The rollover is the most frequent IRA transaction. Yet, it is fraught with traps and is the source of many expensive mistakes.
You want to avoid the two nasty consequences of rollovers that don’t comply with the fine points of the tax law.
An improper rollover usually is included in gross income and taxed as ordinary income, except for any portion that was after-tax or nondeductible money. In addition, you’re likely to be hit with a 6% penalty for making excess contributions to an IRA.
There are many types of rollovers, more than 30, according to Ed Slott, a certified public accountant (CPA), though taxpayers often know them by different names. A conversion of a traditional IRA to a Roth IRA, for example, is a rollover.
Fortunately, we know the most likely rollover mistakes and how you can avoid the hit they make to your family’s after-tax wealth.
Many people are annoyed that they are required to take distributions from their retirement plans after age 70½ and look for ways to reduce the required minimum distributions (RMDs) and the taxes on them. Often, the strategies they develop don’t comply with the tax law.
You can’t roll over an RMD to another qualified retirement plan. First, trying to roll over an RMD isn’t going to save you any taxes. You still must include the RMD in gross income, except any portion that already is after-tax money. Second, any amount rolled over to an IRA or other qualified retirement plan usually is treated as an excess contribution to the plan, subject to a 6% penalty for each year you leave it in the plan.
Remember I said an IRA conversion technically is a rollover. So, you 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 RMD still must be included in gross income. If you aren’t eligible to make a Roth IRA contribution for the year, it’s an excess contribution and you owe the 6% penalty.
When you’re over age 70½, you first must take your RMD for the year from a traditional IRA. You can convert any amount that is left in the traditional IRA after you take the RMD.
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. It could be an IRA contribution that you couldn’t deduct because your income was too high.
Most 401(k) plans allow you to contribute money above the amount that can be excluded from gross income for income tax purposes ($19,000 in 2019). You pay income taxes on those contributions, so they after-tax money. After-tax funds are tax-free when you withdraw them from the plan. But there are some limits on other actions you can take with after-tax money.
You can’t rollover after-tax IRA 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 in the IRA or 401(k), but any after-tax money can’t be rolled over to an employer plan.
This rule can be an advantage. Sup-pose you have after-tax money in a traditional IRA and work for an employer whose plan accepts rollovers. You can roll over the after-tax money to the employer plan and leave all the after-tax money in the IRA. Then, you can roll over the after-tax money to a Roth IRA and not owe any taxes on that conversion. The IRS issued rules in 2014 that
make it easy for taxpayers to execute a tax-free IRA conversion in this way.
Or you can keep the after-tax money in the IRA and in the future, most of the distributions will be tax free. Only the portion that represents future investment returns would be taxable.
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). You might want to do this rollover in the other direction. Suppose you have after-tax contributions in a 401(k) plan.
When you decide to roll over your 401(k) to an IRA, you can separate the pre-tax and after-tax contributions. The pre-tax contributions can be rolled over to a traditional IRA tax-free as is usually done. The after-tax contributions can be rolled directly to a Roth IRA, and there are no additional taxes paid.
To receive this treatment, you must roll over the entire IRA in the same year. These rollovers also must be done trustee-to-trustee. You can’t receive the funds personally and then try to roll them over. This strategy makes it easier for higher-income employees to eventually have Roth IRAs.
The 60-day rollover trap.
You know that you can take a distribution from an IRA. If you return the same amount to the IRA within 60 days (a rollover), the distributed amount is not included in gross income. Here’s the trick. You MUST return, or roll over, the same property that was distributed. If cash was distributed, then the rollover must be in cash.
If you were distributed shares of stock or a mutual fund, then you have to roll over the same number of shares of the same stock or mutual fund. There is one loophole. Suppose you receive a distribution of property from an employer retirement plan, such as stock of the employer. You can sell the stock and roll over the cash proceeds to an IRA. That would be a tax-free rollover.
A few years ago, I reported how the IRS changed its policy and decided the 60-day rollover can be done only once every 12 months (not every calendar year) per taxpayer (not per IRA).
Many people still fall into that trap by trying the 60-day rollover more than once every 12 months.
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 an IRA owner takes an IRA distribution and hands a check for that amount to the other spouse.
The receiving spouse deposits it in his or her IRA. The spouse who owned the IRA will be treated as taking a distribution and will have to include it in gross income. If un-der age 59½, the spouse also might owe a 10% early distribution penalty. The other spouse will be penalized for making an excess IRA contribution. 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 a document known in the tax code as 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.