Both an individual retirement account and a 401k are tax-deferred investments that reduce your taxable income for the year. You pay taxes when you withdraw the money. The process for this varies based on the type, which can lead to some confusion during tax time when you've rolled over your 401k.
401k Tax "Deduction"
401k plans reduce your taxable income for the year, but not through a traditional deduction. Your company deposits your contributions into the 401k account before applying taxes to your salary. Thus, when you roll over the money into an IRA account, this money is not eligible for a deduction because it has already reduced your income.
Conversely, you pay into an IRA account with taxed dollars. You are then able to take a tax deduction when you file your taxes. You can deduct the amount that you contributed to a traditional IRA, but not funds that you contributed to a Roth IRA. The maximum limit for IRA contributions as of publication is $5,000 for those under 50 and $6,000 for those 50 and older, an amount which can be split between more than one account.
Deducting a Rollover IRA
If you rolled over your 401k into a traditional IRA, which has similar rules to the 401k plan, you cannot deduct amount that you rolled over, because the income was not taxed. However, if you contributed to the new IRA account after the initial rollover, you can deduct the contributed amount, up to the limit. For example, if you rolled over $20,000 into a traditional IRA, then deposited $3,000 into that account and $2,000 into a Roth IRA, you would be able to take a $3,000 deduction on your taxes.
Making Withdrawals from the Rollover IRA
Once you've rolled over the money into an IRA, it follows the withdrawal rules for an IRA, which are more lenient than the withdrawal rules for a 401k. You can withdraw any amount, though you will have to pay taxes at your current income level and pay a 10-percent penalty in many cases. However, you can avoid the penalty if you use the money to pay for college expenses, certain health care expenses, a down payment on a home or to help cover costs from a disability.