There are many reasons in the course of our lives that we might consider doing a retirement account rollover. And while we tend to think this is a routine matter, if done incorrectly, there can be huge negative financial implications.
There are two ways to rollover a retirement account:
- Direct rollover. Whether it’s a 401k, 403B, IRA or other retirement account, with a direct rollover, you simply request your existing trustee (or custodian or brokerage firm) to roll your funds over directly to another custodian account in your name that is also a qualified retirement account. This avoids any taxable gain associated with the transfer.
- ’60-Day Rule’ rollover. The IRS allows you to have your retirement plan cut a check payable directly to you personally and if you take those funds and deposit them into another qualified retirement plan (IRA) within sixty days, you’ll suffer no tax consequences.
All the potential trouble happens when someone uses the 60-Day Rule rollover approach. So why would anyone do this versus a trustee-to-trustee transfer? One reason is that folks feel it gives them the opportunity to use their money personally for the sixty days before they have to redeposit back into a retirement account. Unfortunately, in too many cases, they miss the deadline and face potentially disastrous income tax consequences in the form of ordinary income on the entire account. This mistake is easier to make than you might think. For one thing, you only are allowed to do one of these types of rollovers every twelve months. Note that I didn’t say one per calendar year, it’s one per 365 days. Say for example, you have your company retirement account paid directly to you with the intention of using the funds personally for a few weeks but redeposit the money into an IRA within sixty days. So far, no problem. However, if, within 365 days, you did a similar rollover with a different IRA account, that second rollover is not valid and the proceeds would be subject to ordinary income. This is an easy mistake to make.
How bad is the 60-Day Rollover Rule problem? It’s bad enough that the IRS has developed a ‘self-certification procedure’. If you violate the 60-Day Rule and fall under one of the eleven exceptions, you can revalidate the rollover. The IRS has created a model or template ‘self-certification letter’ that you complete and provide to your custodian. The eleven valid reasons for missing the deadline include:
- Your financial institution made an error;
- The distribution check was misplaced or never cashed;
- Distribution check was deposited into an account the taxpayer believed was a rollover account;
- Taxpayer’s residence was severely damaged;
- Member of taxpayer’s family died;
- Taxpayer or member of taxpayer’s family was seriously ill;
- Taxpayer was incarcerated;
- Restrictions were imposed by a foreign country;
- Postal error occurred;
- The distribution was made on account of a levy under Section 6331 and the proceeds of the levy have been returned to the taxpayer;
- The party making the distribution delayed providing information that the receiving plan or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain the information.
The simple solution to this potential problem is to always do direct transfers via trustee-to-trustee rollovers.
If you’d like to have me answer your financial question email me at firstname.lastname@example.org and place AL.com in the subject line. Consult your own professional legal, tax or financial advisor before acting upon this advice.