Kevin Shahan, CPA
Frequently Asked Questions--IRA Rollovers
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What is an IRA Rollover?

An IRA Rollover is a tax-free transfer of funds from a tax-deferred plan, such as a 401(k) plan, to a traditional IRA. An IRA Rollover occurs when an employee changes jobs and is entitled to a distribution from the old employer's 401(k) plan. By doing an IRA Rollover, the funds can be transferred tax-free to the employee's own IRA. This means the funds can continue to grow on a tax-deferred basis inside the IRA. It also means that the funds are under the control of the employee with respect to investment decisions and future distributions.

The term "IRA Rollover" can also be applied to a transfer of funds from one IRA to another IRA. This too can be done on tax-free basis under a different set of rules that apply to IRA-to-IRA rollovers. Those rules are covered separately.

When is an IRA Rollover permitted for distributions from an employer-sponsored plan?
An IRA Rollover is permitted for any "eligible rollover distribution" from an employer-sponsored plan. This includes distributions from 401(k) plans when an employee changes jobs or retires, but also includes eligible rollover distributions from other employer-sponsored plans, such a qualified pension and profit-sharing plans, defined benefit plans, 403(a) annuity plans, 403(b) annuity contracts and governmental 457 plans.

What is an "eligible rollover distribution" from an employer-sponsored plan?

Any distribution, whether all or less than all of the employee's account, is an eligible rollover distribution, except for the following:

  • Any distribution which is part of a series of substantially equal periodic payments;
  • Any required minimum distributions;
  • Any distribution which is made upon hardship of the employee;
  • Certain returns of elective 401(k) contributions, corrective distributions, loans treated as distributions, and similar items.

When are distributions permitted to an employee from a 401(k) plan or other employer-sponsored plan?

Distributions from a 401(k) or other employer-sponsored plans are governed by IRS rules as well as the terms of the plan. In general, plan distributions require a triggering event, such as:

  • Termination of employment
  • Attainment of the plan's normal retirement age
  • Death

Check with the plan administrator to be sure that the employee is entitled to a distribution under IRS rules and the terms of the plan and to determine what procedures are used to request such a distribution.

 

 

How are IRA Rollovers from employer-sponsored plans accomplished?

The employee usually has a choice of two methods to accomplish the IRA Rollover - the direct rollover or the indirect rollover.

Direct Rollover

In a direct rollover, which is also sometimes called a "plan-to-plan transfer," the eligible rollover distribution that is transferred directly by the employer-sponsored plan to the employee's IRA. The funds are never actually transferred to the employee individually.

Indirect Rollover

Under the indirect rollover method, the employer-sponsored plan writes a distribution check to the employee, who then deposits the check in his or her own account. The employee then has 60 days to transfer all or a portion of the amount received in the distribution to an IRA. The distribution is not taxable to the employee if the transfer occurs within 60 days.

 

 

What are the advantages and disadvantages of the direct rollover vs. the indirect rollover for distributions from an employer-sponsored plan?

An important advantage of the direct rollover method is that it allows the employee to avoid the IRS mandatory withholding rules. Under those rules, when a distribution is made by the plan to the employee, even if the employee intends to roll over the distribution into an IRA within 60 days, it is subject to a mandatory 20% income tax withholding rule that applies to all qualified plan distributions.

This means that the actual distribution check will represent only 80% of the amount of the distribution that is eligible to be rolled over. Therefore, in order to satisfy the 60-day rule for the entire distribution, the employee would need to "make up" the withheld 20% out of other funds (if available) to complete the rollover. Otherwise, the 20% withheld would be treated as a taxable distribution that was not rolled over on time resulting in only 80% of the distribution being tax deferred.

There may be practical advantages to the direct rollover as well. The transfer of funds can be handled directly by the two institutions. This eliminates concerns or mix-ups regarding calculating the 60-day period and making sure that it is adhered to.

If the employee has a short-term need for funds, the indirect rollover does give the employee use of the funds for up to 60 days, which is not the case with the direct rollover. In most cases, that is not a significant consideration.

 

 

Are employer-sponsored plans required to give employees the option to do direct rollovers?

Yes, as long as the direct rollover is to an IRA. Every plan, as a condition of qualification, must provide that a distributee of an eligible rollover distribution may elect to have the distribution transferred directly to an IRA. Distributions of less than $200 are excluded from the direct rollover requirement. (See below direct rollovers from other eligible retirement plans.)

 

 

What procedures are used to elect a direct rollover?

The plan administrator can use any reasonable procedure for a participant to elect a direct rollover. That is why it is important for an employee to check with the plan administrator about the IRA Rollover process.

 

 

How is the direct rollover accomplished?

A direct rollover may be accomplished by any reasonable means of direct payment to the IRA chosen by the plan administrator, including:

  • A check mailed by the employer-sponsored plan to the IRA custodian or issuer of the IRA annuity, as long as the check is negotiable only by the IRA custodian or annuity issuer;
  • A wire transfer, as long as it directed only to the IRA custodian or annuity issuer;
  • Hand delivery of a check by the distributee to the IRA custodian or annuity issuer, as long as instructions are given to the distributee to deliver the check to the IRA custodian or annuity issuer and the check is made payable to the IRA custodian or annuity issuer.

Can employer-sponsored plan benefits be rolled over into other types of retirement plans besides IRAs?

Yes. Eligible rollover distributions can be made to any "eligible retirement plan." This means, in addition to an IRA (including an IRA annuity), another qualified plan, a 403(a) annuity plan, a 403(b) annuity contract, or certain governmental 457 plans. For example, this rule enables an employee who is switching jobs, who is entitled to a distribution from the prior employer's 401(k) plan, to roll over his or her plan benefits to the new employer's plan, whether it is a 401(k) or some other type of employer-sponsored plan.

Although many employer-sponsored plans do accept such rollovers, note that an eligible retirement plan does not have to accept rollover distributions. So any employee who wants to move his or her 401(k) balance from an old employer to the new employer's plan needs to make sure that the new employer's plan accepts such rollovers. If it does not, then the employee would still be able to do an IRA Rollover.

 

 

Can after-tax amounts in an employer-sponsored plan be part of an IRA Rollover?

Yes, after-tax amounts can always be rolled over from an employer-sponsored plan to an IRA. However, for rollovers to other eligible retirement plans, the only employer-sponsored plans that can accept after-tax amounts are defined contribution plans that agree to separately account for the pre-tax and after-tax portions of the rollover.

 

 

Can anyone who is entitled to a distribution from an employer-sponsored plan do an IRA Rollover?

No. The only individuals who can do an IRA Rollover are the participant, the participant's surviving spouse, in the case of the participant's death, or, in connection with a divorce proceeding, the spouse or former spouse as an alternate payee under a qualified domestic relations order. Other individuals, such as a non-spouse beneficiary of a deceased participant, are not permitted to do an IRA Rollover.

 

 

IRA Rollovers from IRAs

 

What are the rules for IRA Rollovers from one IRA to another IRA?

The rules are very similar to those for employer-sponsored plans, but take into account the technical differences between an employer-sponsored plan and an IRA.

Since an IRA owner can take distributions any time from the IRA, subject only to potential premature distribution penalty taxes, there is no requirement that the distribution constitute an eligible retirement distribution before it can be rolled over. Thus, in general, it is easier to do an IRA-to-IRA rollover. However, there are other rules that also need to be satisfied.

Partial distributions from an IRA can be rolled over, but a required distribution under the minimum required distribution rules cannot be rolled over.

 

 

In the case of an IRA-to-IRA rollover, how can the rollover be accomplished?

This can be done either as a direct rollover or an indirect rollover, just as a rollover from an employer-sponsored plan. Either method results in a tax-free transfer of the funds from one IRA to another IRA. Since the mandatory withholding rules do not apply to IRA distributions, that is not a factor for choosing one method or the other.

The main difference is that, in the case of an indirect rollover (i.e., a rollover in which the funds are distributed from an IRA to the IRA owner who then has 60 days to transfer them to another IRA), such a rollover is limited, for each IRA owned by the IRA owner, to one such indirect rollover in any one-year period. If an individual owns more than one IRA, a tax-free indirect rollover from one IRA will not prevent another tax-free indirect rollover from a different IRA within that one-year period.

The key point is that the one-rollover-per-year rule does not apply to direct rollovers (i.e., direct transfers from one IRA custodian or annuity issuer to another IRA custodian or annuity issuer). The direct rollover thus eliminates a potential technical issue the individual wishes to do a second rollover of those funds within a one-year period.

There are also practical advantages to the direct rollover, including the practical benefits of moving the funds by wire transfer, if available, as well as avoiding any need to calculate and comply with the 60-day rule.

Obviously, if the IRA owner has a short-term need for cash, the indirect rollover does give the owner the use of those funds for up to 60 days, which is not the case with the direct rollover, but those instances where that is an important consideration are not common.

 

 

Can additional funds be added to the Rollover IRA in the future?

Yes. An IRA owner can either make annual contributions to the IRA under normal IRA contribution rules or can make future IRA Rollovers to the IRA. Prior rules that prevented or discouraged commingling of rollover funds with non-rollover IRA amounts have been repealed.

 

 

This information should not be used as a basis for legal and/or tax advice. In any specific case, the parties involved should seek the guidance and advice of their own legal and tax counsel.