Avoid IRA Rollover Tax Traps

An IRA rollover is usually a tax-smart move, because it allows you to continue to defer taxes on the amount you roll over. But Congress has laid traps for the unwary. Here's how to avoid the most common IRA rollover tax pitfalls.

Arrange Direct Transfers from Company Plans

After leaving a job, you may want to roll over funds from your former employer's qualified retirement plan (or plans) into an IRA. That way, you gain full control over the funds while continuing to defer taxes. Unfortunately, there's a tax trap for the unwary. Thankfully, you can dodge it by arranging for a direct trustee-to-trustee transfer from the plan into your IRA. In other words, the check or electronic funds transfer from the plan should go directly to the trustee or custodian of your IRA. While you must have an IRA set up and waiting to receive the rollover, the account can be empty before the transfer. 

Here's why doing a direct transfer is key: If you receive a retirement plan check that's payable to you personally or a distribution that's put into a personal account via an electronic funds transfer, 20% of the taxable amount of the payout must be withheld for federal income tax. Then, you'll have only 60 days to come up with the "missing" 20% and get it into your IRA. Otherwise, you can't accomplish a totally tax-free rollover. That means you'll owe income tax on the 20% and possibly a 10% early withdrawal penalty tax if you're under 55.

Case in Point

To drive home this point, suppose you leave your job at age 52, and you have $250,000 in the company's 401(k) plan. You want to roll over the entire amount, but you fail to arrange for a direct transfer. Instead, you receive an electronic funds transfer into a personal account in 2022. Unfortunately, the transfer is for only $200,000. The "missing" $50,000 (20% times $250,000) went to the U.S. Treasury for mandatory 20% federal income tax withholding.

Now you must somehow find $50,000 to put in your IRA within 60 days to pull off a completely tax-free rollover. Even if you manage to do that, you can only recover the $50,000 that went to the federal government by making reduced tax payments over the remainder of 2022 and/or by claiming a refund when you file your 2022 return sometime next year. Either way, it'll take a while to get your money back. 

If you fail to find $50,000 to roll into your IRA within 60 days, you'll owe federal income tax on that amount (because it wasn't rolled over) plus you'll owe another $5,000 for the 10% early withdrawal penalty tax (because you're under 55). This entire mess could have been avoided simply by arranging for a direct transfer of the $250,000 into your IRA.

When to Avoid Rollovers of Company Plan Funds

There are some situations where it makes sense to avoid rollovers of company plan funds when you leave the company. If you're 55 or older when you receive a payout from your former employer's qualified retirement plan, you won't owe the 10% early withdrawal penalty tax on money you choose to keep in your own hands by not rolling the amount over into an IRA. You'll still owe federal income tax (and maybe state income tax) on the amount you don't roll over, but you'll avoid the 10% penalty tax.

In contrast, if you roll over money into your IRA and then need to withdraw some or all of that amount before age 59½, you'll generally owe the 10% early withdrawal penalty tax on top of the income tax hit. 

Plan ahead to avoid getting unnecessarily slammed with the 10% penalty. If you're going to need some money that you're thinking about rolling over, don't roll it over. Instead, put the money into your taxable checking, savings or brokerage firm account. 

Another situation where a rollover may be inadvisable is when your qualified plan account includes appreciated company stock. Click here for more information. If you have this situation, contact your SSB tax advisor before rolling over anything. 

Workaround for the One-IRA-Rollover-Per-Year Rule

You can take money out of an IRA and then roll it back into the same IRA or another IRA tax-free, as long as you put the money back within 60 days. However, you can only do one IRA-to-IRA rollover within any 12-month period. If you take two or more withdrawals within that period, the extra withdrawal(s) will count as taxable IRA distributions that can trigger an income tax hit and the 10% early withdrawal penalty tax if you're under 59½. 

Thankfully, you can dodge the one-IRA-rollover-per-year trap by moving money from one IRA into another via a direct trustee-to-trustee transfer that never passes through your hands. These transfers—which can be in the form of checks or electronic funds transfers—don't count as rollovers for purposes of the one-IRA-rollover-per-year limitation.

For instance, say you have a large IRA balance. You want to move the money into separate IRAs set up for each of your four beneficiaries, 25% each. You can make tax-free direct transfers from the existing IRA into four new IRAs set up for your beneficiaries.

On the other hand, if you simply receive a distribution from your existing IRA—via check or electronic funds transfer—and then move the money into four IRAs set up for your beneficiaries, only one transaction would be treated as a tax-free rollover. So, 25% of your distribution would be rolled over tax-free, and the other 75% would be taxable to you, under the one-IRA-rollover-per-year rule. The taxable distribution also would be subject to the 10% early withdrawal penalty tax if you're under 59½.       

Under another loophole, rolling over a distribution from a qualified retirement plan, such as a 401(k) plan, into an IRA doesn't count as a rollover for purposes of the one-IRA-rollover-per-year limitation. So, you can make that kind of rollover as often as you wish. Just be sure to make direct transfers into your IRA to avoid potential tax pitfalls.

Special Advice for Surviving Spouses

What should you do if you inherit your deceased spouse's qualified retirement plan account or IRA? Quickly roll the money over into an IRA set up in your own name. That way, you'll get full control over the money, and you won't have to take any annual required minimum distributions (RMDs) and pay the resulting extra income tax bills until you reach age 72. Until then, you can continue earning tax-deferred income with no restrictions.

If you inherit your deceased spouse's Roth IRA, roll the money into your own Roth account. Then you won't have to take any RMDs for as long as you live. You can continue earning federal-income-tax-free income until you die.

Need Help?

Leaving your job can be stressful, but retirement account rollovers don't have to be. Contact your SSB tax advisor for help arranging tax-free IRA rollovers of your retirement account money and avoiding potential pitfalls set up by Congress.