New IRS Rule Could Provide Relief on IRA Rollovers

Sooner or later, almost all investors will eventually be faced with the decision of whether to roll their 401k (or other employer sponsored retirement plan) into an IRA. The IRS recently issued a new rule that could actually make life a little bit easier for taxpayers in this regard.

First, some background. As we have written about many times in the past, fixed pension plans are going the way of the dinosaur. For most people going forward, their major sources of retirement income savings will be their 401k. Depending on where you work, chances are good that you are eligible to contribute to a 401k plan through your employer. And if you move from job to job, you may begin to build up a collection of 401k plans from each employer.

Sooner or later, you’ll be faced with the decision of what you should do with these 401ks and begin considering rolling them into an IRA. Maybe you would like to pull all the 401k money together from the different plans into one IRA account to make it easier to administer and keep track of everything. Maybe you want a wider assortment of investment options than what the 401ks offer, and/or you want just one comprehensive set of investment options that applies to all the money rather than having each of the 401k’s subject to their own individual limitations. Or maybe you’re finally ready to retire and you want total flexibility to take distributions from the entire amount whenever you want, to meet your retirement income needs.  In any of these cases, you could potentially consider consolidating all the 401ks into an IRA by doing a rollover. Of course, this is a decision that must be made on a case by case basis depending on the needs of the taxpayer.

There are generally two ways to accomplish an IRA rollover. Many taxpayers who are not familiar with these rules, who maybe have never done this before, might only be familiar with the first method, known as the “60-day rule”. Under this method, the taxpayer just asks the 401k provider for a total distribution, and the taxpayer then has 60 days to deposit the money into their new IRA.  The problem is that if they miss the 60-day time window the whole thing is considered a taxable distribution rather than a rollover, including being subject to a 10% penalty if the person is under age 59 ½. Certainly an ugly situation in which no one would want to find themselves, but it’s happened to many taxpayers in the past.

Up until now there was almost no way for taxpayers to avoid the harsh consequences of missing the 60-day time window. But under a new rule issued this past August, for once it’s “the IRS to the rescue”!  Under the new rule, if a taxpayer misses the 60-day time period they can actually fix this problem themselves, and at practically no cost. All they have to do is fill out a form asking for a waiver of the time period, provided that the reason for the late rollover is among a specific list of permissible reasons allowed by the IRS. There are 11 acceptable reasons under this new rule, including financial institution error, misplacing the rollover check, mistakenly depositing the rollover into the wrong account, and other misfortunes such as severe damage to a personal residence, death or serious illness of a family member, and incarceration.

It’s not often that the IRS actually issues rulings that are so helpful and, dare we say it, “compassionate”! So this is certainly good news. On the other hand, taxpayers should be aware that this ruling does not change the fact that the rollover has to otherwise be valid in all respects, such as being the taxpayer’s only rollover within a 12-month period.  Also the new IRA custodian will still have to alert the IRS that this is a late rollover, which could invite an audit to make sure that the relief conditions were properly met.

Taxpayers should also be aware that there is a better method to make a rollover that avoids all these problems in the first place, known as a “trustee-to-trustee transfer” or a “direct rollover”. This is actually considered the “gold standard” for how to make a rollover. Under this method, you first have to decide who your new IRA custodian is going to be. Then you direct the 401k plan (preferably by phone if the plan so allows, otherwise via rollover paperwork) to make out a check directly to your new IRA custodian. The key is that the check is not made out to you personally; it’s made payable to “XYZ Custodian, IRA FBO (“for the benefit of”) John/Mary Smith”. That’s what makes it a direct rollover. The check is mailed to your address, and you forward it to your new IRA custodian.  In this case there is no 60-day time limit at all to worry about. You can initiate a direct rollover at any time for 401ks that you’ve had for many years, and take as long as you like to deposit the check into your new IRA (not that you’d necessarily want to wait very long!)

Any time the IRS issues a ruling like this that is actually helpful, it can be considered a victory for taxpayers.  However, there are still plenty of other rules and traps to watch out for. If you are considering a rollover, feel free to contact us for more detailed guidance.