Many taxpayers transfer money from one pension plan or IRA account to another. This is known as a “rollover” and is generally not subject to tax. There are, however, several potential problems that taxpayers should know about. In this article I will refer to all such accounts as IRAs, but this information applies to all pension plans such as SEP, SIMPLE, 401(k), 403(b), etc.
Types of rollovers
There are two fundamental types of rollover that can occur.
In a direct rollover, the money or securities held in old IRA account are transferred directly to the new IRA account, without ever being in the possession of the taxpayer. At the end of the year, the old IRA account issues a form 1099-R (withdrawal from IRA) which indicates, under type of withdrawal, code “G”, direct rollover. Therefore, the IRS immediately knows that this was a rollover. The rollover still has to be reported on the tax return.
In an indirect rollover, the money or securities held in old IRA account are sent to the taxpayer, who then has 60 days to redeposit them into a new IRA account. If the money is redeposited within the 60 days, the rollover is considered valid. At the end of the year, the old IRA account issues a form 1099-R (withdrawal from IRA) which indicates simply that the money was withdrawn. Therefore, the IRS doesn’t know if this is a withdrawal or a rollover. The fact that this is a rollover is indicated on the tax return, but the IRS has no separate proof that it wasn’t a withdrawal.
Audits of indirect rollovers
The first issue with indirect rollovers is that the IRS doesn’t automatically know it was a rollover. Therefore, this is a frequent audit item. In a typical year we see 3-10 audits on indirect rollovers, in which the IRS requires the taxpayer to prove the money was redeposited within 60 days. While this is not hard, the correct paperwork is sometimes hard to find. The taxpayer needs to show a statement from the old IRA showing the amount and date of withdrawal, and a statement from the new IRA showing the amount and date of deposit.
Some potential pitfalls: The documents in the possession of the taxpayer sometimes don’t have all of the required information, and may be difficult to get, especially from the old IRA which no longer cares about a former client. Money may not have been transferred simultaneously – for example, the taxpayer may have withdrawn $20,000 from IRA 1 and $10,000 from IRA 2, and then deposited all $30,000 into IRA 3 (see below for other problems with this). This makes it difficult to match up the amounts.
Annual limit on indirect rollovers
There has always been a rule limiting taxpayers to one indirect rollover per year. As this was applied in the past, it meant that if you move money from IRA 1 to IRA 2, you can’t move that money again for a year, but you can move money from IRA 3 to IRA 4.
Recently, the IRS policy has changed. The limit is now one indirect rollover, of any kind, per year. This policy is set to take effect as of Jan 1, 2015, but in at least one case the IRS has already denied a rollover and assessed penalties for exceeding this limit.
Conclusion
Avoid indirect rollovers. In almost all cases a direct rollover is possible. When moving pension funds, insist that the broker handling the transfer perform a direct rollover. Be careful with this, and make sure they use the term “direct rollover”. In some cases, the broker has the old IRA issue a check in the taxpayer’s name, but mail it to the broker who deposits it into the new IRA. While this looks like a direct rollover, the fact that the check was issued in the taxpayer’s name means it’s an indirect rollover in the eyes of the IRS.
If you absolutely must do an indirect rollover, make sure you have paperwork showing the required information. This means you need 4 pieces of information: 1) date of withdrawal, 2) amount of withdrawal, 3) date of deposit, 4) amount of deposit. Ideally, items 1 and 2 will be on one piece of paper and items 3 and 4 will be on another. The amounts need to match, and the dates need to be within 60 days of each other.
If you are planning a rollover, or have already performed one and are concerned about the tax implications, please give us a call. There are these and other pitfalls for the unwary, and we’ll be happy to help avoid them.
