Rollover Traps Revisited

Take-Away: Some transfers of retirement account assets are not technically rollovers. Other transfers of retirement account balances do constitute rollovers, which subjects that transfer to many risks. Mistakes often occur when retirement account transfer rules get confused, which is easy to do when you consider the common use of the term rollover to describe any transfer of retirement funds. To repeat my mantra (which you no doubt are tired of hearing): always use a custodian-to-custodian transfer of retirement account assets to avoid multiple traps in the Tax Code.

Background: I suspect that you are getting tired of reading about retirement account distribution rules. However, a week does not go by where there is not some private letter ruling or Tax Court decision that addresses a mistake or erroneous assumption made about the transfer or distribution of retirement account assets that entangles the owner in some tax or penalty trap. Hence, yet a return to these complicated rules.

Rollovers: When retirement funds are transferred directly between IRA custodians that transfer is not technically a rollover. If it is not classified as a rollover, most of the traps that are associated with rollovers can be completely avoided.  Unfortunately, however, the transfer of any retirement funds is informally called a rollover, which can be a misnomer. Example: When a spouse dies, his/her surviving spouse may rollover the inherited IRA or qualified account balance to their own IRA and continue tax deferral on the transferred funds. However, non-spouse beneficiaries cannot rollover an inherited IRA. Yet often the transfer of retirement assets to an inherited IRA by the designated beneficiary is called a rollover.

60-day Rollover: The distribution of IRA retirement funds from the account directly into the hands of the account owner is a rollover. A 60-day rollover commences with the distribution from the IRA that is directly paid to the IRA account owner. The owner’s receipt of the funds starts a 60-day clock running. To avoid being taxed as a distribution, the distributed funds must be returned to the retirement account within that 60-day period.  Contrary to the IRS’s recent arguments in the Tax Court, the funds received in a 60-day rollover by the account owner can be used for any purpose; the funds just have to be put back in the retirement account before the 60-days have passed.

Rollover Traps: The consequences of blowing a 60-day rollover can bring many expensive headaches:

1. Taxation: If the 60-day deadline is missed, there is no Instead, the transaction is treated as a taxable distribution from the IRA or qualified plan account to its owner.
2. Withholding: A rollover triggers the mandatory 20% federal income tax withholding obligation by the IRA custodian. If a transfer of retirement funds is a direct transfer of funds to another IRA custodian or qualified plan, then that direct transfer avoids the mandatory 20% withholding rule. This withholding rule creates a problem when the goal is to satisfy the 60-day rule and transfer the assets back into a new IRA within the 60 days. Example: IRA owner withdraws $100,000 in an intended IRA rollover transaction; the IRA custodian withholds $20,000, distributing the ‘net’ $80,000 to the IRA owner. In order to avoid the rollover being classified as a taxable distribution, the IRA owner must place $100,000 in the new IRA before the 60-days pass- but he/she will have only the ‘net’ $80,000 that was distributed to contribute to the new IRA. In order to meet the 60-day deadline the IRA owner will also have to lay his/her hands on another $20,000 from somewhere so that 100% of the amount that was subject to the IRA rollover can be transferred in order to satisfy the 60-day rollover The owner must then file for an income tax refund for the 20% that the IRA custodian had withheld.
3. Penalty: If the 60-day deadline is missed and the IRA owner is under age 59 ½ then a 10% penalty for an early distribution is assessed, along with the income tax liability.
4. One-Rollover-Per-Year: IRA-to-IRA rollovers or Roth IRA to Roth IRA rollovers are subject to a one-rollover-a-year limitation. This is a 365-day rule, not a calendar year rule. There must actually be at least 365 days between rollovers, not just that the rollovers occur in different calendar years. Example: A traditional IRA owner-father takes a rollover on October 15, 2018 and moves his retirement funds within 60 days to a financial investment firm where the father’s son just relocated as a stockbroker. Stockbroker-son does not like his new employer’s policies, or a large bonus is dangled in front of stockbroker-son by a new financial advisory firm, so stockbroker-son moves yet again on July 1, 2019 to another brokerage business [probably using his signing bonus to buy a big boat.] Father takes another rollover on September 15, 2019 with the intent to move his IRA funds to follow his son to his new employer where his son can continue to manage his father’s IRA.  The second transfer does not qualify as a rollover because it occurred within 365 days of the first Father is taxed on the entire IRA balance as a taxable distribution. Exception: This one-rollover-per-year rule does not apply for transfers from a qualified plan account to an IRA, or from an IRA to a qualified plan account. In addition, the one-rollover-per-year rule does not apply to a Roth IRA conversion.
5. Roth and Traditional IRAs: For purposes of the one-rollover-per-year rule, Roth IRAs and traditional IRAs are combined. Example: A Roth IRA owner does a 60-day rollover of his $8,000 Roth IRA to a new IRA custodian. That IRA owner will then have to wait at least another 365 days in which to rollover his $450,000 traditional IRA to the new traditional IRA custodian. Roth IRAs and traditional IRAs are combined for purposes of applying the one-rollover-per-year This is a trap if both a Roth and traditional IRA are owned and the owner’s intent is to move, via a rollover, both retirement accounts [Roth and traditional IRAs] at the same time to a new IRA custodian
6. Required Minimum Distributions: Once a retirement plan owner is age 70 ½ he/she must take his/her required minimum distribution (RMD.) The first dollars taken from the IRA after the owner’s required beginning date (RBD) is reached is the RMD obligation. RMDs are not eligible to be rolled over. Example: IRA owner turns 70 ½ and must start taking her RMDs. Her IRA account has a balance of $1.0 million; her RMD for the year is $36,498. The IRA owner intends to rollover her entire IRA account balance to a new IRA custodian. The $36,498 cannot be rolled over to the new IRA. The first-money-out of the IRA is the RMD for the year; there is no option of rolling over the entire balance to the new IRA and then, later in the same year, withdrawing the $36,498 as the RMD for the year. The RMD must be taken first, and the balance of the account can then be rolled over to the new IRA. If the entire IRA is rolled over to the new IRA, the result is an excess contribution to the owner’s new IRA (of $36,498), which carries a 6% penalty assessed as an excess contribution to her traditional IRA for each year until the excess contribution is removed from the IRA. This first-dollars-out rule does not apply to direct transfers between IRA custodians. If the IRA owner transfers her IRA balance to a new IRA via a custodian-to-custodian transfer, the entire balance can be transferred to the new IRA, with the owner taking her RMD from the transferred IRA funds later in the same calendar year.
7. Property Distributions: Some brave souls actually own unique property in a self-directed IRA, such as real estate. Ignore for the moment that the self-dealing rules are notoriously tricky and easy to violate which will cause the entire IRA to lose its qualified status for income tax deferral purposes. The exact same property must be contributed to the new IRA at the end of a 60-day Example: Charlie owns real estate in his self-directed IRA. Charlies takes a rollover of the entire balance of his self-directed IRA. During that 60-days Charlie sells the real estate. Prior to the expiration of the 60-days Charlie transfers the entire IRA account balance, which now includes the sales proceeds from the sale of the real estate, to his new IRA. Charlie blows the 60-day rollover rule; he did not transfer the same real estate into the new IRA. Even if Charlie had sold the real estate and invested the sales proceeds in another parcel of real estate, that new parcel is not the same property that Charlie withdrew from his IRA. Exception: This rule does not apply to property distributions from qualified plans. Nor does it apply to marketable securities. Example: Charlie owns Ford stock in his IRA. Charlie takes a 60-day distribution of the Ford stock, sells the stock, and reinvests the sales proceeds in General Motors stock. The General Motors stock is transferred to the new IRA within the 60-days. Charlie will not violate the 60-day rollover rule when the Ford stock is replaced with the General Motors stock as each investment is publically traded.

Conclusion: I am first to concede that the topic of 60-day rollovers is repeatedly covered. However, confusion continues with regard to the mysterious IRA distribution rules, not to mention the sizeable tax and penalty consequences that are associated with a missed 60-day rollover. The obvious message is that whenever possible, use a direct transfer from IRA custodian-to- IRA custodian in order to completely avoid the rollover traps just identified. With direct transfers between IRA custodians: The 60-day timing trap is entirely avoided. The 20% tax withholding rule is avoided. The one-rollover-per-year trap is avoided. The RMD first-dollars-taken trap is avoided. The inadvertent 10% early distribution penalty or the 6% excess contribution penalty rules are avoided. There is a lot to worry about if an IRA owner engages in a 60-day rollover. Most of us would rather sleep at night rather than worry about stumbling into the traps presented by all of these rollover rules.