3998 / What is required to roll over a distribution received from a qualified retirement plan or an eligible Section 457 governmental plan?

If any portion of the balance to the credit of an employee in a qualified retirement plan is paid in an eligible rollover distribution and the distributee transfers any portion of the property received to an eligible retirement plan ( Q 3995), then the amount of the distribution so transferred generally will not be includable in income.¹ Unless otherwise indicated, the rules that apply to qualified plans are incorporated by reference into the requirements for eligible Section 457 governmental plans.

An eligible rollover distribution is any distribution of all or any portion of the balance to the credit of the employee in a qualified trust, except that the term does not include:

(1)  any distribution that is part of a series of substantially equal payments, at least annually, made over the life or life expectancy of the employee or the joint lives or life expectancies of the employee and his or her designated beneficiary,

(2)  any distribution made for a specified period of ten years or more,

(3)  any distribution that is a required minimum distribution under IRC Section 401(a)(9), and

(4)  any hardship distribution.²

Regulations specify other items that are not considered eligible rollover distributions, including any portion of a distribution excludable from gross income other than net unrealized appreciation (although this has been modified by subsequent legislation), the Table 2001 or P.S. 58 cost of life insurance ( Q 3948), corrective distributions of excess contributions and excess aggregate contributions ( Q 3808), excess deferrals ( Q 3760), and dividends paid on employer securities under IRC Section 404(k) ( Q 3824).³ Treasury Regulations Sections 1.402(c)-2, A-9, and 1.401(a)(31)-1 provide guidance on the treatment of plan loans for purposes of the rollover and withholding rules.

If a qualified retirement plan distributes an annuity contract to a participant, amounts paid under that contract are considered to be payments of the balance to the participant’s credit and may be treated as eligible rollover distributions to the extent they would otherwise qualify. Therefore, a participant may surrender the annuity contract and treat the sum received as an eligible rollover distribution to the extent that it is includable in income and is not a required distribution under IRC Section 401(a)(9).⁴ The IRS determined that a separate lump sum settlement payment to the widow of a plan participant who already was receiving monthly payments under the plan was eligible for rollover treatment under IRC Section 402(c)(4).⁵

A distribution of property other than money is treated the same. The amount transferred equals the property distributed.⁶ A taxpayer may not retain property received in a distribution and simply rollover a cash amount representing the fair market value of the property.⁷ Conversely, a taxpayer may not take cash received in a distribution, convert it into stock or any other type of investment, and then contribute the converted cash investment into an IRA as a rollover.⁸ This rule applies to IRA and qualified retirement plan rollovers, including rollovers into Roth IRAs.

Where a distribution includes property and exceeds the rollover contribution, the participant, following a sale, may irrevocably designate the portion of the money received, and the portion of the proceeds of the sale, that are to be treated as included in the rollover and the portions that are to be deemed attributable to nondeductible employee contributions, if any. If the taxpayer fails to make a designation, allocations will be made on a ratable basis.⁹ Under the basis recovery rules of IRC Section 72(e), nondeductible employee contributions are recovered first from amounts not rolled over.¹⁰

The IRS determined that a mistaken transfer by a broker of an otherwise eligible rollover distribution from a qualified plan into a brokerage account and then into an IRA failed to qualify as an eligible rollover and was includable in the taxpayer’s gross income.¹¹ Taxpayers who were defrauded by their investment advisor of IRA distributions intended to be rollovers were not permitted to replace the stolen assets from other funds and treat the replacement assets as rollover contributions.¹²

The maximum amount that may be rolled over generally is the amount that would be includable in income if not rolled over.¹³ After-tax contributions can be rolled over from a qualified plan to a traditional IRA or transferred in a direct trustee-to-trustee transfer to a defined contribution plan provided the plan separately accounts for after-tax contributions. After-tax contributions, including nondeductible contributions to a traditional IRA, may not be rolled over from a traditional IRA into a qualified plan, Section 403(b) tax sheltered annuity, or eligible Section 457 governmental plan.¹⁴ Rollover amounts will be treated as first consisting of taxable amounts.¹⁵

Unless a rollover is carried out by means of a direct rollover, a rollover generally must be completed within 60 days after receipt of the distribution ( Q 4016).¹⁶ The IRS has the authority to waive the 60-day requirement where failure to waive it would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to the requirement.¹⁷ The IRS has provided guidance on the requirements for a hardship waiver of the 60-day requirement.¹⁸ See Q 4017 for a discussion of the new self-certification process that may allow a taxpayer to obtain a waiver of the 60-day time limit.

Unless a rollover is carried out by means of a direct rollover, the distribution amount will be subject to a mandatory income tax withholding rate of 20 percent ( Q 4001, Q 4004).¹⁹

Rollover contributions may be divided among several traditional IRAs.²⁰ These may be either existing plans or plans newly created to receive the rollover ( Q 4008). A traditional IRA inherited from someone who died after 1983, other than a deceased spouse, generally is ineligible to receive a rollover. If an individual retirement annuity is used, it may not be an endowment contract. Although property may normally be rolled over, a rollover to a traditional individual retirement account may not include a retirement income, endowment, or other life insurance contract because IRC Section 408(a)(3) prohibits investment of individual retirement account funds in life insurance contracts.²¹ A rollover may be made from a qualified plan even though the participant is an active participant in another plan.

See Q 3999 for the new rules that allow a taxpayer to roll pre-tax and after-tax contributions into separate accounts in a single distribution.