IRA rollover screw-ups are common. They are also easily avoidable.
Not everything can be rolled over to an IRA. In order to avoid expensive tax problems, advisors need to know which funds are not rollover eligible. When ineligible rollovers occur, two bad things happen.
First, the funds withdrawn are usually taxable (except for after-tax funds) — and possibly subject to a 10% early distribution penalty. Second, the funds rolled over are considered excess contributions and may be subject to a 6% penalty.
The result can be huge tax bills, especially if the failed rollover is substantial, which is often the case when an entire plan balance is being distributed. There are repercussions for the advisors guiding these clients, too: Lost trust, lost business, or even potential legal action. Advisors need to get ahead of these moves and tell clients to consult with them before moving any IRA or plan funds. There’s too much at risk and the tax laws are generally unforgiving when it comes to ineligible rollovers.
Hopefully by now, most financial planners are aware of the biggest three ineligible rollovers:
- Violations of the once-per-year IRA rollover rule.
- Missing the 60-day rollover deadline.
- Distributions to non-spouse beneficiaries. A non-spouse beneficiary can never do a rollover. The funds must be moved as direct transfers.
However, there are many lesser-known examples of ineligible rollovers. Here are seven of them:
1. RMDs
RMDs can never be rolled over, yet this is a common error, especially in conjunction with Roth conversions. If an RMD is rolled over, it becomes an excess IRA contribution subject to the 6% penalty unless it is removed by October 15 of the year following the year of the excess contribution. Clients sometimes fall into this trap when they take their RMD but then convert those funds to a Roth IRA. Their logic is that since they are already paying the tax on the RMD, why not convert it to a Roth IRA? That sounds sensible but it cannot be done.
Under the tax law, a Roth conversion is a rollover and so the RMD can never be converted to a Roth IRA. If that is done, the RMD is still satisfied since the funds have been withdrawn, but the funds rolled over to the Roth are excess contributions. Once the RMD is satisfied, then any balance remaining in the IRA is available to be converted.
2. After-tax IRA funds
After-tax IRA funds cannot be rolled over to a company plan. Only pre-tax IRA funds can. That is actually to the client’s advantage because it allows the basis in the IRA to be isolated, leaving more IRA funds to be distributed tax free or converted tax free to a Roth IRA. IRA basis includes the after-tax funds from nondeductible IRA contributions and any rollovers of after-tax plan funds into the IRA. Clients are required to keep track of their IRA basis on Form 8606 (Nondeductible IRAs) when they file their taxes.
Roth IRA funds also cannot be rolled over to a company plan, even to a company Roth 401(k).
3. Hardship distributions
Company plans can allow hardship distributions (although they are not required to). These withdrawals cannot be rolled over. That makes sense because if the employee desperately needs to access their 401(k) funds for a financial emergency, why would they need to roll the funds over to their IRA? They should be spending the funds for that emergency.
The hardship distribution is not only taxable (to the extent of pre-tax plan funds being withdrawn) but also subject to the 10% early withdrawal penalty if no exception applies. There is no financial emergency or hardship exception to the 10% penalty, except in the case of special rules for natural disasters.
These hardship distributions do not apply to IRA withdrawals, since all IRA funds are eligible to be withdrawn at any time, regardless of the reason. The distribution might be subject to tax and the 10% early distribution penalty. If IRA funds are withdrawn for a hardship and not needed, they can be rolled over to the same or another IRA, as long as they are eligible for rollover under the 60 day and once-per-year rollover rules.
4. Plan loans — deemed distributions from a loan default
Generally, a defaulted plan loan is considered a “deemed” distribution.” The plan will report the outstanding loan balance on Form 1099-R with code L in box 7. A deemed distribution isn’t offset from the employee’s plan balance. Instead, this unpaid amount will remain recorded as an outstanding loan by the plan until a distribution can occur under the plan’s terms. A deemed distribution is taxable and may be subject to the 10% early distribution penalty. It is not eligible to be rolled over to an IRA, even if the employee has the funds to complete the rollover.
This is different than a plan loan offset, which can be rolled over. In this case, the loan is not in default. The employee may have left the company but still had an unpaid loan balance in the plan. When the employee withdraws her 401(k) balance, it will be offset by the amount of the unpaid plan loan. The full distribution will be taxable, however, even though the employee only received a net amount (net of the outstanding loan balance).
Mathieu Beauchesne is Head of Life and Health Insurance at GFT Canada, where he works with leading insurance carriers to transform their operating models into new digital and AI-powered architectures. He has more than a decade of experience in IT consulting in the insurance space, specializing in business architecture, IT strategy development and business analytics.
Sales were mostly flat until 2020. Over the past four years though, they've nearly doubled.
However the employee can avoid taxes and penalties by rolling over the loan offset amount to an IRA. Last year’s tax overhaul gives more time now to complete a rollover of an offset distribution. If the offset distribution is the result of plan termination or separation from service, the distribution must be rolled over by the tax-filing deadline, including extensions, for the year the distribution is received. The employee will have to come up with the cash, either from personal assets or a bank loan, but at least they have an opportunity to avoid taxes on the offset amount. If they don’t repay the outstanding balance, it is treated as a distribution.
Since a loan offset is not in default (as in the deemed distribution case), any offset amount is eligible to be rolled over.
5. 72(t) distributions
These are a series of early withdrawals that are set up to avoid the 10% penalty.
To qualify for the penalty exception, the withdrawals must be a series of substantially equal periodic payments. The general idea is that you can tap your IRA (or company plan if no longer working there) before 59½ without a 10% penalty if you commit to a plan of withdrawals according to the rules set out in Section 72(t)(2)(A)(iv) of the Internal Revenue code. Clients can begin a 72(t) payment schedule from an IRA at any age, even if they are still working. These payments must continue for at least five years or until age 59½, whichever period is longer and the distributions cannot be rolled over.
There are a number of additional rules associated with 72(t) payment schedules. You must take consistent distributions, not modify the agreed upon schedule or account and pay the appropriate tax. If you violate this contract ( by rolling the distribution over, for example), then the 10% penalty will apply to all distributions taken prior to age 59 ½. This is known as the recapture penalty).
Take the hypothetical client Ron, for example. Ron is 60. He started a surf and paddleboard rental business when he was 56 and was desperate for cash. Ron agreed to a 72(t) series of substantially equal periodic payments from his IRA. Remember that the rule is that these payments must continue for at least five years or until age 59½, whichever period is longer.
Ron’s rental business is doing well, and he no longer needs the 72(t) payments from his IRA. Ron thinks that because he is older than 59 ½, he can stop taking distributions and delay the taxes due. Before Ron speaks with his advisor, he receives an automated 72(t) distribution. Ron takes the funds and rolls them into a second IRA at another institution. With that move, he has just blown the 72(t) payment schedule and will owe the 10% penalty retroactively for all prior distributions taken before he reached age 59 ½.
The unsuspecting bank that accepted the ineligible rollover will issue Form 5498 showing the rollover into their institution. Now Ron has an excess contribution that needs to be rectified.
Another way a botched rollover can mess up a perfectly good 72(t) distribution schedule, is when eligible rollover dollars go into the IRA that is subject to an active 72(t) payment schedule. That rollover of new funds into this IRA will modify the IRA balance and trigger the retroactive 10% penalty.
6. Different property
If a client withdraws cash from an IRA, then only cash can be rolled back over. If a client withdraws stock from an IRA, then only that stock is eligible to be rolled back over. It must be the same property, otherwise it cannot be rolled over.
For IRA-to-IRA or Roth-to-Roth 60-day rollovers, the same property received is the property that must be rolled over. For example, an individual could not receive a distribution of cash and then roll over shares of stock that he purchases with the cash or that he currently owns. Clients cannot receive a distribution of stock in XYZ company and rollover an equivalent value in shares of ABC company stock.
There is one exception: Property distributed from a company plan can be sold and the cash received – but no other type of replacement property – can be rolled over to an IRA.
7. Divorce
When IRA funds split in a divorce are withdrawn, those funds are taxable and cannot be rolled over to the ex-spouse’s IRA. Trying to do so is a common and very expensive mistake.
For example, Jim and Jenna, both 48 years old, get divorced. It is amicable, and the former couple wants things to run as smoothly as possible. The divorce agreement states that Jim and Jenna will split Jim’s $300,000 IRA equally. Jim goes to the bank and withdraws $150,000. He deposits the money into a joint checking account with his ex-wife. Jenna writes a check for $150,000 to her own IRA and tells the bank it is a “rollover from another IRA.” Unfortunately, this cannot be rolled over. Jim will be taxed on the $150,000 and will owe a 10% penalty since he is under 59 ½. Jenna could be hit with an excess contribution penalty on the $150,000.
To avoid this tax consequence, IRA funds should be moved from one spouse’s IRA to the other’s, via a tax-free direct transfer.
The upshot of all this is that advisors should know which retirement funds can and cannot be rolled over and advise clients before any funds are moved. This simple advance planning can save a retirement account.
