Save your client from the late 60-day rollover quagmire
A late IRA rollover spiraled into a five-year ordeal, with an investor barely escaping being taxed on over $500,000. That’s the mess that landed Nancy Burack in Tax Court.
It’s a nightmare that could have easily been avoided. What's more, this incident serves as a cautionary tale for financial advisors regarding the need for vigilance in monitoring all rollovers of retirement funds — 60-day rollovers in particular, which are subject to more stringent tax rules than the preferred method of direct transfers. Advisors should also be aware of the various relief provisions available to avoid the time and expense of a full-blown Tax Court case like this one.
On June 25, 2014, Burack received a distribution in the amount of $524,981 from an IRA held with Capital Guardian, with Pershing serving as custodian. Burack used the distribution to purchase a new home while awaiting the closing of the sale of her former home. She intended to redeposit the sale proceeds back into her IRA as a 60-day rollover.
On Aug. 21, Burack received a check in the amount of $524,981, drawn from the closing. Burack was told by someone at Capital Guardian that she could carry out the rollover by overnighting the check to Capital Guardian, which she did on Aug. 21.
Capital Guardian received the check on August 22 — 58 days after the June 25 distribution to Burack. However, Capital Guardian did not record the deposit of the check into Burack’s IRA account at Pershing until Aug. 26 — 62 days after the distribution. (The Tax Court said that it “is not entirely clear” what happened between the receipt of the check by Capital Guardian on Aug. 22 and the deposit of the check at Pershing on Aug. 26.)
The IRS determined that Burack’s redeposit of funds was not made within the 60-day rollover period and therefore assessed her $524,980 of additional taxable income for 2014.
Burack appealed to the court, making two arguments. First, that the late rollover should be excused as it was due to a bookkeeping error, citing the seminal Wood v. Commissioner, 93 T.C. 114 (1989), where a custodian made an error recording the rollover. Second, that she was entitled to a hardship waiver, citing IRS Rev. Proc. 2003-16. The court accepted both arguments and found her rollover to be valid.
Burack’s rollover was saved, plus the IRS tax bill of $214,333, and additional penalties assessed of $42,867 were all removed.
Dangers of 60-day rollovers
This case offers a number of indispensable IRA lessons for advisors. First and foremost: as tempting as it is for a client to use an IRA distribution as a short-term loan with the intention of paying it back within 60 days, a lot can go wrong to cause that deadline to be missed. Although it is now easier than ever to obtain relief for a late rollover (as discussed later), there are still circumstances in which a taxpayer will be forced to spend a lot of money and time trying to convince the IRS or Tax Court to waive the 60-day rule.
As tempting as it is for a client to use an IRA distribution as a short-term loan with the intention of paying it back within 60 days, a lot can go wrong to cause that deadline to be missed.
However, the taxpayer will not always be successful and the consequences of a failed rollover can be devastating.
Had the IRS prevailed in Burack, the rollover amount would have been considered a taxable distribution, adding over $500,000 of taxable income to Burack’s 2014 tax bill. Plus, the IRS was assessing an accuracy-related penalty of $42,867. Furthermore, if Burack was under the age of 59 1/2, an additional 10% early distribution penalty would have applied. Finally, if considered late, the rollover could have been deemed an excess contribution in the receiving IRA and subject to a 6% annual penalty unless timely withdrawn.
An indirect, but crucial, lesson to be gleaned from this case is that even a rollover made within 60 days won’t relieve clients from potentially serious tax consequences if they violate the IRA once-per-year rule, which limits certain 60-day rollovers to one in every 12-month period.
Note that this period does not comprise a calendar year; it starts on the date when funds are distributed — not when they are rolled over. And while there may be a relief when the 60-day deadline is missed, the IRS has no authority to provide relief when the once-per-year rule is violated — it is a fatal error that cannot be fixed.
Another danger area an advisor should be on the lookout for is that if a company plan participant takes a distribution and does not elect a direct transfer (as discussed below), the plan must withhold 20% of the distribution for federal income taxes and may be required to withhold for state taxes as well. This holds even if the participant does a valid 60-day rollover. (Note that 20% mandatory withholding does not apply to IRA distributions.)
Therefore, instead of a 60-day rollover, clients should be strongly advised to do a direct transfer whenever possible, in which the IRA custodian or plan trustee of the outgoing funds directly transfers the funds to the receiving IRA custodian. The funds are never made available to the IRA owner or plan participant. (Direct transfers are often called “direct rollovers” when the distribution is paid from a company plan.)
Since Burack easily satisfied the conditions for the automatic hardship waiver, it is unclear why this matter could not have been resolved at the IRS level. Going to Tax Court no doubt forced her to spend substantial amounts in legal fees and dragged out her case for over five years.
And it still may not be over: the IRS could still decide to appeal the Tax Court decision.
Avenues of relief
To help clients avoid similar messes — and even potentially salvage a lifetime of retirement savings put into jeopardy by a late rollover — advisors need to know that avenues of relief outside the courtroom may be available when the 60-day deadline is missed.
There are three such recourses: an automatic hardship waiver, a PLR, and self-certification.
The automatic hardship waiver is a seldom-used but easy and completely free way to immediately salvage a late rollover. Note that there is a strict deadline for this fix so advisors should act quickly if this option is on the table. Under Rev. Proc. 2003-16, an automatic waiver is granted when the following two conditions are BOTH met:
(1) The funds are deposited into an eligible retirement plan within one year from the date the distribution was received.
(2) The rollover would have been a valid rollover if the financial institution had deposited the funds as instructed.
A PLR is a written statement issued to a taxpayer in which the IRS applies tax laws to a particular set of facts represented by the taxpayer. In Rev. Proc. 2003-16, the IRS allowed taxpayers to apply for a waiver of the 60-day rule by requesting a PLR, and hundreds of taxpayers have taken advantage of that opportunity. (As discussed, the Revenue Procedure also established an automatic hardship waiver — without requesting a PLR — when a financial institution’s error causes a late rollover.)
But PLR requests are expensive — the IRS user fee is $10,000 and professional fees can add thousands of dollars more. They are also slow — a ruling can take as long as nine months. Even then, there is no guarantee of success. For example, the IRS will typically not issue a PLR for a late rollover if the taxpayer uses the IRS funds as a “60-day loan.” This may explain why Burack did not request a PLR.
A client who misses the 60-day rollover deadline can now obtain relief through self-certification under Rev. Proc. 2016-47 — a cheaper and faster alternative to a PLR. An individual can use self-certification only if the late rollover was for one or more of the 11 reasons specified in the Revenue Procedure.
The self-certification procedure was established too late for Burack to use, but it might not have helped her anyway. Rev. Proc. 2016-47 does not specifically address whether self-certification can be used if the IRA owner makes use of the distribution (as she did), but some wording in the guidance suggests that it cannot be used in that situation.
The most important lesson is this: Using a direct transfer instead of a 60-day rollover means the client doesn’t have to worry about complying with all of the strict IRS rules or about fixing the rollover if those rules aren’t complied with.
If clients feel they must use the 60-day rollover because they need the funds, they must be extra careful to make sure the funds are eligible to be rolled back over and that the rollover is completed well before the 60-day deadline.