Unless you have the right training, credentials and errors and omissions insurance, you should probably not go into much detail with clients about the tax implications of retirement plan rollovers. But you may need to know something about the tax rules for rollovers just to stay out of trouble, and to hold your own in conversations with accountants and tax lawyers.
Here’s a look at some key retirement plan rollover basics from a team of compliance experts.
Tax-free rollovers of distributions from qualified plans, individual retirement arrangements (IRAs) and other retirement plans allow the continuation of the tax deferral of the earnings generated by these plans.
Generally, an “eligible rollover distribution” is rolled over to an “eligible retirement plan.”
However, if the individual fails to transfer the eligible rollover distribution to an eligible retirement plan no later than the 60th day following the day of receipt, such amount would be included in gross income subject to tax.
Rollovers from qualified plans do not need to be converted to cash prior to completing the rollover. Stock, bonds, mutual fund shares or other noncash property may be rolled over without being sold.
Here are four rollover situations that might be of interest to financial professionals.
1. When a Participant Receives a Distribution from a Qualified Retirement Plan
If the participant receives a distribution from a Qualified Retirement Plan, it must be rolled over to an eligible retirement plan within sixty days after the funds are received. The sixty-day period begins on the day after the distribution is received. If the sixtieth day falls on a weekend or legal holiday, the next business day will be considered the last day for the rollover to occur.
An eligible retirement plan generally includes any of the following:
a traditional IRA,
a qualified pension, profit sharing or stock bonus plan,
an eligible Section 457 governmental plan (if certain separate accounting requirements are met), and
a Section 403(b) plan.
An eligible rollover distribution is any distribution to a participant of all or part of his or her account balance in a qualified retirement plan that is not:
part of a series of substantially equal periodic payments made at least annually over (a) the life or life expectancy of the participant or the joint life expectancies of the participant and designated beneficiary or (b) a specified period of ten years or more – the test is applied at the beginning of the payout period,
a minimum required distribution
the nontaxable portion of a distribution unless made to a traditional IRA or a qualified plan and certain requirements are met,
the excess 401(k) annual additions of elective deferrals that are returned due to Code Section 415 limitations,
corrective distributions of excess contributions, deferrals or aggregate contributions along with the income allocable to the corrective distributions under a 401(k) plan,
distributions to a beneficiary other than a surviving spouse or a current or former spouse under a qualified domestic relations order,
hardship distributions, or
deemed distributions of plan loans.
The downside of an eligible rollover distribution paid directly to the participant is the 20% federal income tax withholding.
Additionally, state income tax withholding may be required. On the other hand, if the distribution is rolled over directly to the eligible retirement plan, there is no withholding requirement. A direct rollover may be in the form of a trustee-to-trustee transfer accomplished through a wire transfer or a check made payable to the trustee.
2. When a Client Wants to Make Temporary Use of Rollover Distributions
Due to a temporary lack of funds, some participants use all or part of an eligible rollover intending to replenish those funds prior to the expiration of the 60-day period. In that case, the participant risks adverse tax consequences should he or she be unable to roll over the full amount of the distribution within that period.
To the extent the participant fails to roll over all or part of the distribution into a new IRA, the amount of the shortfall would be treated as a distribution subject to income tax and potentially a 10% premature distribution penalty if the participant is under the age of 59½.
3. When a Client Wants to Make Multiple Rollovers
An individual is limited to only one rollover from an IRA in any 365-day period. The 365-day period begins on the date of the first IRA withdrawal.
However, trustee-to-trustee transfers and direct transfers to and from qualified retirement plans are excluded from the one-year rule. The rationale for this rule is to prevent individuals from taking a series of short-term loans from IRAs tax-free by being able to roll over the amount distributed to another IRA within the 60-day period.
On March 1, Sarah Parker withdraws $10,000 from her IRA at ABC Bank. This is the first time Sarah ever made a withdrawal from an IRA or other qualified retirement plan.
On April 29, Sarah rolls over that withdrawal by depositing $10,000 into another IRA at First National Bank.
On July 3, she rolls over her account balance from a qualified retirement plan maintained by her former employer into a rollover IRA at Finest Investments.
On July 29, Sarah directs a trustee-to-trustee rollover of the balance in her rollover at Finest Investments to an IRA at Prudent Bank.
On Feb. 3 of the following year, Sarah withdraws $10,000 from her IRA at First National Bank.
On Feb. 20, Sarah rolls over the Feb. 3 withdrawal by depositing $10,000 into another IRA at Prudent Bank.
The first rollover by Sarah, the plan to IRA rollover and the trustee-to-trustee rollovers are all permissible. This is because the first withdrawal on March 1 was rolled over by Sarah within 60-days and there was no other withdrawal from a qualified retirement plan within 365 days prior to that withdrawal.
The next two withdrawals were permissible because direct plan to IRA transfers and trustee-to-trustee transfers are not subject to the 365-day rule.
However, the Feb. 3 withdrawal from Sarah’s IRA at First National Bank is taxable because it occurred less than 365 days from her March 1 withdrawal. Therefore, the $10,000 withdrawal will be taxable in the year of distribution and potentially subject to the 10% premature distribution penalty.
Previously, the one rollover in a 365-day period rule was applied to each IRA separately. Therefore, an individual with two IRAs could withdraw and rollover funds from each IRA within the same 365-day period.
Beginning in 2015, the IRS announced that only one rollover will be permitted in the 365-day period regardless of the number of IRAs an individual owns. This policy change does not impact the type of rollovers that have never been subject to the 365-day rule (such as direct trustee-to-trustee transfers, etc.).
4. When a Client Is Weighing the Pros and Cons of Rollovers From an Employer-Sponsored Qualified Retirement Plan to an IRA
There are several good reasons not to roll over a distribution from an employer-sponsored qualified retirement plan to an IRA. This is because, as detailed below, the participant has more flexibility with funds in such a plan than he or she would have if those funds were in an IRA:
Taxpayers may borrow from qualified plans (provided the plan permits participant loans), but not from IRAs.
Life insurance can be purchased within a qualified plan, but not with an IRA.
If the employee separates from service after age 55, distributions taken from an employer-sponsored qualified retirement plan are not subject to the premature distribution penalty. Conversely, the IRA premature distribution penalty applies until the account holder reaches age 59½ unless an exception to the penalty applies.
Employer-sponsored qualified retirement plans provide broader federal creditor protection in the case of malpractice, bankruptcy, divorce, business, or creditor problems.
On the other hand, a rollover from a qualified plan into an IRA will preserve the ability to roll over the funds back into a qualified plan in the future. The future rollover into a qualified plan preserves the benefits listed above.
— Read Dealing With Rollovers Under the DOL Fiduciary Rule on ThinkAdvisor.