THE FISCAL BLUE PRINT
WITH COACH JEFF MONTGOMERY
Episode 49: Avoid Penalties & Confusion: Know The Difference Between a Rollover and a Transfer
On today’s show, we are going to discuss the difference between a rollover and a transfer, and if you think that’s a boring topic, you might be right.,
However, it is an extremely important topic because if you do it wrong, the IRS can levy some large tax penalties. Let’s deconstruct the difference between rollovers and transfers.
Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to give advice to clients. So, unless you are a client, I cannot give you advice because I do not know you. So, think of this as helpful hints and education only. And please before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser…………. right? that’s just common sense.
(0:45) Practical Planning Segment: In today’s episode we are going to “deconstruct” the difference between a rollover and a transfer. This is something that we deal with almost weekly in our office.
Seriously though, there are some important differences to understand from the client’s point of view regarding a transfer versus a rollover.
So as usual, let’s just start with a basic understanding of retirement accounts.
When distributions are taken from tax-deferred retirement accounts, ordinary income taxes are due. However, sometimes funds may simply need to be moved from one retirement account to another – perhaps because an employee is retiring or switching jobs and chooses to move their 401(k) from their old employer to another 401(k), or an IRA account, or because a client wishes to work with a new financial advisor and chooses to move all of their accounts over to the new advisor’s firm.
Whatever the reason, there are specific rules for different types of money movement that folks should understand to make sure their accounts are protected from unnecessary taxable distributions.
Now, if you are working with a reputable firm that does this quite often and is familiar with the differences between rollovers and transfers, then the financial advisor’s firm will do all this for you, and you should not have a thing to worry about. However, you need to make sure you have a basic understanding and ask good questions.
(4:40) There are two categories of money movement between retirement accounts:
Indirect and Direct transactions.
(4:50) Indirect Rollovers:
For an Indirect Rollover, the account owner withdraws funds to be moved from the originating account and takes actual custody of the funds. The full amount of funds withdrawn must be deposited into the target account within 60 days. This is commonly referred to as a 60-day rollover.
The 60-day clock starts when you take possession of the check. NOT when the custodian actually sent the funds, or the funds left the account. Beware of mail delays!
One caveat for Indirect Rollovers from employer-sponsored retirement plans is that there is generally a mandatory 20% withholding for Federal income taxes that the plan sponsor makes directly to the IRS, with the balance of the funds sent to the account owner. This means that to avoid the tax withholding itself to be considered a taxable distribution from the account, the employee must ‘make up’ for the withheld amount by depositing funds from another source into the target account within the 60-day Indirect Rollover window.
(8:20) Important note: This 20% mandatory withholding does NOT apply to IRA accounts, including IRA-based employer plans such as SIMPLE IRAs and SEP IRAs.
Taxpayers are also limited to one Indirect Rollover between IRA’s or Roth IRA’s accounts every 365 days; any additional attempted Indirect Rollovers would be considered an account contribution and can potentially result in a 6% excess contribution penalty annually until corrected.
To reiterate: 20% Mandatory Withholding Applies to Indirect Rollovers Distributed from Employer-Sponsored Retirement Plans only!
(10:30) Direct Rollovers:
In addition to Indirect Rollovers, there are two types of “Direct” methods to move funds between accounts: Direct Rollovers and Direct Transfers.
Direct Rollovers move funds between two retirement accounts, but unlike an Indirect Rollover, the funds are never in the account holder’s custody, nor is there any mandatory tax withholding.
For Direct Rollovers, funds are moved from the trustee of one account directly to the trustee of the second account.
Important distinction: each account is a different type of accounts, e.g., 401(k) to IRA or vice versa). Direct Rollovers also have no time limit in which the transaction must take place (i.e.: no 60-day rollover) and there is no limit to how many Direct Rollovers can be done in a given year.
While Direct Rollovers are not taxable events, they are reportable events and as such, are reported on Form 1099-R. You should receive a 1099-R reporting the direct rollover.
(15:40) Direct Transfers:
Similar to Direct Rollovers, Direct Transfers are made directly between the trustees of each account and don’t involve the account holder ever having custody of the funds being transferred.
What distinguishes a Direct Transfer from a Direct Rollover, though, is that the accounts in a Transfer must be ‘like’ accounts (e.g., IRA to IRA, 401(k) to 401(k), etc.).
Similar to Rollovers (including both Direct and Indirect), Transfers are not taxable events BUT unlike rollovers, they are not reportable events and thus do not require submission of any forms to the IRS. NO 1099 is issued because the accounts are like for like.
Ultimately, the key point is that each of the various ways funds can move between retirement accounts has its own distinct set of rules and requirements.
Direct Rollovers are generally preferable over Indirect Rollovers, as they are subject to neither the 60-day time limit nor the 20% mandatory withholding but do require to be reported to the IRS.
On the other hand, Transfers do not need to be reported to the IRS and are used when an individual simply needs to change custodians or consolidate accounts involving the same kind of account.
So, in our coachable segment today we are going to run through an example of a fictional client named Andrew. Let’s take a look at a common mistake we have seen folks make without the help of an experienced firm.
(17:30) Coachable Segment:
Example #1: Andrew is a 50-year-old participant in a former employer’s 401(k) plan. Recently, Andrew decided to roll his $200,000 401(k) balance to an IRA, and without fully understanding the impact of his decision, he requested a complete distribution of his 401(k), via check, made payable to him, personally.
When Andrew’s check arrives in the mail, it will not be for the $200,000 balance he has in his 401(k), but rather, for only $200,000 – $40,000 (20% of the balance being withheld) = $160,000. At the same time, Andrew’s check is sent, the plan will also send $200,000 x 20% = $40,000 to the IRS as withholdings for Federal income taxes.
If Andrew wants to avoid a tax bill, he will have to come up with $40,000 from another source, on top of the $160,000 he receives from the plan, to get $200,000 of cumulative retirement money back into an eligible retirement plan within the 60-day rollover window. Because if $200,000 left the original retirement account, then $200,000 must appear in the new retirement account to be fully treated as a rollover… even if Andrew, personally, did not receive the entire $200,000 distribution!
Thus, if instead Andrew only rolls over 100% of the money he received from the plan – the $160,000 check – then the $40,000 sent to the IRS for withholdings will, itself, be treated as a distribution, and Andrew will owe Federal income tax on that $40,000 amount (plus a 10% early distribution penalty, unless an exception were to apply).
In either case, to the extent the amounts withheld create (or increase) an overpayment of Andrew’s Federal income tax (because the withholding is mostly or entirely unnecessary if a rollover actually does occur), that overpayment would be recoverable by Andrew as a refund once he has filed his Federal income tax return at the end of the year.
So, in this example, what would be a better way to do this? Send it directly. It would be considered a direct rollover because it’s not a like-for-like account. It’s a 401k to an IRA. The full 200k would transfer or a check made out to the new custodian of the IRA (not in the name of Andrew) And a 1099 R would be issued reporting a non-taxable direct rollover.
If it were already an IRA and Not a 401k it would be a direct transfer and no 1099 issued (not reportable)
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