IRA Rollover Mistakes

Take-Away: “IRA money in motion is IRA money at risk.” Mike Jones.

Background: As a gross generalization, 3 things can go wrong when the transfer of funds, or a rollover of funds, into an IRA from a qualified plan or another IRA occurs.

(A)Hardship Waiver:  If the rollover misses the applicable deadline (usually 60 days) for depositing the rolled funds into the recipient IRA, a deemed distribution of the funds occurs with taxation and possibly a 10% early distribution penalty.

Solution: Fortunately,  there is a hardship waiver of the 60-day deadline to address this situation, self-certified, or otherwise, if the delay is due to factors beyond the control of the IRA owner. [IRC 402(c)(3)(B); IRC 408(d)(3)(I.)] A private letter ruling requesting a waiver can be sought from the IRS, but that is time consuming and expensive, including legal fees. [Revenue Procedure 2003-16.] A waiver can also be obtained through a self-certification process if the delay is due to specified causes, which is much easier and cheaper for the IRA owner to pursue. [Revenue Procedure 2016-47.]

(B) Recharacterization: The funds might be transferred into the wrong IRA. Fortunately there is a ‘recharacterization’ solution for this situation. This does not entail any IRS filing, nor any filing fee, and the ability to transfer the amount to the correct IRA (including the income earned on that amount, despite the funds sitting in the wrong IRA.)

Solution:  The Tax Code provides an option for any IRA contribution that is not specifically excepted from the Code or Regulations. If there is a custodian to custodian transfer of any contribution to an IRA made during the taxable year from a qualified plan or another IRA, then that contribution will be treated as having been made to the transferred plan (and not the transferor plan.) [IRC 408A(d)(6)(A).]

Exceptions: The Tax Code (and Regulations) prohibit using recharacterization for only two types of IRA contributions: (i) a valid Roth conversion contribution occurring after 2017 cannot be ‘recharacterized’ to a traditional IRA [IRC 408A(d)(6)(B)(iii)]; and (ii) under the Regulations, a valid rollover contribution, or any tax-free transfer, cannot be recharacterized. [Regulation 1.408A-5, A-4.]

(C) Transfer-Mistake: The intended rollover might not be ‘legal’ in that the Tax Code does not permit rolling or transferring the particular distribution into the owner’s IRA. For this situation, there is a ‘distribution-followed-by-regular-IRA treatment for this situation.

Example: This might occur if, for example, the IRA owner requests a direct transfer of funds from her employer’s retirement plan to the IRA owner’s IRA at a time when the owner is subject to required minimum distributions (RMDs) but has not yet taken her RMD for the year of the proposed transfer.

Restated, an RMD is not an ‘eligible rollover distribution’ so it is not a proper candidate for the transfer to an IRA, – and the first distribution that comes out of the employer’s qualified plan in each calendar year is applied to the RMD for that year. [Regualtion 1.402(c)-2, A-7(a).]

Private Letter Ruling 202147015:

Waivers were the center of this recent private letter ruling. A recharacterization could also have been done to ‘fix’ the problem.

Facts: The defect/mistake was that a distribution from the taxpayer’s ‘designated Roth account’ (DRAC) in his employer’s 401(k) plan was erroneously deposited in the taxpayer’s traditional IRA account instead of his Roth IRA in a ‘direct rollover’ performed at the same financial institution. The taxpayer had intended that the DRAC balance be transferred to his Roth IRA in a ‘direct rollover’ and he had made that intention very clear in his instructions to the financial institution. Note, this was a trustee-to-trustee transfer of funds, or a ‘direct rollover,’ which was actually completed within 60 days; the funds just got deposited by the financial institution into the wrong IRA (traditional not the Roth). [Regulation 1.401(a)(31)(A).]

Law: Even if the taxpayer had not intended to transfer the funds into a Roth IRA, under the Tax Code the DRAC funds cannot be legally rolled over or transferred from a DRAC to a traditional IRA. [IRC 402(c)(8.]

Problem: Based on both the law and the taxpayer’s intent, the money that came out of the taxpayer’s DRAC was deposited into the wrong IRA, the traditional IRA. It took 9 months (into the next calendar year) before the taxpayer discovered the error. His first advisor told him he did not have to move the funds. Uncomfortable with this advice, he sought a second opinion, and his second advisor told him the deposited funds had to be moved to a Roth IRA. The financial institution, which had made the mistake, told the taxpayer that he had to obtain an IRS waiver that allowed a late rollover of the funds into the correct Roth IRA account.

IRS Waiver: The  IRS granted a ‘hardship waiver’ of th 60-day rollover deadline on the grounds that the mistake was due to the financial institution’s error, i.e. it failed to follow the taxpayer’s instructions, and it gave the taxpayer additional time in which to transfer the amount into the Roth IRA.

Observation on Self-Certification: Financial institution error is one of the specified hardships that entitles an IRA owner to self-certify his hardship waiver and legally complete his rolllover without applying to the IRS for a private letter ruling. Why the IRA owner took the more expensive path to rectify the situation was not clearly revealed in the private letter ruling.

As-soon-as practicable:  Perhaps the reason the IRA owner took the more expensive route to obtain a PLR is that with a self-certification hardship waiver, the  owner must complete the rollover as soon as practicable after that factor that prevented the owner from completing it on time no longer prevents the IRA owner. Since the IRA owner did not notice the error until at least 9 months after it happened, that delay might have raised the issue whether the financial institution’s ‘error’ actually prevented the taxpayer from fixing the problem for such a long period of time.

Erroneous Advice: Obviously the first advisor’s advice to leave the transferred funds in the traditional IRA was in error. Note, however, that erroneous professional advice is not one of the causes that justify a self-certified hardship waiver.

Recharacterization: A recharacterization would also have been available for the taxpayer. It was not a Roth conversion, as the funds were already in a Roth account before it was transferred. Nor was it a valid tax-free rollover, because a distribution from a DRAC cannot be legally rolled into a traditional IRA. Thus, this IRA contribution was eligible for recharacterization so long as the funds, along with the net income earned on them, were transferred from the traditional IRA into the Roth IRA by the extended due date of the taxpayer’s return for the year of the contribution to the ‘wrong’ IRA. The recharacterization result is that the funds are treated as being deposited into the ‘correct’ IRA on the same date for the same taxable year that the contribution was made to the ‘wrong’ IRA.

Conclusion: Whenever assets move from one retirement account to another, not only must the financial institution, aka custodian, remain on high alert, so must the account owner.