Many of our readers may be considering the common practice of rolling over their IRAs.
Perhaps you want to consolidate your retirement accounts. Or you’ve recently changed your banking relationship. Or you’re just looking for different investment options.
Rolling over your IRA is easy, right? Just have your financial professional move it from one IRA account to another and you’re done.
Well – it’s not as simple as you may think. And even with the help of an accountant, a lawyer, and a financial advisor, you can still make costly mistakes.
Here are the three rules that trip up investors the most.
Clamoring for Clarity
First, let’s assume you’re a tax-paying individual and you received two IRA cash distributions paid directly to you early in the year. Furthermore, you would like to purchase shares in a hot new stock, Acme Corp.
You purchase the Acme Corp. stock with all of the funds from the first IRA distribution and a portion of the funds from the second distribution and put the shares in a self-directed IRA.
That was easy, right? Wrong.
You see, many investors who follow this scenario don’t account for a number of IRA rules that would get in the way of this simple allocation. In this scenario, your investment failed on three fronts.
Rule No. 1: The Once-Per-Year Rollover Rule
In the above example, you can’t make this Acme Corp. transaction because only one IRA is eligible for a rollover in the same 12-month period and you were funding it with two.
According to the once-per-year rule, beginning in 2015, you can make only one rollover from an IRA to another (or the same) IRA in any 12-month period, regardless of the number of IRAs you own. The limit applies by aggregating all of your IRAs, including SEP and SIMPLE IRAs as well as traditional and Roth IRAs, effectively treating them as one IRA.
There are some exceptions, which aren’t limited. They include trustee-to-trustee transfers between IRAs and rollovers from traditional to Roth IRAs (also known as conversions).
The rule also doesn’t include some 2014 distributions. IRA distributions rolled over to another (or the same) IRA in 2014 won’t prevent a 2015 distribution from being rolled over, provided the 2015 distribution is from a different IRA involved in the 2014 rollover.
As an example, if you have three traditional IRAs – IRA A, IRA B, and IRA C – and in 2014 you took a distribution from IRA A and rolled it into IRA B, you couldn’t roll over a distribution from IRA A or IRA B within a year of the 2014 distribution. But you could roll over a distribution from IRA C. This transition rule applies only to 2014 distributions and only if different IRAs are involved.
Rule No. 2: Same-Property Rollover Rule
Here’s another problem with the Acme Corp. scenario: It doesn’t comply with the same-property rollover rule. This states that when a financial asset is withdrawn from a retirement account or IRA for the purpose of funding a new IRA, it must be rolled over into the same property (or format) of an IRA.
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Unless you’re over 59.5 years old, failure to comply with this rule will result in the IRS taxing the withdrawn asset as ordinary income.
So, let’s say you’re 51 years old. Since your withdrawal asset changed properties (from cash to Acme Corp. stock) during the rollover and you’re under 59.5, you’ll end up owing tax on the withdrawn amount at a rate that equals your normal income tax rate. On top of that, you’ll also incur a 10% penalty. Ouch!
Note that the rule only applies to the asset and not its value. It doesn’t matter if the asset has appreciated or depreciated in value, as long as it’s the same asset. As such, you can’t roll Acme Corp. to Widget Corp. either, even though they’re both stocks.
There is an exception to the rule for rollovers distributed from a company retirement plan, such as a 401(k).
In this case, you can either roll over the same property to an IRA, or you can sell the assets distributed from the plan and roll over the cash proceeds from the sale. You wouldn’t have to recognize any gain or loss on the sale.
Rule No. 3: 60-Day Rollover Deadline
The Acme Corp. scenario fails a third time as it breaks the 60-day rollover deadline because you received the IRA distributions early in the year but waited until September to fund the new IRA.
The rule states that if a distribution from an IRA or a retirement plan is paid directly to you, you may deposit all or a portion of it in another IRA or a retirement plan within 60 days.
Taxes will be withheld from a distribution from a retirement plan, so you’ll have to use other funds to roll over the full amount of the distribution.
The IRS may waive the 60-day rollover requirement in certain situations if you missed the deadline because of circumstances beyond your control, including casualty, disaster, or other events.
Such events include:
- Errors committed by a financial institution,
- The taxpayer’s inability to complete a rollover because of death, disability, hospitalization, incarceration, restrictions imposed by a foreign country, or a postal error,
- The taxpayer’s use of the amount distributed, and/or
- The time elapsed since the distribution occurred.
You can request a waiver of the 60-day period by applying for a private letter ruling.
Let’s say you try to get around this rule and pursue a waiver by submitting a private letter asking for an extension due to an illness that left you incapable of handling your finances during that period.
The IRS would investigate to see if you were going to work or handling other affairs in a normal fashion. If they found that you were, they would conclude that your medical condition wasn’t serious enough to impair your ability to handle your IRA.
In the end the best protection against rollover mistakes is this: Know your rules, consult your advisors, and keep in mind the three rules.