Common IRA Rollover Mistakes to Avoid
by Cathy Pareto, MBA, CFP®
If you don’t know the rules of the game, it’s easy to get fouled out, and when it comes to IRA Rollovers, those fouls can cost you big money if you are not careful. It’s inevitable, at some point or another we might ditch one provider, advisor or fund company for another. Or we may leave one job for a new one or simply retire. If you are planning to, or have already initiated an IRA Rollover, watch out for these common mistakes, because one misstep can cost you dearly.
So what is a Rollover IRA? A rollover IRA is a special type of IRA that is used to receive distributions from an employer sponsored qualified plan, such as 401k, 403b, defined benefit or profit sharing plans.
60 day Rule: Whether you’re rolling over a company retirement account or IRA assets, you have a maximum of 60 days in which to complete the rollover to another IRA if the distribution is made directly to you, instead of the rollover IRA account. Failure to complete the rollover in this time frame will result in taxes and possibly penalties. Specifically, you must include the amount of the distribution as ordinary income on your taxes, and if you are younger than 59 ½ you also get sacked with a 10% penalty on the withdrawal.
Any rollovers you make involving a traditional IRA must be reported on your tax return for the year the distribution is made. Your financial institution will typically issue a 1099R documenting the distribution, and the receiving financial institution will issue a form 5498 documenting the receipt of the funds in the new account.
One Year Waiting Rule: You may not make another rollover from the same IRA to another IRA if you have already conducted a rollover (full or partial) from that same IRA account. The exception to this rule is a distribution from an employer sponsored qualified plan.
Same Property Rule: IRA Rollovers from one IRA to another must consist of the same property. Specifically, this rule prohibits your ability to take a distribution from your IRA and purchase other assets with that cash, only to later deposit the newly acquired assets into another IRA. The IRS frowns upon this transaction and will consider this as a cash distribution, which of course, will cause a taxable event.
Hands down, the most effective way to avoid IRA transfer blunders is to request “trustee-to trustee” transfers. This simply means is that the financial institution holding your IRA assets will provide directions on how to transfer those assets to an IRA directly to another financial institution. This bypasses the need for you to take possession of the funds (ie. receive a check payable to you). In most cases, the transfers can be electronically sent directly to the new firm or Fund Company. In other instances, a check may be sent to the investor, but payable to the new provider or custodian for your benefit (ie. check payable to Fidelity FBO John Smith).
Frankly, the “trustee-to-trustee” method this is the easiest way to transport your money from one bucket to the next if you are merely moving your IRA from one custodian to another. A “transfer” is not necessarily considered a “rollover”, can be done an unlimited number of times, and is not reported as a distribution, which therefore exempts you from the one year waiting rule.
Not All Rollovers are Created Equal
Pay particular attention to rollovers from employer plans like the 401k. Rollovers are slightly different than “direct rollovers”. Company 401k direct rollovers allow you to transfer your retirement funds directly over to your new employer’s retirement plan or into a rollover IRA plan as a trustee to trustee transfer. With a 401k direct rollover, a retirement distribution check is directly made payable to your new qualified retirement plan or custodian. Conversely, with an indirect rollover, your 401k plan proceeds are distributed to directly you, but the law requires that the plan administrator withhold 20% of your funds in an indirect rollover which is sent directly to the IRS. This means, that in order to satisfy the 60 day rule, you’d have to deposit not only the check proceeds from the 401k, plus the money withheld for taxes! Ouch.
The bottom line is this, when it comes to rollovers, you better know your stuff–or at least have the proper oversight with a competent advisor. The IRS is just waiting for you to botch the transaction so they can collect their precious taxes and penalties. That could spell disaster for you, both in terms of taxes and the wasted opportunity to grow your IRA’s on a tax deferred basis. So, before you roll….do your homework.