After discussing direct IRA rollovers in a previous article, I will outline basic rules for transferring funds via indirect ira rollovers in this article and then I will provide responses to some questions that I encountered with real investors, as well as provide a few examples of how these rules apply in real-life indirect rollover situations.
Like I already explained in the article about direct rollovers, I am using terms direct rollover and indirect rollover to differentiate between two types of IRA transactions in my articles. However, you might encounter different terms in other written materials. Some writers will use the term transfer for direct rollover and the term rollover exclusively for indirect rollover.
The U.S. Internal Revenue Service (IRS) uses the terms direct rollover and 60-day rollover. Different terminology notwithstanding, below you will find a bullet-point summary of rules and regulations that all IRA owners must follow to avoid tax liability and penalties during indirect rollovers.
Q. I took my first required minimum distribution (RMD) this year. However, I would like to reverse this and wait until next year when my tax bracket will be lower. Can I do this?
A. It is possible. If less than 60 days has passed since you took the distribution, you may return it to the Traditional IRA (TIRA) from which you took the distribution. Earnings or loss on the withdrawal do not matter, only the actual dollar amount of the distribution. You only can do this one time in any 12-month period. For example, if you made the withdrawal on June 1 of this year and put the dollars back into the TIRA on July 1, then you may not make another indirect rollover – withdrawal and redeposit within 60 days – on any of your IRAs until July 2 of next year. If you took the distribution more than 60 days ago or if this is your second withdrawal/replacement in the past 12 months, then you may not reverse the distribution. Additionally, you must remember that if you delay your first RMD to the next year – up until April 1 – you will have two RMDs for that year.
Q. I retired from my employer early last year and shortly thereafter submitted a written request to have my 401(k) balance of about $560,000 rolled over to my TIRA. I was assured by the employer’s HR department that “the check was in the mail”. However, approximately three weeks later, I received a check made out to me for only $448,000. A frantic call to the HR department revealed that they had made an error and should have made the check out to the TIRA account number I provided and should not have withheld 20%. Despite admitting their error, they said they could not correct it! Is this true?
A. Unfortunately, that is true. This example helps to explain why former employees should not contact and try to coordinate the rollover of their retirement plan balance. Instead, the former employee should allow the receiving IRA custodian to arrange and to handle the rollover.
The former employer’s HR department withheld 20% of the total rollover amount and sent that to the IRS. Once they sent the funds to the IRS – which usually is done electronically these days – it is nearly impossible to reverse it. Therefore, this is what you must now do:
– Deposit the check into your receiving TIRA within 60 days of receiving it. If you fail to do this, you will have to declare the entire $448,000 as income that year.
– Make up the 20% withholding – $112,000 – out of personal funds and deposit that in the receiving TIRA. If you do not, this must be declared as ordinary income for that year.
– Claim the 20% withholding as a tax withholding when you file your tax return for that year. Your IRS refund will be about $112,000, thus returning it to you.
This is clearly a major inconvenience to you. When this has happened in the past, some employers have provided the 20% amount as an interest free loan to be repaid with your refund after filing your normal tax return. However, if the employer provides no such benefit, any part of the 20% that you cannot replace within 60 days, you must declare as income. To add insult to injury, if you have not reached age 59.5 yet, you will be assessed a 10% early withdrawal penalty.
Q. I withdrew $40,000 from my TIRA earlier this year to buy a stock that my broker told me would double in a month. Well, the stock did not double. It lost about 20% of its value. It has now been 50 days and I understand that I need to put those dollars back into the TIRA to avoid tax and penalty – I am 28 years old. Since I lost money on this investment, can I put back the actual reduced amount and call it good?
A. No, you must redeposit the entire $40,000. If you redeposit within the 60-day period an amount that is less than the original amount – $40,000 in your case – you will have to declare the difference as ordinary income for the year. There is no rule that says you must deposit the same dollars. You may redeposit any dollars, as long as the amount equals the amount of the withdrawal.
Q. I am 52 years old and I have a TIRA that currently has a mutual fund. The mutual fund announced that it will be paying a large annual dividend next month. The payout will consist mostly of long term capital gains and qualified dividends. Could I do an ‘in-kind’ transfer of these mutual fund shares into my taxable brokerage account, take the dividend there and then roll the same shares back into my TIRA within the 60-day period and have the distribution taxed to me through my taxable brokerage account?
A. When you do an indirect rollover from a TIRA “in-kind,” the IRS “same property rule” applies. This rule requires that to avoid treating any of the rollover amount as taxable income for the year, you must roll-back to the TIRA – or another TIRA or other retirement plan – within 60 days the same mutual fund shares.
However, to qualify as a tax-free rollover, the dollar amount of the withdrawal must equal to the amount of the redeposit, whatever number of shares this may be. Because mutual fund share price – called Net Asset Valuation or NAV – will be reduced by exactly the amount of the annual dividend, then this scheme would have no tax value. The dividend would reduce the fund’s NAV and require you to purchase additional shares, using the dividend or simply reinvesting the dividend in additional shares. In fact, this could create a problem for you in that the mutual fund’s dividend in a taxable account would be taxable income to you even though you would derive no benefit from those funds.
Now that we have discussed elective withdrawals from Traditional IRAs, withdrawals from Roth IRAs, direct IRA rollovers in previous articles and indirect IRA rollovers in this article, the only remaining transaction to discuss involves mandatory withdrawals from TIRAs. Because of the complexity of these mandatory withdrawals, I will discuss these in two separate articles. One article will be about mandatory withdrawals from a TIRAs while the owner is living and the other article will explain mandatory withdrawals from a TIRA and RIRA at the death of the owner.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.