In my line of work, I am often asked about IRA rollovers. Most commonly, clients have a 401k with a previous employer and are wondering what steps they need to take to remove their funds from the plan. Starting in 2015, the IRS now follows a stricter interpretation of the 60-day IRA rollover rule. I wanted to shed some light on this rule and what the changes mean for investors.
First off, there are two ways to move IRA money from one IRA to another IRA: indirectly and directly. With indirect transfers, also known as 60-day rollovers, clients receive a check from their IRA made out to them. They then have 60 days to redeposit the funds to another IRA and you can only have one of these per 12-month period. The second way is a direct transfer, also known as a trustee to trustee transfer. This is when funds move from one IRA to another without the client touching the money. For example, if a check is the method of payment, the check is written by one custodian out to another custodian, i.e. Fidelity writes a check to Charles Schwab and Co. This is always our recommended method of rollover and this method is not subject to the once-per-year rule.
Ever since IRAs have existed, there has been an IRS rule in place that allows IRA distributions to be rolled over within 60 days to avoid taxation. Under the original rule, there could be one indirect IRA rollover per year, and the IRS interpreted this once-per-year rule to apply on an IRA-by-IRA basis. Beginning in 2015, you can only make one indirect rollover form an IRA to another IRA in any 12-month period, regardless of the number of IRAs you own.
You may be wondering why the IRS decided to limit indirect rollovers to one per year. I’m sure you won’t be surprised to find they did so because people figured out a way to abuse the system. It is possible to use the rollover funds as a personal short-term loan, as long as the rollover contribution is made within 60 days. Under the previous interpretation, an individual with several IRAs could potentially take a series of rollovers, allowing for an extended period of personal loans much longer than the 60 day period.
This issue surfaced as a result of the recent ruling in Bobrow v. Commissioner. Alvan Bobrow, a tax attorney, engaged in a series of sequential rollovers from separate IRAs to form an extended loan strategy. His strategy involved two of his own IRAs and one of his wife’s. He actually made a mistake and his final rollover took place after 61 days and was $25k short. He claimed he had made a timely request and that he had requested the full $65k amount, but couldn’t produce any evidence for either. Since the last rollover was not complete, it was reported as being partially taxable, but Bobrow disputed it. I’m not sure which was the dumber move, the original “mistake” or disputing it which is what ultimately drew the IRS’ attention. He could have just paid his tax bill and moved on. As a tax attorney, he chose to represent himself in Tax Court. The Tax Court ended up not only supporting the IRS’ decision, but also declared that since IRAs are aggregated together for income tax purposes, that aggregation should also apply for the once-per-year rollover rule as well.
There are hefty penalties associated with violating the once-per-year rollover rule. A second rollover made within a year could cause a taxable distribution plus a 10% penalty if the individual is under the age of 59 ½. Also, this rollover will be considered an excess contribution subject to a 6% penalty for every year the ineligible rollover funds remain in the account. It’s important to note that the year is a 12-month rolling period starting with the date of the distribution, not the calendar year.
Although 60-day rollovers are now riskier than in the past, these types of rollovers are easy to avoid by just sticking with direct, trustee to trustee rollovers, which is what we have always recommended. There is no limit on the number of direct rollovers you can make in a year. Keep in mind that it’s rarely a good idea to leave funds in a previous employer’s 401k. While 401ks are a great benefit while you are employed as you can take advantage of salary deferrals and employer matching, they come with a very limited list of investment choices and generally high administrative expenses that are hidden within the funds. When you’re no longer receiving the employee benefits, it’s time to roll the account over to an IRA. Feel free to contact me if you’d like guidance on handling a 401k left behind with a former employer.