The rollover is the most frequent IRA transaction, but most people do only a few rollovers during their lifetimes. Mistake are a result of this inexperience, leading to unnecessary taxes and penalties.
Most of the time a rollover that is done correctly is tax free.
An rollover done incorrectly causes the rolled over amount to be 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 for those under age age 59½. Plus, there can be a 6% penalty for making an excess contribution to an IRA.
Here are the most likely rollover mistakes and how you can avoid them.
The 60-day rollover trap. One way to do a tax-free rollover is to take a distribution from an IRA or 401(k), usually in the form of a check payable to the account owner, and deposit the money in another retirement account within 60 days.
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 shares of stock or a mutual fund were distributed, then you have to rollover 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 rollover 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 must 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 have to 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 it can be done only once every 12 months (not every calendar year) per taxpayer (not per IRA). Try doing a 60-day rollover more frequently and the amount of the excess distributions will be taxed, even if you deposit them 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.
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 web site (or any internet search engine) for “waivers of the 60-day rollover rule for IRAs.”
Trustee-to-trustee rollovers. The better 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, 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 rollovers 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 from retirement accounts must begin after reaching age 73. 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 have to include the RMD in gross income, except any portion that 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.
Divorce distributions. 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 a divorcing 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 the IRA owner is younger than 59½, a 10% early distribution penalty also might apply.
The other spouse is likely to 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.
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 custodian or administrator of the other account.
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