For many, finances can be challenging. For some, it’s simply enough to know that an individual retirement account (IRA) has been established. Establishing one may have come early in a work career as part of an employment package, or it may have been set up with money from an inheritance, for example. There are several kinds of IRAs and each comes with its own rules for investing and distributing funds. The best goal is to invest for optimal gains without incurring stiff IRS penalties.
One crucial piece of information which everyone should know about IRAs is that it is possible to take assets from one kind of an IRA and move them into a different kind of account. There are huge IRA rollover rules, however. The way IRAs are rolled over can result in reduced tax payments or present some smart investing options. But if they’re broken, it could lead to IRS penalty payments. It is crucial to learn as much as possible to protect retirement savings from needless penalty payments. The way to do it carefully, is to learn a simple dozen of the most significant IRA rollover rules.
1. An IRA rollover is simply taking the assets from one kind of IRA and moving them to a different kind of account.
The most often used rollover is moving funds from a retirement plan sponsored by a former employer and moving them into an IRA. Moving 401(k) funds into an IRA is a common one. Employees are eligible to take funds (distributions) from a 401(k) when leaving the workplace, but until reaching age 55, paying taxes on the funds is required and a 10% penalty will most likely need to be paid as well. The way to avoid the extra penalty is to roll over the 401(k) funds into a different, yet qualified, retirement plan.
It’s also common to roll over funds from a traditional IRA to a Roth IRA, but these two kinds are taxed differently. With a traditional IRA, there is a tax deduction offered the contribution year, but taxes are paid on distributions. With a Roth IRA, taxes are paid on the contribution year, but no taxes are paid on distributions. Rolling over traditional IRA funds to a Roth IRA will require taxes paid on the distribution but could save taxes in the future.
Because rollover IRAs usually have better investment options and lower fees than 401(k) plans, most experts suggest that it’s better to max out IRA contributions before 401(k) contributions. Of course, maximizing a 401(k) takes contributing enough investments to match the full employer amount offered. It’s common to find 50% matches, dollar for dollar matches, or percentage of salary matches. Whatever the match offered; be sure to contribute enough to a 401(k) to get the highest amount possible.
Assets are typically rolled over “in kind”. This means that bonds, mutual funds, and stocks owned in one brokerage account are rolled over by transferring directly into another brokerage account. There are times when these assets must be first liquidated, sold, and transferred into cash in order to transfer them.
2. There are many kinds of retirement accounts and the IRS specifies which kinds allow rollovers.
The IRS offers a chart with handy rollover information. It’s available at the IRS for study purposes. Two key take-aways from the chart are that rollovers are now irreversible and that rollovers are not two-way options. While tax-deferred accounts can roll over into Roth accounts, it’s not possible to roll Roth accounts into tax-deferred ones. It’s also no longer possible to recharacterize Roth IRA contributions to IRA contributions within the same year. It is always possible to roll over brokerage accounts into the same type of account to achieve better investment options and lower fees in a newer plan or with a new broker. When a retirement plan sponsored by an employee offers better options than a traditional IRA, it’s also possible to roll over an IRA into that retirement plan.
3. The plan administrator must provide a written explanation of IRA rollover options
When leaving the workplace, the plan administrator must provide a written explanation of rollover distribution options if an election to rollover has not yet been made. When no election is made, the plan administrator may deposit into an IRA in the employee’s name, and this amount may be between $1,000 and $5,000. When there is less than $1,000 in the employer-sponsored retirement plan, the plan administrator may withhold 20% taxes from the amount and send a check to the employee for the balance. After the distribution is received, a rollover must be completed within 60 days to avoid a penalty.
4. A few distribution options are not eligible to roll over
At age 70 ½, required minimum distributions (RMDs) are mandatory for traditional IRAs and all tax-deferred accounts, and the RMDs are taxed at that time. Funds which exceed an IRA’s contribution limit are never eligible for preferential tax treatment, so they are not eligible for rollover. Other ineligible rollover distribution options include:
- Distributions of excess contributions and related earnings
- Distributions to pay for life, health, or accident insurance
- A distribution which is one of a series of substantially equal payments
- Loans treated as a distribution
- Required minimum distributions
- Hardship distributions
- Dividends on employer securities
- S corporation allocations treated as deemed distributions
- Withdrawals which elect out of automatic contribution arrangements
5. It’s not mandatory to roll over the entire IRA balance.
In low income years, rolling over some funds from a traditional IRA to a Roth IRA might provide the option of incurring some savings on taxes.
6. The two ways to do an IRA rollover are the direct and indirect rollover.
A direct rollover is rolling over assets from one retirement account to another without touching the funds in person. It can be completed with an in-kind transfer or making a check payable to the new account. The plan administrator is responsible for providing instructions when rolling over employer-sponsored retirement plans. An indirect rollover is rolling over a distribution check from a retirement plan. The plan administrator will arrange for withholding 20% to pay IRS taxes and send that amount directly to the IRS. A trustee to trustee transfer may be implemented where the financial institution holding an IRA can be instructed to make payment directly to another IRA or retirement plan. With this option, switching brokerage accounts or splitting a large IRA into smaller accounts is possible without taxes being withheld from the transfer amount and avoiding the one-per-year IRA rollover rule.
7. There is a same-property rule for rollovers
Basically, this means that the property withdrawn out of an original brokerage account must be the same property contributed as a rollover into a different account. A check distribution must be rolled over with a check contribution. A stock distribution must be rolled over with a stock contribution. If this process is not followed, the IRS considers the distribution as a normal withdrawal rather than a rollover. At that point, taxes must be paid on the withdrawal amount and a 10% early withdrawal penalty may be owed.
8. When multiple IRAs are owned and a distribution is taken, the IRS treats all non-Roth IRAs as if they are one
When reaching age 70 ½, annual required minimum distributions (RMDs) are required. The aggregation rule allows for computing the RMD from each traditional IRA, SIMPLE IRA, and SEP IRA to get a total RMD. Then, it is possible to take the total RMD from all or any of those IRAs in any proportion. The aggregation rule applies to all IRAs.
9. The IRS allows for 60 days to complete an indirect rollover
Indirect rollovers must be completed within 60 days or the IRS will treat the distribution as a regular withdrawal and will charge taxes on the entire amount. Then, the distribution amount may be subject to an additional 10% early withdrawal penalty While indirect rollovers do allow for borrowing IRA funds without interest or penalty, it is mandatory that the rollover be completed within the 60-day time period. Depending on the distribution amount, not completing the rollover on time could result in a huge penalty paid to the IRS.
10. There is a one-rollover per year limit for certain types of IRAs
When rolling over funds from traditional IRAs, SEP-IRAs, or SIMPLE IRAs to another account of these types, eligibility for rollovers is limited to once per 12 months and it doesn’t matter how many brokerage accounts are owned. This rule doesn’t apply to rollovers from tax-deferred IRA accounts to Roth IRA accounts or rollovers from or to retirement plans sponsored by employers. Breaking this rule will create an early withdrawal 10% penalty and taxes paid on the distributions for every rollover after the first. Penalties may also be charged for overcontributing to an IRA when funds are not eligible for rollover.
11. Inherited IRAs have specific rules for rollovers
When inheriting a spouse’s IRA, the assets of the inherited IRA may be rolled over into a named brokerage account so that the surviving spouse can treat the assets as their own. In the case of an inherited IRA, the individual inheriting the account can claim as the beneficiary, take the RMD, and pay the taxes owed on the distribution without penalty even if the distribution takes place before the beneficiary is age 59 ½.
12. Employer-sponsored retirement plan funds can be rolled over
It is typical that employees must separate from service to become eligible for taking distributions from retirement plans sponsored by employers for the purposes of rolling over the funds into an IRA or chosen account. But if the employer offers in-service withdrawals, it is possible to roll over the funds to an IRA.
Written by Judy Greenless
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