IRA Rollover Loophole Soon To Be Plugged

IRA Rollover Loophole Soon To Be Plugged

The IRS wants to make it easy for you to set up and maintain IRA accounts.  Part of that strategy involves keeping your IRA accounts at whichever qualified custodian you prefer.  Should you become unhappy with the costs or services provided by one custodian, the IRS allows you to move some or all of the assets in the IRA account to an IRA account at another custodian anytime you wish.  You have to be careful, however, to avoid any potential tax consequences – such as the IRS recognizing the distribution as a taxable withdrawal – when transferring IRA assets.  The easiest and safest form of rollover is called a direct trustee-to-trustee rollover, where one custodian electronically transfers the assets to an account at the new custodian.  Since all custodians may not have the technology to transfer assets in this way, the IRS allows an alternative transfer method (which applies only to cash) in which the first custodian sends a check to you, and then you contribute an equivalent amount to another IRA account at the new custodian.  If you fail to make the contribution within 60 days, the IRS considers the withdrawal from the first custodian as a distribution, subject to taxation as well as any penalties that might apply.

Taxpayers are forever attempting to game the system, and IRA transfers are no exception.  It didn’t take long for people to figure out that you could utilize this cash transfer mechanism to create a perpetual loan from your IRAs by constantly withdrawing cash, replacing it within 60 days, then withdrawing it again.  The IRS had never intended for taxpayers to be able to repeatedly move funds in and out of their IRAs on a tax-free basis.  So not long after introducing the IRA, the IRS added a new limitation: only one transfer per year is allowed between IRA accounts.  This reduced the scope of such practices but of course did not eliminate them.  One of my clients, in fact, utilized this capability several years ago in order to get a short-term loan to close on a vacation home because her bank mortgage was taking too long to fund.

IRS Publication 590 had always stated that if an individual has more than one IRA, the rollover rule applies separately to each IRA.  And the general interpretation of “once per year” meant once per calendar year.  However, as a result of a recent U.S. Tax Court decision, the IRS has changed its interpretation of the IRA rollover rule to mean that only one IRA-to-IRA rollover is permitted during a 365-day period from any of an individual’s IRA accounts.  The one year period starts on the day the IRA owner receives the distribution.  This new rule will take effect on January 1, 2015.

If you have an IRA, what should you be concerned about?

The short answer is, probably nothing.  If you want to rollover your IRA to another custodian (e.g. from Fidelity to Pershing), and you utilize a trustee-to-trustee transfer, this rule does not apply.  You can do it as many times as you want (recognizing, of course, that your custodian may impose transfer or closure fees on the accounts).  This rule also does not apply to IRA to Roth transfers (more commonly known as Roth conversions), or from employer retirement plans such as 401(k)s to IRAs.

However, if you are planning to roll over one IRA to another and will be doing it by check, it is very important to follow this 60-day rule.  A violation can have significant tax consequences.  While the IRS has the authority to waive the 60-day rollover rule, it may not waive the once-a-year rule. When this rule is violated, the withdrawn amount is taxable and may be subject to the 10% early distribution penalty.  Even worse, if the IRS denies the rollover, the amount contributed to the new IRA account would be treated as part of your annual IRA contribution.  If you had separately maxed out your IRA contribution for the year, or do not qualify for an IRA contribution, this excess contribution would trigger a 6% excess contribution penalty, and would be applied for every year the excess remains in the account.  You may not even realize that you are incurring this penalty, which could turn out to be a costly burden once discovered.

The IRS constantly faces the need to update rules around tax-qualified plans in order to address the unintended consequences of the originating legislation.  It’s important for you, your tax accountant, and your financial planner to be aware of these changes so that you do not accidentally fall into a tax trap.

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