When properly planned, an IRA rollover should be a tax-free (and a trouble-free) transaction. But you do have to follow the rules to keep the tax-deferred status of your IRA assets, or face the consequences of the IRS.
The IRS gives you 60 days to rollover funds from a traditional IRA or a similar qualified account to another traditional IRA or qualified account. If you haven’t completed the rollover within this 60-day window, your IRA rollover essentially becomes a taxable IRA withdrawal. That means the entire amount of the rollover will be subject to taxes at your current ordinary income tax rate. Plus, if you haven’t reached age 59½, you’ll also face a 10% penalty on the withdrawal.
Ouch!
Another rule states that a rollover can only consist of the same property. You cannot take the lump-sum distribution from your IRA, purchase other assets with the cash, then roll those assets over into a new IRA. This violates the same property rule. The IRS would consider the cash distribution from your IRA as income, subject to taxes at your current ordinary income rate plus any applicable penalties.
Here’s an example of how an investor could run afoul of this rule:
A just-retired executive, age 58, has decided to rollover his 401(k) account from his former employer into an IRA. He wants to purchase some shares of the company’s stock with his rollover assets. So, he takes a portion of the funds he has received from his 401(k) account to buy the shares, and places the remainder of the qualified money in a new IRA. Then, he deposits the shares of stock he purchased into the same IRA, in order to maintain the tax-deferred treatment of these assets.
The IRS would view the portion of the 401(k) rollover used to purchase the stock as taxable income, and the investor would owe taxes at his current ordinary income tax rate on this amount. Plus, the IRS would also assess a 10% penalty on this taxable amount because he is younger than 59½.
There’s a relatively easy way to avoid these income taxes and penalties – do a direct trustee-to-trustee transfer.
This will let the IRA and retirement plan custodians do all the work of moving your assets. You don’t have to worry about receiving a lump-sum distribution check and making sure you deposit the funds in a new IRA within the 60-day window. The trustees can also ensure that your assets are transferred in a time efficient manner.
Please keep in mind the services provided by a Trustee may involve costs which can reduce the overall return on your investment.
If you have multiple IRA’s or other qualified retirement accounts and would like to consolidate these assets into one account, we can help you manage the process and make sure it is done as efficiently as possible. Please call our office at 800-960-3499 or send us a message with your questions.
About Eli Mitcham
Husband and proud Dad. I also help investors preserve their capital and protect their retirement against recessions and market crashes (but who really cares about that?)
Here’s a dandy for you. I took a $10k loan on my 401K to help finance the purchase of our first home. I was assured by customer support that if I left that position I’d still be able to repay the loan monthly, they provide a coupon book. This was important since I knew I was going to be leaving that company within two months. And I did. And the load came due, I was not able to repay it in installments. And I did not have the lump sum to pay it back, but it got us our house and I was ok with the penalties. Since this happened in the summer of 2010 I wouldn’t have to worry until 2011 taxes. Early in 2011 I decided to roll it over to an IRA just to be done with that company. Finding out that I couldn’t do a direct rollover because of the defaulted loan (according to the plan supposedly), I opted for a direct deposit, knowing the next day it would be deposited into my IRA. And it was. Afterall I have 60 days to deposit it into a qualified plan. The problem was since this was technically a distribution, there was an enormous amount of taxes withheld, so the direct deposit was roughly 30% of the actual amount of the distribution (don’t forget the 10K loan). I didn’t think twice about it figuring it would all even out at tax time. Big mistake. Not only is all that withholding gone as if it never existed, and even though I deposited every single dime of what was “rolled over” to me, I’m now paying regular income tax on the entire amount. And apparently there’s no recourse. Even though I’m essentially paying taxes on this distribution twice.