IRA Rollovers vs. Transfers - Part I

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IRA Rollovers vs. Transfers, Part I

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By Roy Lewis

In the Tax Strategies discussion folder, we often discuss rollovers or transfers from one IRA to another, or from an employer's plan to an IRA, or from a Roth IRA to another Roth IRA. Many people believe that the terms "rollover" and "transfer" are really the same thing. I might have fostered that belief from time to time by using the terms "rollover" and "transfer" interchangeably. But, the truth of the matter is that a rollover and a transfer are two entirely different things. They have different tax treatments and also have different rules that govern them.

Let's start with some basic definitions:

Rollover: Taking receipt of the assets for up to 60 days before reinvesting in a new retirement plan.

Transfer: Moving the assets directly from one custodian to another custodian without taking receipt of the funds.

Example #1: John (age 40) has a traditional IRA. John takes $30,000 of those funds, payable to himself, and intends to open a new IRA rollover account with a new broker. John places the money into his personal bank account for 30 days until he finds a new broker that he is happy with. When John finds his new broker, he writes a check from his personal account to the new broker and establishes a new IRA rollover account. This is an example of a rollover.

Example #2: Jill (age 36) had a 401(k) plan with her old employer. Since she left the company, she now wants to take those 401(k) funds, move them to an IRA account, and manage those funds Foolishly herself. Jill directs the 401(k) administrator to move the funds directly from her old 401(k) account to her new broker. Jill never receives or has any control over those funds. The funds move directly from the old 401(k) administrator to the new IRA account. While Jill might think of this as a rollover, it is really what is known as a "trustee-to-trustee" transfer.

[Note: In some cases, the 401(k) administrator will mail the check to the ex-employee rather than directly to the new broker when a transfer is requested. That is still a "trustee-to-trustee" transfer, as long as the check is drawn in the name of the new broker "FBO" ("for benefit of") the ex-employee (Jill, in this case). Using a real-world example, if the new broker is Charles Schwab, the check should be made out to "Charles Schwab FBO Jill Smith." Jill can deposit this check into her new account, but can't cash it for her own use, and that's the key. If the check is made out just to "Jill Smith," it's not a transfer, it's a rollover like in Example #1.]

You might look at these two examples and say, "Who cares... the result is the same." While the result might be the same, Jill has many more options than John has with respect to the future use, transfer, or rollover of the funds in question. To understand those differences, we must first take a closer look at the rules regarding rollovers and transfers.

Types of Rollovers

From one IRA into another IRA: All or a portion of the funds in an IRA are withdrawn and the IRA custodian makes the check payable to the taxpayer. The taxpayer then deposits the funds into another IRA within 60 days. The good news is that you can use the funds for a 60-day period for your own personal use. The bad news is that you can only make a rollover like this once every 12 months.

Example #3: In Example #1 above, John made an IRA rollover in the amount of $30,000. After only 2 months, John decides that he is not happy with his new broker, and decides to take this $30,000 and move it to yet another new broker. John requests a check from the broker, payable to himself, and begins his search for a new broker. John is now in hot water. Because he violated the "once in 12 months" rule, John's $30,000 distribution will be subject to both income taxes and early withdrawal penalties.

From an employer's plan into an IRA: All or a portion of the funds from an employer's qualified pension, profit-sharing, stock bonus, annuity, or tax-sheltered annuity plan are distributed to the taxpayer. The taxpayer then deposits the funds into a rollover IRA within 60 days of receiving the distribution. This is a common rollover when a taxpayer leaves his or her employment and takes his/her retirement funds out of the employer's plan.

From one employer's plan into another employer's plan: An employee can rollover funds from one qualified retirement and/or deferred compensation plan into another by using a "conduit" IRA. The funds are first rolled over to an IRA as a holding account. Later, these IRA funds can be rolled over into a new employer's qualified retirement/deferred compensation plan (if the plan allows it). Just remember that only funds from the first employer's plan plus the earnings on those funds can be rolled over into the second employer's plan. And, it is very important that the employer does not mix regular IRA contributions or other IRA rollovers with the conduit IRA. If the conduit IRA becomes "tainted" with IRA contributions or other rollover funds, you will lose the ability to move these funds to the new employer's plan.

Example #4: Betty leaves her employment, and wants to take the $10,000 in her company retirement account with her. Betty takes those funds and makes a rollover to an IRA account within 60 days of the distribution. Early in the following year, Betty finds new employment and is told that the new employer will accept her retirement funds from her old employer (keep in mind that not all employer plans will accept these funds). The value of the IRA has grown to $16,000 due to investments she made with the $10,000. Since Betty did not "taint" her conduit IRA with any new IRA contributions or IRA rollovers or transfers from any other sources, Betty can rollover these IRA funds to her new employer's plan without tax or penalty.

This is only the very tip of the iceberg with respect to rollovers. Rollover rules can get pretty complex, and I'll discuss some of those tricky issues in Part II. We'll also be discussing transfers in additional detail.
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