IRA rollover vs IRA transfer Annuity rollover

IRA Rollover vs IRA Transfer – Don’t Make This Mistake

***Update notes before reading:

  1. IRA Rollover Important update: news from a recent Tax Court decision – see below (highlighted) .
  2. Also some of the figures have changed since this article was originally published, the concepts are still very much, if not more applicable. For example, with recent increases in Medicare premiums for “higher income” individuals, keeping realized income (i.e. what shows up on the 1040) as low as possible has become that much more important!

Leaving a Job – What to Do Next

Many people, when leaving their job, wonder what to do about their 401(k) balance at their old employer. And they worry about making a mistake – rightfully so. Therefore, what should one do when considering this option? Let’s use a story – let’s examine the case of “Mary” who encountered this situation. Upon hearing advice from her cousin Beth, that she should “roll over” her money to an IRA, she looks into the process and decide that the reasons to “roll over” are pretty good; reasons which can include:

  • more control over her moneybetter with a financial advisor
  • quicker access in case of emergency
  • many more investment options than the limited number in the old 401k

Mary then executes the rollover and it results in her receiving a check in the amount of their 401k balance, which not knowing what to do with it, she deposits it into her bank account. About 4 months later, Beth tells Mary that she must roll that money into an IRA to avoid taxes, which she subsequently does. Then, somewhat surprised, Mary receives a notice sometime the next year from the IRS informing her that she owes a 10% penalty on the amount “rolled over” and that taxes are due on the balance. “But wait,” she thinks to herself, “I thought a rollover was not taxed?”

IRA rollover vs IRA transfer top IRA rulings
What were the top IRA legal rulings of the past year and how can they benefit you? Click the image to find out!

How an IRA Rollover Gets Taxed

Let’s review what happened. First off, you might be asking, technically, what is a “rollover?” Let’s go to IRS Publication 590, the complete guide to IRA rules, for the answer:

Generally, a rollover is a tax-free distribution to you of cash or other assets from one retirement plan that you contribute to another retirement plan. The contribution to the second retirement plan is called a “rollover contribution.” A written explanation of rollover treatment must be given to you by the plan (other than an IRA) making the distribution.”

Also remember this about reporting a rollover (also from Pub 590):

You cannot deduct a rollover contribution, but you must report the rollover distribution on your tax return as discussed later under Reporting rollovers from IRAs and Reporting rollovers from employer plans .” (other sections of Publication 590)

Why did the person above get hit with the penalty and tax? Here’s why:

You generally must make the rollover contribution by the 60th day after the day you receive the distribution from your traditional IRA or your employer’s plan.  The IRS may waive the 60-day requirement where the failure to do so would be against equity or good conscience, such as in the event of a casualty, disaster, or other event beyond your reasonable control.

Annuity rollover options the laymans guide

In the absence of a waiver, amounts not rolled over within the 60-day period do not qualify for tax-free rollover treatment. You must treat them as a taxable distribution from either your IRA or your employer’s plan. These amounts are taxable in the year distributed, even if the 60-day period expires in the next year. You may also have to pay a 10% additional tax on early distributions…

As you can see, Mary waited for months and it cost her. What could she have done? If she did not want to handle the money, she could have elected to take a “Trustee to Trustee Transfer.”

IRA Transfer to the Rescue

A transfer of funds in your traditional IRA from one trustee directly to another, either at your request or at the trustee’s request, is not a rollover. Because there is no distribution to you, the transfer is tax free. Because it is not a rollover, it is not affected by the 1-year waiting period required between rollovers. This waiting period is discussed later under Rollover From One IRA Into Another . (another section of publication 590)

better with a financial advisor

A trustee to trustee transfer is a direct exchange of the assets, and never touches the hands of the investor. Many people carelessly request IRA “rollovers” when they really want a trustee to trustee transfer. This likely happens more where employee consulting is not available.

Or perhaps when an investor handles an IRA rollover or transfer from an old 401k over the phone. Language often catches people. for example, another minefield of using correct “wording”: moving traditional IRA money to a Roth. This is a “conversion.” Not an IRA rollover or transfer, and reversing the decision is called a “recharacterization!”). Therefore, it is essential that a person seeking to move money from their old 401k be careful and ask questions of their HR department if confused. It would also be helpful to secure the help of a professional when conducting such a maneuver.

Important Update:

a recent Tax Court decision clarified IRA ROLLOVER laws. Under previous interpretation, the 1 rollover per year limit was thought to apply to each IRA you owned. So if you owned a brokerage IRA, and a bank IRA, you could do a rollover once per year from each of those accounts. And that’s how the IRS previously interpreted the rule.

However, the tax court recently ruled that the IRS’ interpretation was incorrect. And that each tax payer is limited to only one rollover per year among all of his/her IRAs COMBINED.

Read more about that decision HERE  from the IRS site.

So now it makes even more sense to consult a professional before making tax decisions.

IRA Rollover vs Transfer Bottom Line

IRA rollover (s) is an area that can appear simple but offers many possible traps. Are you considering hiring a serious advisor who can help you make smarter choices about your money? See if we’d be a good fit to work together HERE.

Whomever you decide to work with,  I highly recommend you obtain professional advice on doing a rollover or transfer.

Further Reading on IRAs

Top Recent IRA Rulings You Will Be Happy to Know About

IRA Rollover

IRA Transfer

5 Things to Consider Before Taking a 401(k) Hardship Withdrawal (from my personal website

Thanks for reading!

Chris Grande

Cover photo courtesy of Jakob Montrasio