You probably have several retirement accounts. It’s common. But you may start to think about consolidating some of those accounts as you approach retirement. The simplicity in managing fewer accounts is hard to ignore. This means consolidation – and the 60 day rollover rule.

There are two ways to consolidate accounts: direct and indirect transfers. Direct transfers are generally preferred. These are transfers that happen solely between institutions. Funds never touch your bank account. Indirect transfers do hit your bank account. With these transfers you essentially step in between the institutions to facilitate the transaction. Funds go from custodian A to your bank account, and then from your bank account to custodian B.

Indirect transfers have several rules that get people tripped up, including the 60 day IRA rollover rule. We’ll break down all the rules and how to do these indirect transfer transactions correctly in the article below.

Note – rollovers occur from retirement plans. Transfers occur from IRA to IRA. We use these terms interchangeably for the sake of brevity. Don’t hold it against us.

What is the 60 day IRA rollover rule?

Once money comes out of a retirement account – be it a 401k, 403(b), IRA, SEP, SIMPLE, or even a Roth IRA – you have 60 days to get that money into another retirement account. It’s considered a distribution if money doesn’t make it to the new account within that window. Distributions are subject to tax and potentially an early distribution penalty (10%) as well if certain criteria aren’t met.

You need to be at least 59.5 years old, permanently disabled, or have unreimbursed medical expenses greater than 10% of adjusted gross income to avoid the 10% early withdrawal penalty. There are a few other situations where you can avoid the penalty as well. The full list can be found here.

Qualified Plan mandatory withholding

Distributions from qualified plans like a 401(k) are required to withhold 20% of whatever is distributed for Federal taxes. This rule applies only to qualified plans but not IRAs. Transfers from IRA to IRA won’t get ensnared in the awfulness I’m about to outline below.

Importantly, that 20% withholding amount won’t be withheld if you complete a direct rollover. Why? Because the government knows the end destination of those funds. It’s going to another retirement account. It isn’t going to you to be spent.

But the IRS doesn’t have a guarantee like that with an indirect rollover. Money is sent directly to you to be deposited into your bank account. The first step to a distribution is identical to the first step in an indirect rollover. The 20% withholding therefore applies.

This is incredibly important in context of the 60 day IRA rollover rule. With an indirect rollover you are effectively getting 80% of whatever was distributed from that qualified plan. But 100% of the distribution must be redeposited to avoid taxes and penalties! This means you need to have some additional cash on the sideline to avoid getting hit with taxes and penalties.

Consider the case of Mark, who takes a $10,000 distribution from his 401(k) to cover a medical bill. He receives $8,000 net after 20% is withheld for taxes as required by law. Mark then gets a windfall when his gofundme page comes through with extra money. He is still within the 60 day window and decides to roll the money he took from his 401(k) back into an IRA. He will have to roll the $10,000 gross distribution into his IRA to avoid taxes and penalties despite only receiving $8,000.

Pretend that Mark only deposits $8,000 to his IRA. The $2,000 that was withheld for taxes will be, well, taxed. Those funds are taxed just like money he earns. In fact, it will stack right on top of income he makes from his job when he files his taxes. If he makes $60,000 for the year, then he’ll tack on that $2,000 that didn’t make it to the IRA and report $62,000 of income for the year.

Odds are he’ll get a decent tax refund on the $2,000 that were withheld and didn’t make it into his IRA. His income puts him in the 22% bracket for the year. 22% of $2,000 works out to $440 bucks. Since the IRS is holding the full $2,000, he’ll be eligible to get $1,560 back in a refund.

Penalties may apply though. If he is under age 59.5 or those unreimbursed medical bills end up being less than 10% of his adjusted gross income, then he’ll owe another 10% in penalties on that $2,000 that didn’t make it back into the IRA. Those penalties will be applied at tax time and will total $200.

The mechanics of an indirect rollover

These tend to be straightforward transactions to complete. Call the custodian that is holding your IRA or 401(k) and tell them to send you a check. The day they cut the check is the day the clock starts on that 60 day IRA rollover window.

Make sure you get a tracking number on the package coming with your check. Regular mail isn’t advised. Better yet, link your bank account to your IRA (or 401k if allowed) and do an electronic transfer. Skip the hassle of the mail.

Since the funds you are depositing into the new retirement account are coming from a bank account, the new custodian will likely require you to complete a form or statement verifying that the funds being deposited came from an eligible retirement account. You’re set to go with that form and the funds in your account.

Just once and only once!

Indirect rollovers may seem like a great choice to help with a short-term cash crunch. It can help float your accounts until a big commission check arrives, for example. But using these accounts like a short-term line of credit isn’t what the IRS intended. For this reason, only one indirect rollover is allowed per year!

The second indirect rollover you attempt for the year will be treated only as a taxable distribution. You will not be eligible to roll those funds back into another retirement account.

Tax reporting forms

We mentioned there being a small clerical difference between transfers and rollovers earlier. Direct rollovers move funds between two retirement accounts without funds ever being in your custody. Funds are moved trustee to trustee. These types of rollovers can be done as many times as you’d like in any give year (no cap!) and do not have any kind of time limit. They are not taxable, but they do generate a 1099-R tax reporting form. You’ll see either a ‘G’ or an ‘H’ in box 7 of that form to indicate a non-taxable rollover.

Direct transfers also move funds from trustee to trustee without you taking custody, but transfers happen exclusively between like accounts (i.e. IRA to IRA or Roth to Roth. They can also happen 401k to 401k if those plans are maintained by the same employer). Transfers are also not taxable events but they do not generate a 1099-R tax reporting form! Similarly, the firm receiving the money should not issue Form 5498 for an IRA contribution.

Indirect transfers and indirect rollovers will always generate tax reporting forms (a form 1099R and form 5498). Its up to you to correctly report the indirect rollover on your taxes to avoid an unnecessary tax bill.

Conclusions and parting thoughts

Avoid indirect rollovers and the 60 day IRA rollover rule entirely by completing a direct rollover. There are too many opportunities to drop the ball and make a mistake with an indirect rollover. The tax reporting that comes after is just salt in the wound. But, if you have to complete an indirect rollover, follow the rules we outlined above. They’ll keep you safe.

REGULATORY DISCLOSURE

Carmichael Hill & Associates, Inc. is a U.S. Securities and Exchange Commission Registered Investment Advisory firm. Registration does not imply that the SEC has endorsed or approved the qualifications of Carmichael Hill or its respective representatives to provide any advisory services. Advisor does not render or offer to render personalized investment advice or financial planning advice through this medium. Advice can only be given after:

  1. Delivery of a disclosure statement by advisor to client.
  2. Execution of our Investment Advisory Agreement between the client and the advisor.
  3. Initial payment of the planning fee or investment advisory fee by the client to the advisor.
  4. Advisor will not solicit or accept business in any state in which she or he is not properly registered or otherwise qualified to conduct business by virtue of a state “de minimis” exemption.
DISCLAIMERS

The information in this web site is based on data gathered from what the Advisor believes are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. The identification of specific funds and model portfolios is being made on the assumption that the investor would participate in that investment or portfolio on a long-term basis and only after consulting with their investment advisor to determine their needs and tolerance for risk. With respect to any such identification, there can be no assurance that the fund or model portfolio will in fact perform in the manner suggested.

The results do not represent actual trading due to the timing of the clients’ trades and their trading costs. They may also not reflect the impact that material economic and market factors might have had on the advisor’s decision making if the advisor were managing the clients’ money. Investment and portfolio results may be different than the results the advisor’s discretionary clients achieve due to the timing of trades and the market conditions.

All references that might be made to an investment or portfolio’s performance are based on historical data and one should not assume that this performance will continue in the future.

LINKS DISCLAIMER

At certain places on this Carmichael Hill & Associates, Inc. Internet site, live ‘‘links’ to other Internet addresses can be accessed. Such external Internet addresses contain information created, published, maintained, or otherwise posted by institutions or organizations independent of Carmichael Hill & Associates, Inc. CHA does not certify, endorse or control these external Internet addresses and does not guarantee or assume responsibility for the accuracy completeness, efficacy, timeliness, or correct sequencing of information located at such addresses. Use of any information obtained from such addresses is voluntary.