Making Two IRA Rollovers in One Year Can Be Costly

Tax law allows you to take a distribution from your IRA account, and as long as you return the distribution to your IRA within 60 days, there are no tax ramifications. However, many taxpayers overlook that you are only allowed to take a distribution once in a 12-month period, and violating this rule can have unexpected tax ramifications.

The one-year period is measured based on the date a distribution is received. If the second distribution is received before the same date one year later, it is a disqualified rollover.

Example – Jack takes a distribution from his IRA on June 30 of year one and subsequently rolls over the distribution (puts the funds back into the IRA) within the 60-day rollover period. Jack must wait until June 30 of year two before another distribution is eligible for a rollover. Any additional distributions taken during the one-year waiting period would be taxable.

Example – A taxpayer received a distribution from his IRA with Chase bank in February, which he immediately rolled into a new IRA with Wells Fargo. Then, in May, he took a distribution from the Wells Fargo IRA and rolled it back into the IRA at Wells within 60 days. Even though he rolled the exact amount back into the same institution within 60 days, the distribution from Chase had started the running of the one-year waiting period. Thus, his second distribution was in violation of the one-year waiting period and was a taxable distribution. The redeposit of what he thought was a rollover was actually a contribution to the IRA.

Like everything taxes, there are exceptions to the one-year rule, including the following:

Direct Transfers – As long as IRA funds are transferred directly between trustees, the transaction is not considered a rollover. A taxpayer can make as many direct transfers in a year as he or she wants; in fact, utilizing direct transfers is the preferred way to move funds from one IRA to another because it eliminates certain tax-return reporting issues.

  • Roth Conversions – Traditional IRA to Roth IRA conversions are not considered rollovers for purposes of the one-year rule.
  • Distributions to and from Qualified Plans – Since the one-year rule only applies to IRA-to-IRA rollovers, rollovers to and from other types of retirement plans are not governed by the one-year rule. However, SEPS and SIMPLE plans are treated as an IRA for purposes of the one-year waiting period.
  • Failed Financial Institutions – An IRA distribution made from a failed financial institution by the Federal Deposit Insurance Corporation is generally disregarded for purposes of applying the one-rollover-per-year limitation.

Tax Consequences – When the one-year rule is violated, any distribution after the first made within the one-year waiting period will not be treated as a rollover, with the following tax consequences:

  • Traditional IRA – In the case of a traditional IRA, the entire distribution will be taxable, and if the taxpayer is under age 59½ at the time of the distribution, the 10% early distribution penalty will apply to the taxable portion.
  • Roth IRA – In the case of a Roth IRA that is a:
    o Non-Qualified Distribution – A non-qualified distribution is one where the Roth IRA has not met the five-year aging requirements. Five-year aging generally means the Roth IRA has been in existence for a continuous period of five years, although the first and last years do not need to be full years. A distribution from a Roth IRA that has not met the five-year aging requirements would be a non-qualified distribution, and the earnings would be taxable. Of course, the original contributions are never taxable based on a specific distribution sequence: contributions, then conversions from traditional IRAs or rollovers from qualified plans (first the part that was taxed when the funds went into the Roth and then the nontaxable part), and lastly earnings. A 10% early distribution penalty applies to any amount attributable to the part of the conversion or rollover amount that had to be included in income at the time of the conversion or rollover (the recapture amount).
    o Qualified Distribution – No tax or penalty applies if a distribution from a Roth IRA is a “qualified distribution,” which is a distribution made after the five-year aging period is met if the taxpayer:

    – Is age 59½ or older,
    – Is disabled,
    – Is deceased, or
    – Qualifies for the first-time homebuyer exception (maximum $10,000).

Disqualified Rollover – An additional problem arises because the disqualified rollover amount will be treated as an IRA contribution, subject to the normal annual contribution and AGI limitations. Tax law includes a penalty when someone contributes more than is allowed (excess contribution). Thus, an excess contribution (except for on the year of the distribution) would be subject, annually, to a 6% excess contribution penalty.

There are a couple of possible remedies available for a disqualified rollover:

  • Corrective Distribution – The excess contribution and the interest attributable to it can be withdrawn by the extended due date of the return for the year the distribution was made, thus undoing the rollover. The distribution that resulted in a disqualified rollover will be subject to tax, as outlined earlier, depending upon whether it was a traditional or Roth IRA. The earnings attributable to withdrawn funds are taxable. However, the annual 6% excess contribution penalty is avoided.
  • Contributions in Future Years – The excess contribution could be left in the IRA and can be treated as an IRA contribution for a later year. However, until the excess contribution is fully absorbed as eligible future contributions, the annual 6% excess contribution penalty will apply.

Early Withdrawal Penalty – If the disallowed rollover occurs before reaching age 59½, an early distribution penalty of 10% of the taxable amount will apply and is in addition to the normal tax.

Although there are a number of exceptions to the under-age-59½ early distribution penalty, the following might be used to avoid or mitigate an early withdrawal penalty associated with a disqualified rollover:

  • Contributions Returned before the Due Date – If the taxpayer already made an IRA contribution for the tax year, the amount of that contribution can be withdrawn tax-free by the extended due date of the tax return, provided:
1. The taxpayer did not take a deduction for the contributions withdrawn, and
2. The taxpayer also withdraws any interest or other income earned on the contributions, and
3. The taxpayer includes in income, for the year during which the withdrawal was made, any earnings on the contributions withdrawn.
  • Medical Insurance Exception – The amount that is exempt from the penalty is the amount the taxpayer paid during the year for medical insurance for the taxpayer and his or her spouse and dependents. To qualify for this exception, the taxpayer must have:
1. Lost his/her job,
2. Received unemployment compensation for 12 consecutive weeks,
3. Made IRA withdrawals during the year he/she received unemployment or in the following year, and
4. Made the withdrawals no later than 60 days after being reemployed.
  • Higher Education Expense Exception – The part not subject to the penalty is generally the amount that is not more than the qualified higher education expenses for the taxpayer and his or her spouse, children, or grandchildren for the year at an eligible educational institution.

The bottom line is to make sure you don’t have more than one IRA rollover in a year. However, if you inadvertently do, please call us as soon as you realize the error so we can determine what actions can be taken to mitigate the resulting taxes and penalties.

IRA Missteps to Avoid

If you have an IRA account or are considering one, there are a number of potential missteps you will want to avoid. Some of them can lead to unwanted taxes and penalties, and of course, we are talking about your retirement funding, so it is an important issue. Here are a number of issues to keep in mind:

Selecting a Type of IRA Account – The first decision you will have to make is whether to choose a traditional IRA or a Roth IRA. A traditional IRA provides a tax deduction for the contribution and tax-deferred growth, but any withdrawal from the account is fully taxable. On the other hand, Roth IRA contributions are not deductible, but distributions after retirement are tax-free. A Roth IRA offers tax-free accumulation, meaning the earnings build up over the life of the IRA tax-free. Making the decision involves a number of factors, some of which will be discussed later in this article.

For those currently with low income and on a limited budget with little extra income to spare for IRA contributions, the traditional IRA offers a tax deduction, which will allow them to make a larger contribution and is better than having no retirement funds at all. In addition, lower-income individuals may qualify for the Saver’s Credit, discussed later, which provides a tax credit that might help them to afford a contribution.

For younger individuals, a Roth IRA provides tax-free accumulation, meaning the earnings will be tax-free when distributed at retirement. Thus, the longer one has a Roth IRA, the more tax-free income it can provide.

Missing out on the Saver’s Credit – As mentioned previously, the Saver’s Credit helps lower-income individuals to save for retirement by providing a credit to help cover the cost of their IRA contribution. The credit can be as much as 50% of the first $2,000 contributed to an IRA (either traditional or Roth), depending upon your income for the year. It is not allowed for individuals under the age of 18, individuals claimed as dependents of another or full-time students. The credit is non-refundable, meaning it can only be used to offset one’s tax liability, so lower-income taxpayers may not have enough tax to benefit.

Taking Distributions before Retirement Age – If a distribution is taken from a traditional IRA before reaching the age of 59½, that distribution will not only be taxable but will also be subject to a 10% early withdrawal penalty. So, consider it carefully before taking an early distribution. Assuming you are in the 22% tax bracket, every $100 of an early distribution will result in you owing $32 of tax, including the penalty. Only take an early distribution if you are desperate. There are exceptions to the 10% early withdrawal penalty, but not for the tax on the early distributions. The common penalty exceptions include limited withdrawals for a home purchase, medical expenses, disability and higher education expenses.

Failure to Keep Designated Beneficiaries Current – A number of life events can change who you want to be the beneficiary of your IRA account when you pass. Divorce and the death of a beneficiary are probably the most common, but regardless of the reason, it is important to keep your IRA trustee or custodian apprised about the current names of your beneficiaries, or else the account could end up in the hands of someone you didn’t want it to be.

Overlooking the Spousal IRA – You may not be aware, but a non-working spouse can also make an IRA contribution based upon the working spouse’s income. The amount that can be contributed is the smaller of the annual IRA contribution limit or the working spouse’s compensation less any IRA contribution made by the working spouse. Contributions to spousal IRAs do not need to be divided equally between spouses, but neither spouse may make a contribution of more than the annual limit. The deduction for contributions to both spouses’ IRAs may be further limited if either spouse is covered by an employer’s retirement plan.

Failing to Recognize Low Tax Distribution Opportunities – Occasionally, a taxpayer will have an abnormally low-income year, or the individual’s deductions will be abnormally high, resulting in a negative or very low taxable income. When this occurs, traditional IRA distributions by those age 59½ or older can be taken with little or a minor tax liability. Because the distribution must be taken before the end of the year, the key is to recognize this possibility, determine how much of a withdrawal will provide the best result and then take the distribution before year’s end.

Also low-income taxable years can provide an opportunity to convert some portion of a traditional IRA to a Roth IRA with minimal or no tax liability.

Social Security Income and Traditional IRA Distributions – If you are retired and drawing Social Security, remember that Social Security income does not become taxable until one-half of the Social Security income plus your other income exceeds $32,000 for a married couple, or $25,000 for most other filing statuses. Even if you don’t need the funds from an IRA distribution, it may be appropriate for you to withdraw enough from your IRA (or other qualified plans) so that your overall income closely matches the taxable Social Security threshold. Then, you can put those withdrawals away for a future major expense item or unexpected financial liability and avoid a large distribution in one year that would cause the SS to be taxed.

Rollover Errors – You are allowed to take a distribution from your IRA accounts, and the distribution won’t be taxable if the same amount is returned to your IRA within 60 days. However, you are allowed only one tax-free rollover in a 12-month period. So, unless you need the funds for just a short period, it is always best to arrange for a trustee-to-trustee transfer, for which there is no frequency limit, when you want to move IRA funds from one IRA to another.

Failing to Take a Required Minimum Distribution – If you have a traditional IRA, you must begin taking required minimum distributions (RMDs) from your IRA once you reach age 70½. Failure to do so can result in a penalty equal to 50% of the amount that should have been distributed. Luckily, at least so far, the IRS has been very liberal about waiving that penalty for almost any reasonable excuse when a request is made.

You can take out as much as you like each year, but it cannot be less than the RMD. If you withdraw more than the RMD, the excess can’t be applied to the following year’s RMD. The RMD amount for any year is the balance of your non-Roth IRA accounts on December 31 of the prior year divided by your remaining life expectancy. The remaining life expectancy is based upon the Uniform Lifetime Table, which appears in IRS Publication 590-B.

There is no requirement for the owner of a Roth IRA to take distributions, but the distribution requirements apply to the beneficiary of a Roth account after the owner passes away.

Understanding the Beneficiary Options – Beneficiaries of a traditional IRA where the decedent had already begun taking RMDs will also be subject to an RMD requirement, even if the beneficiary’s age is less than 70½ years. They must begin taking RMDs over the longer of the deceased owner’s life expectancy or the beneficiary’s remaining life expectancy. If there are multiple beneficiaries, the age of the oldest is used in the determination (but see the section on dividing an inherited IRA later). As an option, a beneficiary may elect to take the entire account at any time before the end of the fifth year following the year of the owner’s death.

If the decedent had not yet begun taking RMDs, the beneficiary can choose either to take the five-year payout or begin taking distributions over their lifetime. For lifetime payouts, the distributions must begin no later than Dec. 31 of the calendar year immediately following the calendar year during which the IRA owner died.

Knowing an Inherited IRA Can Be Divided – When an IRA has multiple beneficiaries, conflicting interests can arise. One beneficiary may want the money all up front, while another one may want to spread it out over time. There can also be conflicting investment strategies. In addition, the distribution period is determined using the oldest beneficiary’s age, which accelerates the payout. These conflicts can be avoided by dividing the account. The law allows an IRA to be divided into separate accounts for each beneficiary, thus giving each the opportunity to select the option that best suits his or her particular circumstances.

Understanding the Special Spousal Beneficiary Option – Spouse beneficiaries not only have the same options as other beneficiaries but also have the irrevocable option to treat the inherited IRA as their own, which is accomplished by re-titling the deceased spouse’s IRA or simply transferring the IRA balance to the surviving spouse’s own IRA. A surviving spouse may also be deemed as having elected to treat the IRA as his or her own if he or she fails to take RMDs as a beneficiary within the applicable deadline or if the surviving spouse makes contributions to the IRA.

Disclaiming an Inherited IRA – If you, as a beneficiary, do not want to inherit an IRA for some reason, the law allows a designated beneficiary to disclaim an inherited IRA and permits the naming of a new beneficiary by the executor of the estate.

Realizing Your Child Can Have an IRA – It may not even occur to parents or grandparents that if a child has income from working (earned income), they can contribute to an IRA. There is no minimum age requirement for establishing and contributing to an IRA. With the tax reform’s new higher standard deduction of $12,000 (2018) for singles, most children won’t even owe any taxes from their part-time or summer jobs, so the obvious choice for starting a retirement program for a child would be to contribute to a Roth IRA. However, most youngsters will balk at the idea, since retirement is the furthest thing from their minds at this stage of their life, and they will have other spending plans for their hard-earned money.

This is where parents, grandparents or others with the financial means can step in and gift the child the money to make an IRA contribution. The child’s contribution is limited to the lesser of their earned income or $5,500, the maximum contribution allowed for IRAs in 2018. Think what that Roth IRA contribution would be worth after 50 years of tax-free earnings accumulation.

Taking Advantage of IRA-to-Charity Distributions – Taxpayers age 70.5 and older can directly transfer up to $100,000 a year from their IRA to a qualified charity. They won’t get a charitable deduction, but instead – and even better – they will not have to pay taxes on the distribution, and because their AGI will be lower, they will benefit from other tax provisions that are pegged to AGI, such as the amount of Social Security income that’s taxable and the cost of Medicare B insurance premiums for higher-income taxpayers. As an additional bonus, the transfer also counts toward their annual required minimum distribution. If you want to take advantage of this tax benefit, be sure the transfer from your IRA to the qualified charity is a direct transfer from the IRA trustee to the charitable organization and that you get the required acknowledgment from the organization to substantiate the deduction.

If you have questions related to IRAs or the issues discussed, please give us a call.