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George F. Bearup, J.D. Senior Legal Trust Advisor

October 31, 2022

IRA Rollover Rules – Learning from Other People’s Mistakes

Take-Away: Retirement plan rules, both with regard to contributions and distributions, can be very confusing. Sometimes the best way to learn the rules is by understanding the mistakes others have made.

Background: Some key court cases over the years have tended to reinforce some of the arcane rules that apply to IRAs, both contributions, distributions, and the always confusing self-dealing rules and penalties. Some important court decision to keep in mind include the following:

  1. One-Rollover-Every 365 Days Rule: There is one rollover available for an individual’s IRA in a 365 year period. An IRA owner may not rollover over a distribution from an IRA within 12 months of a prior distribution. If the once-per-year rollover rule is violated, the distribution is not eligible to be treated as a rollover; if the funds are deposited in an IRA, the deposit is treated as an excess contribution, which will trigger a 6% excise tax, each year, until the excess contribution amount is removed from the IRA. This rule applies to an IRA-to-IRA rollover, Roth IRA-to-Roth IRA rollover. Bobrow v. Commissioner, Tax Court Memo 2014-21.Exception:  The 365 day rule does not apply to: (i) a qualified plan distribution to an IRA; (ii) an IRA distribution to a qualified plan; and (iii) a traditional IRA to a Roth IRA conversion.Take-Away: Retirement funds should be moved via custodian-to-custodian distributions, called direct rollovers. Such transactions can be done an unlimited number of times, and without risk of ‘blowing’ the 60-day time in which the rollover must be completed.
  2. Same Property Rollover Rule : The same property that is distributed from the ‘old’ IRA must be used to complete the rollover to the ‘new’ IRA. A good example of this rule is Private Letter Ruling 201506016. There, the IRA owner’s goal was to purchase real estate in an IRA. In truth, three different ‘rules’ had been violated by the IRA owner with the advice of a CPA and attorney. The IRA owner was advised to take two cash distributions from his traditional IRA. The cash was to purchase real estate outside the IRA, with the intent of then rolling the real estate into the traditional IRA. This first violated the one-rollover every 365 days; two distributions cannot be combined and returned to the IRA as a single rollover- the rule focuses on distributions, not deposits. The next rule violated was the same property rule. This rule requires that the IRA owner must roll over the same property that was distributed from the IRA. Since cash had been withdrawn from the IRA, only cash could be deposited in the ‘new’ IRA. The final mistake was that the IRA owner missed the 60-day rollover deadline.Exception: There is an exception to the same property rule with regard to rollovers from a qualified plan, like a 401(k) account. If the distribution of property  is made from the qualified plan, the recipient can either roll the same property to an IRA or sell the distributed property and then roll over the case proceeds.Take-Away: The most frequent occasion when the same property rule is blown is when the IRA owner seeks to self-direct investments held in their IRA with unique assets like real estate, closely held stock, etc. In those situations, cash or securities need to be deposited into the ‘new’ IRA, with the cash/securities then liquidated inside the ‘new’ IRA, and used to purchase the unique asset.
  1. Federal Tax Withholdings on a Rollover Rule: A mandatory 20% tax withholding does not apply to IRAs. It applies to ‘eligible rollover distributions’ from a qualified plan. Rolling funds from a qualified plan into a traditional IRA is when this rule is triggered. In Mulhern v. Federal  Retirement Thrift Investment Board, Tax Court No. 2:17-cv-00094, March 18, 2019, the federal employee sought to directly roll over funds from her Thrift Savings Plan to her traditional IRA. She completed the required form and elected a full distribution, payable directly to her rather than a direct rollover. The Thrift Plan administrator followed these directions and sent to her a check for $127,381, which was 20% less than the account balance, which the plan was required to withhold. Had this employee elected a direct rollover it would not have been subject to the 20% withholding requirement. Thus, not 100% of the Thrift Savings Plan account balance was available to be deposited in the IRA as a rollover. The employee sued the Thrift Savings Plan claiming that it breached its fiduciary duty and violated criminal statutes by ‘converting’ her funds. She lost.Exception: Some distributions are not eligible for a rollover and, therefore, they are not subject to mandatory tax withholding. This exception covers required minimum distributions (RMDs), periodic payments and hardship distributions.Take-Away: Direct rollovers are not subject to the 20% tax withholding rule.
  2. Dividing IRAs in a Divorce Rule: Normally there are two ways to make a tax-free transfer of IRAs incident to a divorce. One way is to change the name on the IRA to the former spouse. The other way is to do a direct custodian-to-custodian transfer of IRA assets to an IRA that is owned by the former spouse. In Kirkpatrick v. Commissioner, Tax Court Memo, 2018-20, February 22, 2019, Dr. Kirkpatrick was ordered to transfer $100,000 of his IRA to an IRA established by his former spouse. Dr. Kirkpatrick took two distributions from his IRA; he made the payments directly to his former spouse in order to satisfy his divorce judgement obligation. The Tax Court held that Dr. Kirkpatrick’s withdrawals were taxable to him, because he did not follow the acceptable methods for a tax-free transfer of assets from his IRA.Take-Away: The easiest way to comply with this rule is for a direct transfer from the IRA owner’s IRA to an IRA established by his/her former spouse pursuant to IRC 408(d). Pulling funds out of a traditional  IRA will always be treated as a taxable distribution to the IRA owner, regardless of the purpose or use, or court ordered transfer, of those funds.
  1. Spousal Consent Rule: If a qualified plan participant wishes to name an individual other than their spouse as the beneficiary of their qualified plan retirement account, the spouse must consent to that beneficiary designation, in effect waiving his/her joint and survivor annuity rights to the retirement account. The key is that the spouse must be married to the plan participant at the time the spousal consent/waiver is signed. In Greenbaum, Doll &McDonald, PLLC v Sandler, 458 F. Supp 420 (WD Kentucky, 2006) David and Debbie signed a prenuptial agreement. In the agreement each waived claims to each other’s retirement funds. David wanted the funds held in his 401(k) account to go to his children from a prior marriage. However, David never completed the change in beneficiary form prior to his death. Debbie and David’s children then fought over the balance of David’s retirement account. Debbie won, even though she signed the prenuptial agreement, waiving her rights to David’s retirement plan. According to the Court, Debbie never gave the consent required by ERISA. The prenuptial agreement was not a spousal consent because it was not signed by Debbie after her marriage to David- it was signed by her as his betrothed, not his wife.Exception: Since IRAs are not covered by ERISA, there is no spousal consent requirement when an IRA owner wishes to name someone other than their spouse as the designated beneficiary of the IRA. The lack of this rule often can lead to big surprises when the IRA owner dies, effectively disinheriting their surviving spouse.Take-Away: Due to the requirement that a ‘spouse’ sign the waiver/consent to be effective, even when there is a provision in a prenuptial agreement purporting to waive any claims to premarital retirement accounts, always follow up after the marriage with a signed waiver/consent. Alternatively, perhaps make other provisions for the benefit of the surviving spouse that are addressed in the prenuptial agreement conditioned upon the surviving spouse’s waiver/consent.
  1. Surviving Spouse Rollover Rule: A surviving spouse named as the beneficiary of the deceased spouse’s IRA has a couple of choices when their spouse dies. Either rollover the inherited IRA to the spouse’s own IRA and postpone taxable income, or remaining as the designated beneficiary of the deceased spouse’s IRA, i.e. leaving it as an inherited IRA. This decision can have dramatic tax implications to the surviving spouse. In Gee v Commissioner, 127 Tax Court, No. 1:No. 8755-05, July 24, 2006, Charlotte’s husband died naming her as the sole beneficiary of his traditional IRA which held $2,646,798 in assets. Charlotte was then under age 59 ½. Charlotte did a spousal rollover to her own IRA. Charlotte then withdrew $977,888 from her IRA, which the IRS claimed was a taxable distribution and assessed the 10% excise tax for the ‘early distribution.’ Charlotte objected to the 10% penalty claiming that she was a beneficiary of her late husband’s IRA account. The Tax Court held that Charlotte was subject to the 10% excise tax. Had she kept the account as an inherited IRA, Charlotte would have had full access to the IRA’s assets with no penalty. However, once Charlotte engaged in the spousal rollover,  the IRA dollars were treated as her own, from the beginning. In short, if Charlotte had continued with the inherited IRA, she could have had access to those funds without the 10% penalty. Moreover, had Charlotte continued to use the inherited IRA as opposed to the spousal rollover, there would have been no RMDs on the inherited IRA until Charlotte’s deceased spouse would have attained the age 72.Observation: When a surviving spouse does turn age 59 ½, no matter how far into the future that event occurs, a spousal rollover can be done at that time.Take-Away: If the surviving spouse will need access to the inherited IRA in order to pay on-going living expenses,  and the surviving spouse is under age 59 ½, consider leaving some of the IRA funds in the inherited IRA where funds can be accessed penalty free, and rollover the balance of the decedent’s traditional IRA to the surviving spouse’s own IRA. Spousal rollovers are not necessarily an all-or-nothing decision.
  1. Qualified IRA Creditor Protection Rule: As a general rule, IRAs are exempt assets under a Michigan statute. In addition, about $1.45 million held in an IRA is exempt if the IRA owner later files for bankruptcy. This protection is afforded to a qualified IRA. If the account ceases to be a qualified IRA, there will be no creditor protection for the assets held in the account. Such was the case in Kellerman v. Rice, No. 4:15CV))347, Eastern District of Arkansas, 2015. There, the IRA account owner Barry had a self-directed IRA. Barry also owned a land development company outside the IRA. Barry used self-directed IRA funds to purchase 4 acres of land because it benefited his separate land development company.  Barry thus was self-dealing with his IRA funds, which was a prohibited transaction. This led to Barry’s IRA disqualified status. Barry later filed for bankruptcy protection. One of Barry’s creditors demonstrated that he had engaged in self-dealing, which led to the loss of the qualified status of his IRA.  Consequently, all of Barry’s IRA was available to satisfy his creditors’ claims in bankruptcy notwithstanding the Bankruptcy Code’s exemption of $1.45 million of qualified IRA assets.Conclusion: The rules surrounding retirement accounts are highly complex and at times counter-intuitive. We can all learn from the mistakes that other have made with regard to their IRAs.