For various reasons, you might desire to roll over your existing qualified retirement plan (QRP) into another qualified retirement plan or an individual retirement account (IRA) or roll your existing IRA into another IRA or a QRP.
The IRS permits such rollovers but mandates they occur within 60 days. This is formally known as the 60-day rollover rule. Complying with the rule can help you avoid paying taxes and penalties.
Direct vs. Indirect Retirement Rollovers
At its most simple, a retirement rollover is the transfer of funds (contributions and earnings) from one QRP or IRA to another QRP or IRA.
In retirement planning, rollovers might happen for various reasons. A common cause is the change of employer. When employees change jobs, they can roll their 401(k) over from a previous employer to a new employer. If the employee moves from employment to self-employment (or any status in-between), they might roll over from a 401(k) to an IRA.
Rollovers can also happen for various financial reasons, such as moving from a traditional IRA to a Roth IRA to take advantage of tax-free and penalty-free withdrawals after age 59 ½.
- Direct Rollover
- A direct rollover can occur in two ways. First, it can happen when the administrator or custodian of a QRP or an IRA transfers the funds in the QRP or IRA to another QRP or IRA without liquidating the underlying assets. Also called trustee-to-trustee transfer, this is a direct transfer with no taxes or penalties incurred.
A direct rollover can also happen if the administrator or custodian of a QRP or IRA liquidates the underlying assets, but writes a check in the name of the new plan or IRA rather than the beneficiary. Since the beneficiary does not have constructive receipt of the funds, this arrangement also qualifies as a direct rollover. Consequently, there are no taxes or penalties incurred.
Although direct rollovers are free from taxes or penalties, it is best practice to complete them within the 60-day window.
- Indirect Rollovers
- An indirect rollover occurs when the administrator or custodian of a QRP or IRA liquidates the underlying assets and writes a check in the beneficiary’s name rather than to the new plan or IRA.
You can move all or part of the original account’s funds over in an indirect rollover. But the beneficiary must transfer the money into a new account to complete the rollover. Failure to complete an indirect rollover within 60 days can lead to taxes or penalties.
There are two common types of rollovers:
When executing an indirect rollover of a qualified retirement plan, you take possession of the liquidated funds (usually, net of a 20% federal tax withholding). Then, in order to avoid taxes and penalties, you must put the gross amount withdrawn into another qualified retirement vehicle within 60 days of receipt.
How Does the 60-Day Rollover Rule Work?
The 60-day rollover rule specifically targets indirect rollovers. If you miss the 60-day rollover window, taxes and penalties may apply.
When the rollover exceeds the 60-day window, the IRS considers it a distribution. This distinction is important because QRP and traditional IRA distributions are taxable. It also means that the IRS considers the money a withdrawal, making you liable for the 10% early withdrawal penalty if you are younger than 59 ½. The withdrawal will also trigger a tax liability.
Consequences of Breaking the 60-Day Rollover Rule
You can face stiff consequences if you break the 60-day rollover rule. These include paying taxes and penalty fees and losing tax advantages and investment returns.
- Taxes and Penalties
- Exceeding the 60-day limit on pre-tax retirement accounts will cause the money to be considered income for the current tax year. If you are younger than 59 ½, you may also incur an IRS early withdrawal penalty.
- Loss of Tax Advantages
- Failing to deposit funds on time limits tax benefits and contribution amounts, risking permanent retirement fund loss.
- Loss of Investment Returns
- Investing your money is critical to maximizing potential returns. Having the money sit for 60 days or longer while not investing it could cause missed returns.
Consequences for Breaking the 60-Day Rule
Mapping Out Your Retirement: Are You on Track?
Can You Use Rollover Funds as a Loan?
Using the funds from your rollover and replacing the entire amount within 60 days can function like a short-term, interest-free loan.
If you decide against transferring the funds into a new QRP or IRA, you can return it to the account it was withdrawn from to avoid any taxes or penalties. The IRS treats the withdrawal as a distribution and your IRA custodian can withhold 20% of the amount you withdraw for tax purposes.
There are two options to consider when using a rollover as a loan. Each can affect your tax obligations.
- Option 1
- You roll over $20,000 and report it as nontaxable income. Report the $5,000 (the 20% withheld) as taxable income and as $5,000 taxes paid. You will still have to pay a 10% early withdrawal penalty on the $5,000 if you’re younger than 59 ½.
- Option 2
- You roll over the full $25,000. You then report $25,000 as a nontaxable rollover and $5,000 as taxes paid. In this scenario, you avoid paying taxes and penalties — but only if you make up the amount withheld in taxes ($5,000).
Tax Options on a $25,000 Rollover Loan
The 60-Day Rollover Rule and Taxes
In retirement planning, taxes are always a prominent consideration. The same is true with the 60-day rollover rule. There are two points to make here:
If an indirect rollover does not occur within 60 days, the IRS treats it as a distribution. The IRS taxes distributions from QRPs and traditional IRAs at regular income tax rates.
The only exception exists with a Roth IRA. A 60-day rollover Roth IRA is not taxable because the funds deposited into a Roth IRA are already post-tax funds. However, though Roth IRA withdrawals will be free from taxes, they are not free from penalties if the distribution is not qualified.
This point is especially important if you use rollover funds as a loan. You may decide to redeposit the whole pre-tax amount, the post-tax amount or nothing.
- Redeposit the Pre-Tax Amount
- In this case, you will record the gross amount withdrawn as a non-taxable rollover and the tax portion withheld as tax paid.
- Redeposit the Post-Tax Amount
- In this case, you will record the post-tax portion paid as a nontaxable rollover and the tax portion as both tax paid and taxable income. Failure to return the tax portion means the IRS will treat it as a distribution and levy an early withdrawal penalty if you are younger than 59 ½.
- No Redeposit
- In this case, the entire amount will be recorded as taxable income and the tax portion as tax paid.
Three tax reporting situations can occur:
Parts of the 60-day rollover rules also allow you to request a waiver should you fail to roll over or redeposit within 60 days.
- Automatic Waiver
- If you follow all the rules and send in a request for rollover within the 60-day window but the financial institution fails to complete it or makes an error, then you qualify for an automatic waiver from taxes and penalties that would have applied.
- Request and Receive a Private Letter Ruling
- If you believe you qualify for a waiver that has not been automatically granted, you can seek a private letter ruling granting such a waiver. However, there is a $10,000 user fee involved.
- Self-Certify That You Qualify
- You can fill out the modal letter and send it to the financial institution in question if you believe you qualify for a waiver. The IRS will audit your income tax return to determine if you indeed qualify. There are no fees involved with self-certification.
According to IRS rules, there are three ways to get a waiver:
60-Day Rollover Example
To better understand the 60-day rule, consider a comprehensive example showing how the rule applies.
Suppose Cameron has a 401(k) and wants to roll over the funds ($50,000) into a new traditional IRA. If the 401(k) administrator does a direct transfer to a traditional IRA, that’s a trustee-to-trustee transfer and no taxes or penalties can apply.
If Cameron requests the liquidation of assets and the check is written in the name of the traditional IRA, there are no taxes or penalties.
Suppose, however, that the check is written in Cameron’s name. In this case, if Cameron does not conclude the rollover within 60 days, he will incur taxes and penalties if the distribution is not qualified.
Additionally, Cameron must take care to deposit the full $50,000 into the new qualified retirement vehicle, even though they only received $40,000 due to the 20% IRS withholding.
Incidentally, you can execute a rollover from an IRA or 401(k) to a fixed or variable annuity. The same rules apply; a rollover from a traditional IRA or QRP to an annuity is the same as a rollover from a traditional IRA or QRP to a QRP or IRA. Similarly, a rollover from a Roth IRA to an annuity is the same as a rollover from a Roth IRA to any QRP or IRA.
Will You Be Able To Maintain Your Retirement Lifestyle?
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IRAs and the One-Rollover-Per-Year Rule
One of the essential 60-day rollover rules is called the one-rollover-per-year rule. This rule dictates you can only make one rollover within a 12-month period. The one-year rule starts when the distributions are received, not when you return the money. However, this rule has many exceptions.
The following rollovers don’t count towards the one-rollover-per-year rule:
- Trustee-to-trustee rollovers
- Traditional IRA to Roth IRA conversions
- Rollovers to or from a QRP
The bottom line is that while there can be good motivations behind rollovers, you must consider the 60-day rollover rule and how nonadherence can lead to taxes and penalties.
Before making any retirement rollover, speak to your financial advisor. They are in the best position to advise you on what you should or should not do.