Don’t let clients make this fatal IRA rollover error
Some clients’ 2015 tax returns are being hit with costly penalties because of a new ruling about the once-per-year individual retirement account rollover rule.
Only one 60-day IRA-to-IRA rollover can be done per year by an individual, regardless of how many IRAs he or she holds.
A strict new version of the once-per-year IRA rollover rule has been in effect since Jan. 1, 2015, but some advisers are still making costly errors. Some clients, too, are completely unaware of the new rule.
The fallout is happening after the filing of clients’ 2015 tax returns. This was the first year that a second ineligible IRA rollover would trigger an unwanted tax bill and related possible tax penalties.
Unlike some other tax mistakes, running afoul of the once-per-year IRA rollover rule is a fatal error, as it can’t be fixed. The Internal Revenue Service doesn’t have the authority to provide any relief on this error.
As a result of a now-landmark Tax Court ruling (Alvan L. Bobrow, et ux. v. Commissioner, TC Memo 2014-21, Docket No. 7022-11, Jan. 28, 2014) and follow-up guidance from the IRS in Announcement 2014-32 (issued on Nov. 10, 2014), a stricter interpretation of the rule applies.
In the past, the IRS thought that the rule applied separately to each IRA, but that is no longer the case. The new IRS publications make it clear that the rule applies in the aggregate to all IRAs and Roth IRAs.
It is worth noting at the start to what actions these rules don’t apply.
Most important, they don’t apply to direct transfers from one IRA to another. This is why a direct transfer is the preferred method to move clients’ IRA funds.
The once-per-year IRA rollover rule also doesn’t apply to rollovers from other types of plans to IRAs, to rollovers from IRAs back to plans or to Roth conversions.
Further, the rule doesn’t apply to non-spouse IRA beneficiaries, because they can never do a 60-day rollover anyway. Non-spouse IRA beneficiaries can move inherited IRA funds only using direct transfers.
A spouse can do a rollover, but after a spouse’s death, spousal rollovers should also be done as direct transfers.
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Thus, the once-per-year rule applies only to indirect rollovers of one IRA to another IRA (or Roth IRA to Roth IRA), often called 60-day rollovers. A 60-day rollover means that the funds were withdrawn by the IRA owner via a check made out to him or her personally.
By contrast, a direct transfer involves a trustee-to-trustee movement, in which the money moves directly from one IRA to another without anyone touching the money in between.
IRS Announcement 2014-32 makes it clear that a check made out to the receiving IRA will qualify as a direct transfer and isn’t subject to the once-per-year IRA rollover rule. But a check made out to the IRA owner won’t qualify for this exception because he or she can cash this check.
The rule states that only one IRA-to-IRA rollover can be done per year from all IRAs held by an individual, including Roth IRAs, SEPs and Simple IRAs. Note that one year means 365 days, not a calendar year.
Here is an example.
Bob withdraws $50,000 from his IRA on Aug. 5, and rolls it to another of his IRAs on Sept. 10, well within the 60 days. Assuming that Bob hasn’t done any other IRA-to-IRA rollovers during the 365 days before Aug. 5, then this is a good 60-day rollover.
But that is Bob’s one allowed IRA rollover. He can’t do another 60-day rollover from any of his other traditional IRAs, Roth, SEP or Simple until after Aug. 5, 2017.
If he did, that would be an ineligible rollover and taxable to the extent of pre-tax funds withdrawn and subject to the 10% early distribution penalty if Bob is under 59 1/2 and no exception to the 10% penalty applies.
The action could also be subject to a 6% excess IRA contribution penalty if the ineligible rollover isn’t removed in a timely manner. That would require the filing of Form 5329 to report the excess IRA contribution, if not removed by Oct. 15 of the year after the year for which the IRA contribution was made.
Sometimes, advisers are the cause of clients’ problems. In one case, an adviser allowed a client to take withdrawals from several IRAs on the same day so that the client could use the money as a short-term loan for a down payment on a house, while waiting for the sale of another home to close.
This was ill-advised on two counts. For starters, rarely does a house sale close in time to return the IRA
money within 60 days.
Beyond this, however, the adviser thought that the client would be meeting the once-per-year IRA rollover rule because all the withdrawals were done on the same day. This was a huge misunderstanding.
The first withdrawal was all right, assuming no other IRA rollovers had been done within the previous 365 days. But all the other withdrawals from other IRAs, including the client’s SEP IRA were now not eligible to be rolled over.
They are considered as separate IRA rollovers since they were taken from separate IRAs. If all the IRA funds were in one single IRA and several withdrawals were taken from that one IRA on the same day, this would be OK.
In this case, a better approach might have been to do direct transfers from all these IRAs to one IRA because direct transfers don’t count under the rule. Then, the funds could have been taken only from that one IRA.
But even then, the entire plan could backfire if the funds are used for a short-term loan and they aren’t rolled over within the 60 days.
Although the IRS can grant more time when the 60-day period is missed on a legal rollover, it wouldn’t do so in this case because the funds were withdrawn for use as a short-term, interest-free loan. The IRS has ruled against this in virtually every private-letter ruling with these facts.
In this case, the client ended up being taxed on all the succeeding IRA rollovers after the first one, plus a 10% penalty because she was under 59 1/2. To make matters worse, all the withdrawn funds were needed and spent, so at tax time, there was no money to pay the tax and the penalty due.
In yet another case, an adviser was happy to bring in a new client with both IRAs and Roth IRAs. The client agreed to move all the funds to the new adviser and brought a check from his IRA and another check from his Roth IRA to roll over to a new IRA and Roth IRA with the new adviser.
Only one of those checks can be rolled over. The other can’t.
The first impression then that this new client had with his new adviser was that one of his two IRAs is now gone as the withdrawal can’t be rolled over.
Even worse, if in this case the client had done a rollover within the past 365 days before the two rollovers with this new adviser, then neither rollover is any good and the client loses both his IRA and Roth IRA funds to running afoul of the once-per-year IRA rollover rule. This is a horrible outcome.
RULES FOR ADVISERS
As a general rule for advisers, never, ever, take in new client IRA or Roth IRA money as a 60-day rollover. Only use direct transfers.
Advisers don’t know the history of the clients’ other IRA rollover transactions in all their other IRAs and Roth IRAs for the past 12 months. If another 60-day rollover was done, the new client IRA rollover can’t be done, and the funds must be distributed and subject to taxation.
IRA certificates of deposit present another problem. Often they come due, and the bank renews it as a rollover to a new IRA, which counts as a rollover.
If another rollover was done from any of that client’s other IRAs or Roth IRAs at any other financial institution, that rollover is no good. It becomes taxable and can’t be rolled over.
All these IRA problems can be avoided by using only direct transfers. Direct transfers aren’t subject to this rule. An unlimited number of direct IRA transfers can be done.
Sometimes, however, direct transfers can’t be done because of the types of investments that are offered in the IRA.
For example, IRA annuities are generally cashed out. The annuity companies don’t do direct transfers so they will send the client the money to be rolled over, but that counts as one rollover.
Advisers should be careful if they are doing this with clients.
In many cases, the advisers aren’t to blame. Clients may do these rollovers on their own because that is what they have always done.
Sometimes, they do it right at the bank under the nose of a clerk who doesn’t know to ask about prior rollovers or isn’t aware of the new rule or even the old rule, for that matter.
In some cases, 60-day rollovers are unavoidable. Some smaller banks and credit unions just won’t do direct rollovers.
In this case advisers need to monitor the one-year clock and keep track of the clients’ other IRA funds to make sure that no other IRA-to-IRA rollovers are done within that one-year window. Although the adviser isn’t managing the funds in the credit union, for example, a 60-day rollover done on even a small IRA there affects all the other IRAs that the client has with the adviser.
Advisers need to educate all IRA clients about the seriousness of violating this rule. Remember that the IRS can’t fix this.
This story is part of a 30-30 series on tools and strategies for retirement. It was originally published on June 22.