8.10 Tax-Free Rollovers and Direct Transfers to Traditional IRAs
There are two types of tax-free rollovers that you can make to a traditional IRA. You may roll over funds to a traditional IRA from a qualified company or self-employed retirement plan, 403(b) plan, or governmental 457 plan (7.8). If you own a traditional IRA, you may use a rollover within 60 days of receiving a distribution to switch funds to another trditional IRA, although another option, a direct transfer, is a more advantageous way of changing IRA investments, as discussed below.
Inherited IRA. A surviving spouse beneficiary who withdraws funds from an inherited IRA can do a 60-day rollover (see below), but a nonspouse beneficiary cannot roll over a withdrawal. However, a nonspouse beneficiary as well as a surviving spouse beneficiary can make a direct trustee-to-trustee transfer to another traditional IRA (8.14).
Direct transfer from one IRA to another.
A direct transfer is made by instructing the trustee of a traditional IRA to transfer all or part of your account to another IRA trustee. Direct transfers are tax free because you do not receive the funds. With a direct transfer, there is no risk of missing the 60-day deadline for rolling over a withdrawal into a new IRA. The tax law does not require a waiting period between direct transfers, whereas rollovers are subject to a once-a-year limitation, as discussed below.
For example, assume you have a traditional IRA at Bank “A” and decide to switch your account to Mutual Fund “ABC.” The mutual fund will provide you with transfer request forms that you complete and return to the fund, which will then forward the forms to the bank to complete the direct transfer. The transfer from the bank to the mutual fund is tax free. Because the IRA funds were not paid to you, the transfer is not considered a rollover subject to the once-a-year rollover limitation. This means that if within one year you become unhappy with the performance of Mutual Fund “ABC,” you may make another tax-free direct transfer of your IRA to Fund “XYZ” or to Bank “B.”
Rollover within 60 days.
If you withdraw funds from your traditional IRA, you have 60 days to make a tax-free rollover to another traditional IRA. The amount you receive from your old IRA must be transferred to the new plan by the 60th day after the day you received it. Amounts not rolled over within the 60-day period must be treated as a taxable distribution for the year you received the distribution (not the year in which the 60-day period expired, if that is later) and the 10% penalty for a distribution before age 59½ applies unless an exception (8.12) is available.
The IRS may waive the 60-day rollover deadline on equitable grounds if a distribution cannot be rolled over on time because of events beyond your reasonable control, such as illness, natural disaster, or a financial institution’s error; see the IRS waiver guidlines below. An extension to the 60-day deadline is also allowed if your distribution is “frozen” and cannot be withdrawn from an insolvent or bankrupt financial institution; see below. The deadline is extended to 120 days if a distribution is taken to buy or build a qualifying “first home” and the deal falls through; see below.
Once you complete a rollover between traditional IRAs, you must wait one year before you can roll over the same funds; see below.
Planning Reminder
IRS may waive 60-day rollover deadline on equitable grounds.
The IRS has discretion to waive the 60-day deadline for completing a rollover if failure to do so was due to events beyond your reasonable control and failure to waive the deadline would be against “equity or good conscience.”
The IRS will automatically waive the deadline if: (1) you deposit the rollover funds with a financial institution within the 60-day period, (2) you follow all of the institution’s rollover procedures but the rollover account is not established on time solely because of the institution’s error, and (3) the funds are actually deposited in a valid rollover account within one year of the start of the 60-day period.
In other hardship situations not eligible for the automatic waiver, you must apply to the IRS for a waiver by requesting a private letter ruling and paying the required user fee. You must show that failure to meet the 60-day deadline was beyond your reasonable control, such as where you were disabled, hospitalized, or there was a natural disaster, postal error, or error by the financial institution other than one qualifying for an automatic waiver. The IRS will take into account the length of the delay and whether you cashed a distribution paid to you by check.
For example, the IRS issued a private ruling allowing a waiver to a taxpayer whose IRA funds were stolen by his investment advisor. Without a rollover, the advisor’s withdrawals would be treated as taxable distributions to the taxpayer. Since the taxpayer did not learn of the misappropriation until after the 60-day rollover period expired, a waiver was requested. The IRS agreed that not granting a waiver would be inequitable and it gave the taxpayer 30 days from the date of the ruling to make a cash rollover of the misappropriated amount.
However, the IRS has denied waivers to taxpayers who use an IRA distribution as a short-term loan to pay personal expenses but are unable to put back the funds into an IRA within 60 days. For example, an unemployed taxpayer withdrew money from his IRA to pay his mortgage and avoid a threatened foreclosure of the home. After he was turned down for loans by numerous mortgage companies, his mother borrowed against her home and loaned him the funds, which he redeposited into his IRA, but 102 days had passed since he received the distribution. The IRS in a private ruling denied his request for a waiver of the 60-day rollover deadline.
Filing Tip
The once-a-year rollover rule applies separately to each of your IRAs.
A tax-free rollover may occur only once in a one-year period starting on the date you receive the first distribution. If within that one-year period you receive a distribution from the previously rolled over IRA, the distribution is taxable and if you are under age 59½, could be subject to the 10% penalty for premature distributions (8.12). However, this rule applies separately to each of your traditional IRAs. For example, you have one traditional IRA invested in a bank and another invested in a mutual fund. Within the same one-year period, you may roll over the bank IRA to a different traditional IRA and you may also roll over the mutual-fund IRA to a different traditional IRA. However, neither of the new IRAs may be rolled over again within the one-year period starting on the date that you received the distribution from the original traditional IRA.
There is an exception to the one-year waiting period between rollovers if the second distribution is made from an insolvent financial institution by the FDIC (Federal Deposit Insurance Corporation) acting as receiver. The exception applies only if the receiver makes the distribution to you because it is unable to find a buyer for the insolvent institution.
Note: A direct transfer may be used as discussed above if you want to invest in another IRA within the one-year period.
Deposits in insolvent financial institutions.
The 60-day limit for completing a rollover is extended if the funds are “frozen” and may not be withdrawn from a bankrupt or insolvent financial institution. The 60-day period is extended while the account is frozen and you have a minimum of 10 days after the release of the funds to complete the rollover.
If a government agency takes control of an insolvent bank, you might receive an “involuntary” distribution of your IRA account from the agency. According to the IRS and Tax Court, such a payment is subject to the regular IRA distribution rules. For example, a couple received payment for their $11,000 IRA balance from the Maryland Deposit Insurance Fund after the bank in which the funds were invested became insolvent. The Tax Court held that the payment was taxable, even though the distribution was from a state insurance fund and not from the bank itself. Furthermore, since they were under age 59½, the 10% penalty for early distributions (8.12) was imposed, even though the distribution was involuntary. The tax and penalty could have been avoided by making a rollover of the distribution within 60 days, but this was not done.
120-day rollover period after failure to acquire “first-time” home.
A “first-time” homebuyer may be able to limit or avoid a 10% penalty for a distribution before age 59½ by using the funds within 120 days to help buy, build, or rebuild a principal residence (8.12). If the requirements of the exception cannot be met because the planned purchase or construction of the home falls through, the law allows the taxpayer to return the distribution to an IRA within 120 days after receiving the distribution. The extension of the tax-free rollover period from 60 days to 120 days is automatic if the requirements are met; a waiver of the 60-day deadline (as discussed above) from the IRS is not required. For example, a taxpayer withdrew IRA funds to buy a home and would have qualified as a “first-time” homebuyer, but his offer was rejected by the seller and approximately 72 days after the IRA withdrawal he put the amount of the distribution back into his IRA. The IRS in a private ruling held that the recontribution to the IRA was timely under the special 120-day rollover rule.