IRA Rollovers vs. Transfers - Part III

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IRA Rollovers vs. Transfers, Part III
The Rules

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By Roy Lewis

In Parts I and II of this series we discussed IRA rollovers and transfers in general, the similarities and differences between the two, some of the traps and pitfalls, and even some tax-planning strategies. If you haven't yet read Parts I and II, I encourage you to do so now. Much of what I'll discuss here requires the background of the previous articles to make sufficient sense.

The 20% Withholding Rule

One of the biggest problems with taking a distribution from a qualified plan (such as a pension/profit-sharing plan, 401(k) plan, or a 403(b) plan) and then completing a rollover is the mandatory 20% withholding rule. You see, Uncle Sammy isn't too keen on letting you have these funds without taking a little chunk for himself in the form of 20% withholding. To avoid the mandatory withholding, you need to have the funds transferred directly into your new IRA rollover account (or take the check payable to the new IRA custodian, FBO you). Performing a trustee-to-trustee transfer will avoid the 20% withholding.

So, what's the problem with the 20% withholding besides the obvious? Remember that, to avoid taxes and penalties on an early distribution, you must roll over the total amount of the funds that you effectively receive. If Uncle Sammy takes 20% out in withholding, those are funds that you will have to "replace" from somewhere else to avoid taxes and penalties on that portion of the distribution that was not rolled over. Just because you didn't get the 20%, doesn't mean that you are off the hook for rolling those funds over to get out of any tax and penalty problems. In effect, you received the entire distribution and then "elected" to have 20% withheld... to be applied against future taxes.

Example #1: Bob, age 35, leaves his employment and informs his qualified plan administrator to send him a check for $30,000 -- which represents the balance in his retirement plan. Bob intends to make a rollover of those funds into an IRA account. When Bob receives his check, he finds that the check is for $24,000, and that $6,000 was turned over to the IRS in the form of withholding. Bob then takes his $24,000 net check and opens up an IRA rollover account with his new IRA custodian.

What has Bob really done, at least in the eyes of the IRS? He has taken a distribution of $30,000. He has rolled over only $24,000. He therefore has a shortfall of $6,000 which was not rolled over, and which will be subject to taxes and early distribution penalties. What could Bob have done instead? Well, he could have pulled $6,000 out of his personal account and added it to the $24,000 so that the complete $30,000 amount was rolled over. But, it could be a bit of a hardship to come up with those funds. Not only that, remember that Bob only has 60 days to complete a valid rollover, so he'll have to get those funds in a hurry.

What normally happens is that Bob rolls over the $24,000 and believes that he has made a full and complete rollover (that's all the money he really got, right?). Then, when the end of the year rolls around, and Bob receives a Form 1099R for the total of $30,000, the bells and whistles begin to go off. And usually, by that time, the 60-day time period has long since expired. If that happens, Bob is just stuck... with an empty feeling in the pit of his stomach and his wallet.

Bob could have avoided all of this with a trustee-to-trustee transfer. Instead of taking the funds, Bob could have advised his pension plan administrator to forward the entire $30,000 directly to his new IRA custodian. That's what would have happened, and there would be no 20% withholding on the transfer. Bob would have completed a qualified transfer of the funds and would not be liable for any taxes or penalties.

For this very reason, it is usually always better to make a trustee-to-trustee transfer of your qualified funds to your new IRA custodian rather than taking the funds personally (less the required 20% withholding) and trying a rollover.

And, please remember that the 20% withholding is not a tax, just a source of withholding. If you are saddled with a premature distribution, your actual tax and penalty liability will almost certainly be greater than the puny 20% withheld. Think about it, if you are in the 28% tax bracket and you are also hit with a 10% early distribution penalty, do you think that the 20% withholding will cover the entire amount? Hardly. You'll be about 18% short. So, please don't think that, just because there was money withheld from your retirement distribution, your taxes are "covered." In virtually all cases, nothing could be further from the truth.

Finally, there are distributions not subject to the 20% withholding rule. They include:
  1. Distributions that do not qualify to be rolled over (such as "post-tax" distributions from a 401(k) or retirement plan).
  2. Distributions from an IRA.
  3. Distributions of $200 or less.

Other Rollover Rules

As we have previously discussed, you have 60 days from the receipt of the funds to make a qualified rollover. It is always safe to use the date that the distribution check was issued to begin the clock running on the 60 days. But, if there is a big difference between the check issue date and the date that you received the actual funds, make sure to keep any and all proof of when you actually received the funds (such as the envelope and/or the delivery record). You might find that these records come in handy if you ever have to prove that you complied with the 60-day requirement.

If the distribution is not rolled over within the 60-day period, it is taxed on the date that it was received and not the 60th day after withdrawal.

Example #2: Mary receives her distribution check in December of 2000 and decides not to make a rollover. Although her 60 days expires in the year 2001, she will have to report the distribution on her 2000 income tax return.

In a rollover from one IRA to another, the same type of assets must be rolled over. This means that you can't take a stock distribution from IRA #1, sell it, and then try to roll over cash to IRA #2. Likewise, you can't take a cash distribution from an IRA, purchase stock, and then use the stock to complete the rollover into IRA #2. You must roll over the cash first, and then purchase the stock through the IRA account.

The rules are a bit different for distributions from qualified plans (like an employer's 401(k) or similar plan). When a distribution from an employer's qualified plan contains property other than cash, for it to qualify for rollover treatment one of two things has to happen. Either the property itself must be rolled over, or the property must be sold and the proceeds from that sale must be rolled over into the new IRA. You may not retain the property and substitute other funds to complete the rollover.

I hope that this series of articles dealing with IRA rollovers and transfers has helped you understand how they actually work, and has given you some food for thought when dealing with your own rollover/transfer issues. But please remember that the rollover/transfer rules can get pretty complicated, so make sure you read IRS Publication 590 for more complete information. As always, should you have any questions or comments regarding this or any other tax matter, you can always direct them to me in the Tax Strategies discussion folder.
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