IRA Rollovers vs. Transfers - Part II

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Tax Center / Retirement Tax Issues

IRA Rollovers vs. Transfers, Part II

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By Roy Lewis

In Part I, we took a brief look at IRA rollovers. Now, we'll look at transfers. If you haven't yet read Part I on this subject, please take the time to review it now, since much of this article builds on the foundation set in Part I.

A transfer is similar to a rollover in that either all or part of the funds in an IRA are moved to a different IRA. But, unlike a rollover, in a transfer the funds are never in your hands; you never have the ability to use the funds. Transfers are generally done in one of two ways:

  1. The trustee of the old IRA transfers the funds directly to the new IRA trustee. This is usually done via electronic funds transfer, and a paper check is never even issued. This is the reason that a transfer is also called a "trustee-to-trustee" transfer.

  2. The trustee of the old IRA will issue a check and send it to you, but the check will be made payable to the new IRA trustee. For example, say that I want to move my IRA funds to Charles Schwab. The prior IRA trustee may issue a check payable to "Charles Schwab FBO TMF Taxes IRA" and send it to me in the mail. FBO means "for the benefit of." With the check drawn in this manner, it is virtually impossible for me to cash it and use the money for anything. I have to hand it over to good old Chuck Schwab (for my benefit, of course). Because I am restricted in using the funds, this transaction is also considered a transfer, not a rollover.
Because an IRA custodian or trustee always holds the funds, Uncle Sammy does not require the trustee to report IRA transfers on Form 1099R. So, if you make a transfer, don't wait to receive a Form 1099R at the end of the year to prepare your taxes. Chances are that you'll not receive this form. Heck, you don't even have to report the transfer on your tax return.

Transfers are not subject to the "12-month rule" either. You'll recall from Part I that if you move IRA funds via a rollover, you are prohibited from rolling over those funds again for a 12-month period. With transfers, you have no such restriction. If you wanted to, you could make a transfer of your IRA account every month, or even every day, completely without restriction. This is one of the benefits of using a transfer instead of a rollover. In effect, there is absolutely no limit on the number or timing of IRA transfers.

But remember, you certainly are able to "mix and match" rollovers and transfers and keep your nose clean. It works like this:

Example #1: Max takes $50,000 from his IRA account via a check made payable to him. Within the 60-day period that follows, Max either signs over the check to a new IRA trustee or writes a personal check for $50,000 and puts the funds into another IRA account. This is clearly a rollover because Max was able to cash or deposit the check into a non-IRA account for up to 60 days and use the funds. The check was payable in his name only. Therefore, now Max is prohibited from rolling these funds over again for a 12-month period.

But, there is nothing restricting Max from making a transfer of these funds to a new IRA account. Max might decide, after only a few weeks or months, that another broker would do a better job for him. He cannot do another rollover without tax problems, but he can certainly transfer those IRA funds to the new broker without incurring any taxes or penalties.

However, be careful transferring from a qualified plan -- there's a catch.

Now things get a little murky. You need to know that, if you make a transfer from a qualified plan (like a 401(k) or similar plan at work) to an IRA, the transfer must be considered a distribution and subsequent rollover... even if you never received the funds. This being the case, the employer is required to report the "direct" rollover to you on Form 1099R, and you must be careful not to violate the "12-month rule," as we see in the following example.

Example #2: Sarah leaves her employment. She is due a distribution of $15,000 from her employer's qualified pension plan (which would include a qualified 401(k) plan, 403(b) plan, or profit-sharing plan). Sarah tells the plan administrator to send the pension funds directly to her new broker for deposit into her new IRA account. Sarah never has the ability to use any of the funds. Even so, in this specific circumstance, this transaction is treated as a distribution. The employer will issue Sarah a Form 1099R at the end of the year, she will be required to report this "rollover" on her tax return, and she will be required to follow the 12-month rule with respect to any subsequent rollovers out of the new IRA account.

But, as noted above, Sarah can still make any number of transfers that she deems prudent without imposition of taxes or penalties.

Should I or Shouldn't I?

Generally, it's sound advice for employees leaving a job to rollover or transfer funds from a 401(k), 403(b), or profit-sharing plan into an IRA (or eventually to another qualified plan via a "conduit" IRA). Doing that allows you to avoid taxes and penalties on the distribution, and allows you to invest those funds Foolishly while they grow in a tax-deferred manner.

But, there are exceptions. If the qualified plan includes stock contributed by your previous employer that has appreciated substantially, it may be in your best interests to take a taxable distribution of the stock and rollover/transfer the remaining funds into an IRA. Why? Because you can receive long-term capital gains treatment (and a preferred tax rate) on the appreciated portion of the stock. Here's the deal:

Example #3: 500 shares of ABC stock, currently valued at $100 a share, were valued at $25 a share (or $12,500) when they were contributed to Rick's 401(k) plan by his employer. If Rick leaves his employment, he can either rollover/transfer these funds to an IRA or he can elect to take a distribution of the 500 shares and pay income tax and a 10% penalty (assuming an early distribution).

Why would he do that? The ordinary income tax rate and penalty only apply to the value of the shares when they were originally contributed to Rick's account, which was $12,500. The capital gain (the stock's appreciated value minus the $12,500 cost basis) is then taxed at preferred long-term capital gain tax rate.

If Rick makes a rollover, he will be taxed at his ordinary income tax rate on any future distributions from the IRA account. But, if Rick decides to pay the tax and penalty on the original contribution value of the stock now, he only has to pay the long-term capital gains tax rates on the appreciated value of the securities (most of the money, in this case), which will probably be substantially lower than Rick's income tax rate.

In this example, let's say that Rick sells the shares for $120 a share ($60,000 total). That would be a gain of $47,500 (since his "cost basis" would be the original $12,500 value the stock had when his employer gave it to him... the amount that he originally had to report as income). But, this gain would be taxed at a preferred long-term capital gains rate of 20% (or perhaps even lower, at least partially). This could be a significant tax savings for Rick compared to paying regular income tax rates on the money when he withdraws it from his IRA, and it is certainly something that he should consider when planning his retirement distribution from his prior employer.

While this strategy is not right for everybody, it is something that you should be aware of and at least consider when making your retirement/rollover/transfer choices. You can read more about the rules surrounding this strategy in IRS Publication 575.
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