Though the rollover is the most frequent IRA transaction, most people do only a few rollovers during their lifetimes. Because of this inexperience, mistakes are made and people pay unnecessary taxes and penalties on their retirement nest eggs.
There are more than 30 types of rollovers, though taxpayers often know them by different names. A conversion of a traditional IRA to a Roth IRA, for example, is a rollover.
A rollover done correctly is tax free.
But an attempted rollover done incorrectly usually is included in gross income and taxed as ordinary income, except for any portion that was after-tax or nondeductible contributions. There also might be a 10% early distribution penalty added if you’re under age 59½. Plus, there could be a 6% penalty for making an excess contribution to an IRA.
Fortunately, we know the most likely rollover mistakes and how you can avoid them.
The 60-day rollover trap. The most frequent rollovers are to move money from a 401(k) plan to an IRA or from one IRA custodian to another.
The best way to do these rollovers is to have the custodians handle the transfers. But some people want to use the 60-day rule that allows them to take a distribution from an IRA or 401(k) (usually in the form of a check made payable to them) and deposit the money in another retirement account within 60 days. When done correctly and within the 60-day deadline, this is a tax-free rollover.
But there are tricks and traps in the 60-day rollover.
You have to roll over the same property that was distributed. If cash (included in the form of a check) was distributed, then the rollover has to be in cash. If you were distributed shares of stock or a mutual fund, then you have to rollover the same number of shares of the same stock or mutual fund.
There is one loophole. When you you receive a distribution of property from an employer retirement plan, such as stock of the employer, you can sell the stock and rollover the cash proceeds to an IRA.
Another trap is that when you take the distribution as a check from a 401(k) plan, the 401(k) administrator has to withhold 20% of the account balance for federal income taxes. You’ll get that back after you do a successful rollover and file your income tax return for the year claiming a refund. But in the interim you have to come up with that 20% from another source and include it in the rollover. To have a tax-free rollover, you must roll over the amount of the gross distribution from the plan, not the net distribution after taxes were withheld.
Another trap is that a 60-day rollover between IRAs can be done only once every 12 months (not every calendar year) per taxpayer (not per IRA). Try to do the 60-day rollover more than once every 12 months, and the amount of the distribution will be taxed, even if you deposit it in an IRA within 60 days.
Of course, the 60-day deadline itself is a big trap. Miss the deadline by only one day and the entire distribution is taxed to you.
You might be confident of meeting the deadline, but a lot can go wrong. You could be in an accident, get sick, have a family emergency, or lose track of things. Also, you could do everything right only to have the new custodian put the money in the wrong account.
All of these things and more have happened. The IRS can waive the 60-day requirement for a reasonable cause, but the IRS doesn’t waive the requirement very often. Generally, you’ll receive a waiver only if one of the firms involved in the rollover made a mistake, you were free of fault, and you did everything you could to correct the mistake immediately after you learned or should have learned about it.
The good news is the IRS established an automatic waiver when the 60-day rollover failed solely because of an error by a financial institution. For details, search the IRS web site (or any Internet search engine) for “waivers of the 60-day rollover rule for IRAs.”
Trustee-to-trustee rollovers. The recommended way to do a rollover is to have it made directly from one IRA custodian to another or from a 401(k) plan administrator to an IRA custodian.
Even then, you have to be alert for mistakes. Follow up and read the paperwork or online account information closely. Be sure the correct amount of money was deposited in the correct account. Firms sometimes make mistakes such as depositing rollovers into taxable accounts instead of IRAs. You don’t want the hassle of correcting this mistake weeks or months after it occurred.
RMDs. Required minimum distributions (RMDs) from retirement accounts are required after reaching age 72. Many people try to reduce taxes on RMDs by making rollovers that don’t comply with the tax code.
You can’t roll over an RMD to another qualified retirement plan. You still have to include the RMD in gross income, except any portion that already is after-tax money. Any amount you deposit in an IRA or other qualified retirement plan might be an excess contribution to the plan, subject to a 6% penalty for each year you leave it in the plan.
You also can’t deposit your RMD in a Roth IRA and call it a conversion. It can be a contribution to the Roth IRA, if you’re eligible to make one. But the year’s RMD has to be taken and included in gross income before amounts remaining in the traditional IRA are converted to a Roth IRA.
After-tax funds. You might have after-tax funds in either an IRA or 401(k). After-tax money is money on which you paid taxes before it was contributed.
After-tax funds are tax-free when you withdraw them from a 401(k) plan or IRA.
But you can’t roll over after-tax money to an employer retirement plan. If you join an employer whose plan accepts rollovers from other plans, you can roll over pre-tax money from an IRA or other 401(k), but any after-tax money can’t be rolled over to an employer plan.
Roth IRA contributions are after-tax money. Roth IRA money can’t be rolled over to an employer plan, even if the employer has a Roth 401(k).
Divorce distributions. In many divorces a 401(k) plan or IRA is divided. To defer taxes, it’s important to follow key steps. Just to make divorce even more difficult, the tax code has slightly different rules for IRAs and 401(k)s.
Suppose after a divorce an IRA owner takes a distribution of half the IRA’s value and hands it to the ex-spouse. The receiving ex-spouse deposits it in his or her IRA. The ex-spouse who owned the original IRA will be treated as taking a distribution and will have to include it in gross income. If under age 59½, the ex-spouse also might owe a 10% early distribution penalty. The other ex-spouse will be penalized for making an excess IRA contribution, because it wasn’t a valid rollover.
To avoid this result (and a similar result with a 401(k) plan), you need a court document. With an IRA, a standard divorce decree is sufficient, but with a 401(k), you need what the tax code calls a qualified domestic relations order (QDRO). You need a separate QDRO for each 401(k) account involved.
Then, the legal document is presented to the IRA custodian or 401(k) administrator along with details about which account is to receive the settlement amount. The custodian or administrator makes the transfer directly to the other account. To avoid taxes on the rollover, it must be executed from one trustee or administrator to the other.