Rolling over a qualified retirement plan into an IRA is usually a tax-smart move. That’s because a rollover allows you to continue to defer taxes on the rolled-over amount. You might think that arranging for tax-free retirement account rollovers is a relatively foolproof task. Evidently not! Litigation between the IRS and taxpayers over attempted rollovers is a continuing theme.
And the rollover rules also include several traps for the unwary.
Rolling Over Qualified Retirement Plan Balance into an IRA
With a rollover into an IRA, you continue to benefit from tax deferral, because you won’t owe any income taxes until you withdraw funds from the rollover IRA. You also gain full control over investing your retirement account dollars, which is not the case if you leave money in an employer-sponsored qualified plan. If you have an immediate need for some of the qualified plan money, you can keep whatever is required and roll over the rest tax-free into an IRA. Of course, you will owe income tax on amounts not rolled over.
Beware. You will generally owe the 10 percent early withdrawal penalty tax if you do not roll over a qualified plan distribution after separating from service before age 55 – 59 1/2. Separating from service means permanently leaving your job due to retirement, quitting, being laid off, being fired, or any other reason.
Make Sure to Arrange for a Direct Rollover
Here is a very important thing to know. There are two types of transfers that can be used to move qualified plan distributions into IRAs in a tax-free manner: (1) direct (trustee-to-trustee) rollovers and (2) what we will call traditional rollovers. If you want to do a totally tax-free rollover, be sure to arrange for a direct (trustee-to-trustee) rollover of your qualified retirement plan distribution into the rollover IRA.
This is pretty simple to do. Simply instruct the qualified plan trustee or administrator to (1) make a wire transfer into your rollover IRA or (2) cut a check payable to the trustee of your rollover IRA (this option is less preferable than a wire transfer). Your employee benefits department should have all the forms necessary to arrange for a direct rollover. If you personally receive a trustee’s direct rollover, you must deposit it in the rollover IRA within 60 days. (Ideally, the trustee receives the check, not you.)
What Happens If You Don’t Do A Direct Rollover?
If you fail to arrange for a direct rollover, you will receive a check made out to you personally from the qualified plan. When you examine the check, you will discover that 20 percent of the taxable
amount has been withheld for federal income taxes. Not good!
But if you intend to make a totally tax-free traditional rollover, you must come up with the “missing 20 percent” and deposit it along with the rest of the qualified plan distribution into the rollover IRA within 60 days. If you fail the 60-days rule, you will owe income taxes on the amount withheld for federal income tax (and possibly the 10 percent early withdrawal penalty tax on that amount as well).
If you manage to come up with the “missing 20 percent” and thereby succeed in making a totally tax-free traditional rollover, you will be entitled to a refund of the 20 percent federal income tax withholding. But you won’t collect that refund until after you’ve filed your Form 1040 for the year the withholding occurs.
Depending on the timing, you might have to wait many months to get the cash back. Be smart: prevent the 20 percent withholding from happening by arranging for a direct rollover.
Beware of the One-IRA-Rollover-Per-Year Rule
You can take money out of a traditional IRA and then roll it back into the same IRA or another traditional IRA with no taxes or penalties owed, as long as you put the money back within 60 days.
You can also roll over a distribution from a Roth IRA into another Roth IRA without any taxes or penalties under the same rollover rules that apply to traditional IRAs.
Great, but you can only do one of these IRA-to-IRA rollovers within any 12-month period.
If you take two or more withdrawals within a 12-month period, you cannot roll over the extra withdrawal(s). The extra withdrawal(s) trigger an income tax hit and the 10 percent early withdrawal penalty if you are under age 59½ (unless you qualify for a penalty exception).
Warning: SEP IRAs, SIMPLE IRAs, traditional IRAs, and Roth IRAs are all subject to the one-IRA-rollover-per-year limitation.
How To Beat the One Rollover Rule
Thankfully, you can dodge the whole one-IRA-rollover-per-year issue by moving money from one IRA into another via direct trustee-to-trustee
transfers. These don’t count as rollovers for purposes of the one-IRA rollover-per-year limitation. (IRS Revenue Ruling 78-406; IRS Announcement 2014-15)
Another beneficial rule says that rolling over a distribution from a qualified retirement plan, such as a 401(k) plan, into your IRA doesn’t count as a
rollover for purposes of the one-IRA-rollover-per-year limitation. (Reg. Section 1.402(c)-2, Q&A-16; IRS Announcement 2014-32)
Key Point: To be clear, you can engage in these types of IRA transactions (which accomplish the same goals as a rollover) without any limitations, because trustee-to-trustee transfers are exempt from the one-IRA-rollover per-year limitation.
Final Thoughts
For just about every reason you can possibly think of, you should roll over your retirement plan money using the trustee-to-trustee method:
- With the trustee-to-trustee rollover, you have no limits on the number of rollovers you can do.
- With the trustee-to-trustee rollover, you avoid both the 20 percent withholding of your retirement money and the need to find that missing 20 percent money from another place in order to create a tax-free rollover.
The trustee-to-trustee rollover is the best.