Ineligible Rollovers Cause Expensive Tax Penalties
Not all IRA rollovers are eligible to be a tax free transaction. Ineligible rollovers can cause you to be taxed on the rollover, including a 10% penalty. You could also get slapped with an excess contribution penalty, which is currently 6% per year the excess contribution is in the IRA.
If you distribute a large amount (i.e. the entire plan balance), you will have a huge tax liability if the rollover is an ineligible rollover.
3 Most Common Rollover Errors
- Violations of the once-per-year IRA rollover rule.
- Missing the 60-day rollover deadline.
- Distributions to non-spouse beneficiaries.
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Once-per-year IRA Rollover Rule
You can make only one rollover from an IRA to another (or the same) IRA in any twelve month period, regardless of the number of IRAs you own.
The one-per year limit does not apply to:
- rollovers from traditional IRAs to Roth IRAs (conversions)
- trustee-to-trustee transfers to another IRA
- IRA-to-plan rollovers
- plan-to-IRA rollovers
- plan-to-plan rollovers
Once this rule takes effect, the tax consequences are:
- you must include in gross income any previously untaxed amounts distributed from an IRA if you made an IRA-to-IRA rollover (other than a rollover from a traditional IRA to a Roth IRA) in the preceding 12 months, and
- you may be subject to the 10% early withdrawal tax on the amount you include in gross income.
More information is available on the IRS website.
60-day Rollover Deadline
Most pre-retirement payments you receive from a retirement plan or IRA can be “rolled over” by depositing the payment in another retirement plan or IRA within 60 days. If the distribution is paid to you, taxes will be withheld from the distribution. You will need to make up the portion withheld from other funds so the full distribution is rolled over.
There are certain situations that allow a waiver of the 60 day requirement, see this IRS article.
Most plans will rollover the funds directly to another account, which negates the need to make up the taxed funds and stress of the 60 day window.
Distributions to Non-spouse beneficiaries
Rollovers are not permitted for non-spouse beneficiaries. For example, if a single parent dies and leaves the IRA to a child, the distributions cannot be rolled over. They can be distributed. Typically the beneficiaries cash out the IRA and the distribution is taxed as ordinary income, or they convert to an inherited IRA, which they can take Required Minimum Distributions (RMD) annually based on their life expectancy.
The RMDs are required by December 31st of the year following death. It is critical you plan accordingly with the plan administrator to convert to an inherited IRA, collecting all in one year could result in a large tax bill.
There is currently talk in Congress that forces non-spouse beneficiaries to distribute the full balance within a 10 year timeframe.
Those are the common ones, but there a several more rollover errors.
Required Minimum Distributions (RMD)
See my previous retirement article that discusses required minimum distributions.
RMDs can never be rolled over, but it happens often , especially in conjunction with Roth conversions. If an RMD is rolled over, it becomes an excess IRA contribution subject to the 6% penalty unless it is removed by Oct. 15 of the year following that of the excess contribution.
A Roth conversion is a rollover and so the RMD can never be converted to a Roth IRA. If that is done, the RMD is still satisfied, as the funds have been withdrawn, but the funds rolled over to the Roth are excess contributions. Once the RMD is satisfied, then any balance remaining in the IRA is available to be converted.
After-Tax IRA Funds
Only pre-tax IRA funds can be rolled over in an IRA, after tax funds cannot. This segregates the pre-tax contributions and allows you keep up with the basis.
IRA basis includes the after-tax funds from nondeductible IRA contributions and any rollovers of after-tax plan funds into the IRA. Clients are required to keep track of their IRA basis on Form 8606 (Nondeductible IRAs) when they file their taxes. Roth IRA funds also cannot be rolled over to a company plan, even to a company Roth 401(k).
Hardship Distributions
Some plans allow hardship distributions. These withdrawals cannot be rolled over.
The hardship distribution is taxable (to the extent of pre-tax plan funds being withdrawn) and subject to the 10% early withdrawal penalty if no exception applies. There is no financial emergency or hardship exception to the 10% penalty, except in the case of special rules for natural disasters.
These hardship distributions do not apply to IRA withdrawals, as all IRA funds are eligible to be withdrawn at any time, regardless of the reason. The distribution might be subject to tax and the 10% early distribution penalty. If IRA funds are withdrawn for a hardship and not needed, they can be rolled over to the same or another IRA, as long as they are eligible for rollover under the 60-day and once-per-year rollover rules.
Divorce
When IRA funds split in a divorce are withdrawn, those funds are taxable and cannot be rolled over to the ex-spouse’s IRA.
IRA funds should be moved from one spouse’s IRA to the other’s by a tax-free direct transfer.
Plan Loans
A defaulted plan loan is usually considered a “deemed” distribution.” The plan will report the outstanding loan balance on Form 1099-R with code L in box 7.
A deemed distribution is not offset from the employee’s plan balance. Instead, this unpaid amount will remain recorded as an outstanding loan by the plan until a distribution can occur under the plan’s terms. A deemed distribution is taxable and may be subject to the 10% early distribution penalty. It is not eligible to be rolled over to an IRA, even if the employee has the funds to complete the rollover.
A plan loan offset can be rolled over. In this case, the loan is not in default. The employee may have left the company but still had an unpaid loan balance in the plan. When the employee withdraws their 401(k) balance, it will be offset by the amount of the unpaid plan loan. The full distribution will be taxable, even though the employee only received a net amount.
The employee can avoid taxes and penalties by rolling over the loan offset amount to an IRA.
If the offset distribution is the result of plan termination or employment separation, the distribution must be rolled over by the tax-filing deadline, including extensions, for the year the distribution is received.
The employee will need to repay the balance, either from personal capital or a loan. This is the only opportunity to avoid taxes on the offset amount. If they don’t repay the outstanding balance, it is treated as a distribution. Since a loan offset is not in default, any offset amount is eligible to be rolled over.
Different Property from Withdrawal
If you withdraw cash from an IRA, only cash can be rolled back over. Same with stock. It must be the same property, otherwise it cannot be rolled over.
There is an exception for property distributed from an employee benefit plan.
§72(t) Distributions
§72(t) distributions are a series of early withdrawals that are set up to avoid the 10% penalty. To qualify for the penalty exception, the withdrawals must be a series of substantially equal periodic payments.
You can withdraw from your IRA or employee benefit plan before age 59-1/2 without a 10% penalty if you commit to a plan of withdrawals according to the rules set out in Section 72(t)(2)(A)(iv) of the Internal Revenue code.
You can begin a §72(t) payment schedule from an IRA at any age, even if you are still working. These payments must continue for at least five years or until age 59-1/2, whichever longer, and the distributions cannot be rolled over.
You must take consistent distributions and cannot change the agreed upon schedule or account and pay the appropriate tax. If you violate this contract (i.e. by rolling the distribution over), then the 10% penalty will apply to all distributions taken prior to age 59-1/2. See the recapture penalty rules.
Another issue is when eligible rollover dollars go into an IRA that is subject to an active §72(t) payment schedule. That rollover of new funds into this IRA will modify the IRA balance and trigger the retroactive 10% penalty.
I hope this article helps you avoid costly rollover mistakes.
If you need help preparing your taxes, email me at ValdostaCPA at Yahoo.com. Simple tax returns start at $100.
