withdrawing from your rollover IRA for at least 10 years, buying all of your investments immediately can be advantageous.
On the other hand, if you’re about to retire, and if the market is bouncing around multi-year highs, you might want to consider a dollar-cost averaging strategy of buying equal increments or shares of your investments over the course of a year or 18 months. This can reduce market risk, but it can also backfire if the market keeps climbing as you make purchases, and then falls dramatically after your DCA period is over.
In the interest of our theme of simplicity, and in applying the great investing virtue of humility, it may be best to stick to the timeless wisdom of diversification and forget about trying to time the market altogether.
Kent Thune is the owner of a privately held investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent tax advice or a recommendation to buy or sell securities.
