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Be Sure Your Rollover is Done Right

Published on: Sep 29 2021

Though the rollover is the most frequent IRA transaction, most people do only a few rollovers during their lifetimes. A consequence of this inexperience is that too many 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 money.

There also might be a 10% early distribution penalty 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 rollover done most frequently moves 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 transfer.

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 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 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. When 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.

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. But in the interim, you must 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 in the 60-day rollover between IRAs is that a 60-day rollover 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 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 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 website (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 in these cases, you must 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 roll- overs 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 must be taken 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 must 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. This rule can be an advantage.

Suppose you have after-tax money in a traditional IRA and begin working for an employer whose 401(k) 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 rollover 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.

• Divorce distributions. In many divorces, a 401(k) plan or IRA is divided. To defer taxes, it’s import- ant 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 a distribution of half the IRA’s value and hands it to the other spouse. The receiving spouse deposits it in his or her IRA.

The 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 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 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 roll- over, it must be executed from one trustee or administrator to the other.



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