New IRS Ruling about IRA Transfers vs. Rollovers: What’s the Difference?

Ron Papa sitting smiling sm sqA new ruling from the IRS could mean big changes for retirement assets.

 

As a result of a recent U.S. Tax Court decision, the IRS has changed its interpretation of the “once per year” IRA rollover rule to mean exactly that:  Only one IRA-to-IRA rollover is permitted during a 365-day period from any of a client’s IRA’s. 

2013 Publication 590The new rule is a significant change.  For many years, IRS Publication 590, Individual Retirement Arrangements, said that if an individual has more than one IRA, the rollover rule applies separately to each IRA.   The IRS also backed up this stance in two private letter rulings:  one dated June 28, 1996, and one from May 6, 1987.   The new rule began being enforced on January 1, 2015.

The good news here for advisors is that clients who have already done multiple rollovers from separate IRAs will not have to worry about them.  The IRS has effectively grandfathered them by delaying the effective date of the new rule.  But from now on, I’m instructing my clients to stop this practice and use direct (also called trustee-to-trustee) transfers instead

Individual retirement accounts (IRA’s) are required to be held at financial institutions.  These institutions are referred to as the custodians.  When an individual moves an individual account from one custodian directly to another custodian, this is considered a transfer

When you transfer an IRA, there are no tax consequences, and you are not required to report anything on your income tax return.   An individual is permitted to make as many transfers a years as s/he would like.

A rollover may appear similar to a transfer with respect to the mechanics, but it is a very different operation.  Rollovers have strict rules which need to be adhered to or the consequences could be very costly.

IRA Rollover thumbnailRollovers are a tax-free distribution from a retirement plan that is paid directly to you, and then you contribute those funds into another qualified retirement plan.   This is where I can become a bit dicey:   There is a rigid timeline of 60 days to complete the process.  If the distributed assets are not contributed back into a qualified retirement account within the allotted timeframe, a cascade of negative consequences is what follows.   First, the distribution is considered a withdrawal and becomes taxable.   Additionally, if you are under age 59½, then you can tack on a 10% penalty for a premature withdrawal on top of the tax burden.

Another distinction of the rollover is that you are only allowed to have one rollover during a 12-month period per IRA.   There will also be a paper trail you will need to be aware of, so that you do not incur a tax liability.   At the end of the year, you will be furnished with a 1099-R from the institution who distributed the funds, and this distributions will be reported to the IRS.   You would use IRS Form 5498 when you file your taxes to document the contribution into the new retirement account. 

Lastly, if the rollover is paid directly to you, 20% is normally withheld by the payor for tax.  This money may be credited back when filing your taxes.

There are a few key takeaways here 

As always, advisors should have clients do direct (trustee-to-trustee) transfers when moving funds between IRAs.   This will avoid all the once-per-year problems.   A violation of the rule can be fatal to the IRA funds being moved, with no IRS relief available.   While the IRS has the authority to waive the 60-day rollover rule, it may not waive the one-a-year IRA-to-IRA rollover rule.   When this latter rule is violated, the extra rollover amount is taxable and may be subject to the 10% early distribution penalty. 

Even worse, if the funds are rolled over in error, the action will be treated as an annual IRA contribution and could result in an excess contribution, triggering the 6% penalty on such amounts.   Indeed, any excess amounts will be subject to the 6% penalty for each year the excess remains in the account.

This is a potentially costly tax trap.   It is critical that all my clients are informed of this major change for IRA rollovers.

 

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