We often hear the term “rollover” in connection with retirement accounts.
People frequently rollover money from one retirement account to another.
But as casually as the word rollover is used, there are actually two types, direct and indirect. And which one you use will be more important this year – and from this point forward – than it is ever been in the past.
What is an Indirect Rollover?
An indirect rollover is when you transfer money from one retirement trustee to another, but the money passes through your hands in between. For example, an indirect rollover is one in which the funds from your former employer’s 401(k) plan are first sent to you personally, after which you then move over into an IRA account.
Under IRS rules, it is permissible to do this, as long as you complete the transfer within 60 days, from beginning to end. So if one trustee issues your check on March 1, you’ll have to complete the transfer of the funds into the new trustee account no later than April 30.
Failure to do so within 60 days will require that you report the transfer as a distribution from the first plan.
That will mean that you will have to include the amount of the transfer-turned-distribution as ordinary income on your tax return, which will then also be subject to the 10% early withdrawal penalty tax.
Sometimes an indirect transfer is arranged because the taxpayer doesn’t understand the difference between a direct transfer and an indirect one. Other times it happens because the taxpayer has short-term plans for the money, before completing the transfer to the new trustee.
Up until 2014 you were permitted to do one indirect rollover from each retirement account that you owned. However, in 2014 the Tax Court ruled that you can’t make a non-taxable rollover from one IRA to another if you have already made a rollover from any of your IRAs in the preceding 1-year period, so there’s a change for 2015.
We’ll get to that in a bit…
A Direct Rollover is the Preferred Route when Moving Any Retirement Money
A direct rollover is not only the more common way to move retirement money, but it’s also the safest from a tax standpoint.
A direct rollover is just what the name implies, money leaves one retirement account and goes directly to another. It is a trustee-to-trustee transfer, where the money never touches your hands or your bank account. This is the safest – and therefore preferred – way to move any retirement money.
For tax purposes, the IRS doesn’t even consider a direct rollover to be a rollover at all. As a result, there is no limit to the number of direct rollovers that you can do in a given year, and that won’t change going forward.
Let the Receiving Trustee Do the Legwork!
If you are going to arrange a direct rollover, the easiest way to do it is to simply contact the new trustee. They will request the necessary information to accomplish the transfer, and contact your current trustee to arrange the transfer.
This will save you the trouble of having to contact both trustees, and get more involved in the rollover than you need to be. And the more that is done between the two trustees, the less chance there is to trigger events that might turn your rollover into an unintended distribution, and all the problems that that will bring.
New for 2015
Okay, so far we’ve talked about what people have done in the past – as in up until 2014 – particularly as it relates to indirect rollovers. But be advised that the rules have changed for 2015 and subsequent years.
Where the IRS formerly permitted you to do one indirect rollover per retirement account, the new rule is that you will be able to do just one indirect rollover per 12 month period.
Got that? Just one.
And not one per year, but one per 12 month period.
That means that if you do one on June 30 of 2015, you won’t be able to do another on January 1, just because we’ve moved into a brand new year. The 12 month rule means that you will not be able to do another indirect rollover until July 1 of 2015. It doesn’t matter if you have 15 retirement accounts. You’ll be permitted only one indirect rollover per 12 month period – that’s it.
It gets worse.
If you do the unthinkable, and arrange a second indirect rollover, not only will the full amount of the transfer be taxable and subject to the 10% early withdrawal penalty tax, but you’ll also have to pay a 6% per year excess contribution tax on the of the transferred amount in the new account for as long as the rollover remains in an IRA.
But one thing that hasn’t changed is that you can make an unlimited number of direct rollovers between IRAs, or direct rollovers from traditional IRAs to Roth IRA’s.
You can get more information by checking out IRA One-Rollover-Per-Year Rule from the IRS.
A Working Example of an Indirect Rollover Gone Wrong
Let’s say that you were to take $20,000 out of an IRA with Vanguard, and decide that you want to move $10,000 to an existing IRA account with E*TRADE, and $10,000 to a brand new IRA with Betterment. For what ever reason, you have Vanguard send a check for $20,000 directly to you, maybe because you haven’t yet opened up the account with Betterment, so you want to hold the cash for a while, and you know you have 60 days to do it.
But this is where the new one-per-year indirect rollover limit becomes ugly.
You may assume that splitting the money between the E*TRADE account and the soon-to-be-opened Betterment account constitutes a single rollover, since all of the funds in the transfer came out of a single IRA with Vanguard.
The IRS won’t see it that way.
They will consider the transfer of money into E*TRADE and Betterment as representing two separate indirect rollovers. As a result, one of the rollovers – probably E*TRADE – will be considered an allowable rollover, while the second will be regarded as an early distribution. That of course will subject you to including $10,000 as ordinary income in the year the transfer is made, as well as the 10% early withdrawal penalty tax.
And if you go ahead and transfer the money into an IRA account with Betterment anyway, you will then be subject to the 6% excess contribution tax for as long as the rollover money is in an IRA account.
Now let’s say that you have already taken the $20,000 out of Vanguard before you read this article. So you put $10,000 into the E*TRADE account as planned, but then redeposit the remaining $10,000 back into the Vanguard account to avoid all the tax problems.
We can probably say that if you get into such a situation, the best strategy would be to simply pocket the second $10,000 as non-retirement money. You’d have to pay regular income tax on the distribution, plus the 10% penalty. But you won’t be subject to the 6% excess contributions tax for the rest of your natural life, since the rollover won’t be sitting in an another IRA somewhere.
This is complicated stuff, so if you find yourself in a situation like this, you need to talk to a CPA as soon as possible.
In fact, you should talk to a CPA before even considering doing an indirect rollover at any time.
Best Advice: Pretend That the Indirect Rollover Doesn’t Exist!
Given the magnitude of the tax consequences, as well as the lack of options, the best overall strategy is to use the direct rollover method anytime you want to move money between retirement accounts.
Forget that the indirect rollover method even exists. If you try it and make a mistake, things will get ugly in a hurry.
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