An indirect rollover occurs when you request the managers of your current IRA to send you the funds directly so that you can deposit that money into another retirement account.  The problem with this method is that it changes the tax burden on the money.  You must get that money into a new rollover IRA within a set time – typically 60 days – or the money will be considered a withdrawal and you will be subject to taxes, penalties and withholding.  These fees can be substantial, depending on the amount of the money involved in the IRA rollover.

In most cases, moving your money in a way that changes its tax status from tax deferred to taxable makes little sense.  After all, the reason you opened an IRA in the first place was to get out from under an immediate tax burden, while allowing your money to grow for retirement.  These kinds of accounts were set up to encourage savings and to make it easier for both employers and employees to contribute to them.  An indirect rollover runs the risk of changing this tax status that you were working so hard to maintain.

Fortunately, there is a very easy way to keep the tax deferred status that you want.  Contact the manager of the new (or target) IRA and direct him or her to perform an IRA direct rollover.  Be sure to use those exact terms – IRA direct rollover.  This specific wording will initiate a specific process where the money is sent from one IRA into the new IRA.  You will never receive a check or see the funds deposit into your bank account when you begin this type of transaction.

Although you, as the account holder, won’t ever hold the money, you will retain all the benefits of your investments when you cash out the account.  To begin the process, the manager of the target rollover IRA will contact his or her counterpart at the established IRA and make all the necessary arrangements to move the money between accounts.  The transfer may occur in the form of a wire transfer, a check or whatever instrument is most convenient.  The main thing to remember is that the money does not ever come into your hands.

The IRS considers an IRA direct rollover to be a reportable event, but not a taxable one.  For this reason, an IRA direct rollover is generally the most advantageous way to move your money.  If you choose the indirect method, you’re risking the tax status of your investments, as well as the amount you’ll lose to mandatory withholding.  Basically, you’d better have a very good reason to choose the indirect option.  If your consolidation of retirement funds is an attempt to maximize returns, doing anything other than an IRA direct rollover will defeat the whole purpose behind having an IRA.

There are three ways to get your money out of an IRA – transfer, rollover or withdrawal.  A rollover IRA withdrawal is an end game option, so to speak – this is the option you choose when you’ve reached retirement age and are ready to start reaping the benefits of years of diligent savings and investing.  Unless you’re at retirement age, withdrawals are considered premature and come with penalties and taxes, except in a few situations that the IRS qualifies as exceptions.

Transfers and IRA rollovers, on the other hand, are transactions you may elect during the life of your IRA.  Both transactions allow you to move money from an existing IRA into another.  However, the consequences of these transactions can be very different.

First, let’s address the case of the IRA direct rollover, since it’s almost always the better choice for moving your retirement funds between accounts.  Here’s where that sticky terminology issue arises again – according to IRA rollover rules, direct rollovers can also be called trustee to trustee transfers or trustee to trustee rollovers.  The key here is that your money will move directly from one IRA into another, without you or your bank account ever receiving a check.  In this case, your retirement funds will maintain their tax deferred status, and you’ll avoid any unnecessary withholding or penalties.

The other type of IRA rollover transfer, which is usually a less attractive option, is sometimes called an indirect rollover or a “payout-then-transfer” transaction.  In this case, your existing IRA is closed and you’ll receive a check.  Ideally that check will be made out to the trustee of your new rollover IRA account, and you will deposit it promptly into your new IRA.  If the check is made out to you, if you hold on to it too long, or if  you deposit it into your own personal account, then the transaction is going to look like a premature withdrawal to the IRS and you’ll open yourself up to the penalties and taxes mentioned earlier.

If you’re able to get that money into a new IRA within the IRS deadlines (typically 60 days), you may be able to avoid those penalties and taxes, although your funds will still be subject to minimum withholding requirements.  But really, why choose a needlessly complicated transaction that requires more work on your part and has even the possibility to create a potential tax burden when there is a more direct, simpler choice?  That choice is an IRA direct rollover, and chances are, it’s what your financial adviser will recommend as well.