What is a Rollover IRA? (Rollover IRA vs. Traditional IRA)

A reader writes in, asking:

“At my primary brokerage firm I have two IRAs: a traditional IRA and a rollover IRA that holds assets that came from my prior employer’s 401-k plan. What is the difference between the two?”

“Rollover IRA” is just a subcategory of “traditional IRA.” In other words, a rollover IRA is a traditional IRA. Specifically, rollover IRAs are traditional IRAs that contain nothing but assets that came from an employer-sponsored plan.

Because a rollover IRA is a traditional IRA, it gets all the same tax treatment as a normal traditional IRA. That is, distributions from the account are generally taxable; you can do a Roth conversion of the assets in the account; it’s treated the same way with regard to aggregation rules as other traditional IRAs; and so on.

Rollover IRAs are designated as such (rather than just being called regular traditional IRAs) for two reasons.

Reason #1: some employer plans only accept rollovers from an IRA when the IRA contains only assets from another employer-sponsored plan. So keeping those assets separate in their own IRA (rather than combining them with other assets in a traditional IRA) could preserve your ability to roll those assets into a different employer plan at a later date. But fewer and fewer employer plans have this policy every year, so this distinction is becoming less relevant.

Reason #2: assets in an employer-sponsored plan have unlimited creditor protection in bankruptcy under federal law. In contrast, IRA assets are only protected up to a certain limit ($1,362,800 as of 2020). If assets from an employer-sponsored plan are rolled into an IRA and kept separate (i.e., kept in a separate “rollover IRA”), they continue to receive that unlimited protection. If the assets get commingled with other assets in a traditional IRA, then they might lose that unlimited protection and “only” be protected up to the $1,362,800 limit.

That said, some people make the case that if you have good records and could prove that the assets in question came from an employer plan, you would still have unlimited protection for those assets. Also, many states provide additional protection to IRA assets beyond what federal law provides. And of course most people’s IRA assets are never going to exceed the federal protection limit anyway.

To summarize, a rollover IRA is a traditional IRA and is taxed as such, but there are two reasons for keeping rollover IRA assets separate from other traditional IRA assets. It may well be the case, however, that neither of those two reasons is particularly applicable to your own circumstances.