One of the advantages of participating in a retirement plan is that the money in the plan can grow tax deferred until it is withdrawn. There are a variety of types of plans and numerous plan sponsors and institutions that administer the plans. Clients may desire to move retirement funds from one institution to another for many reasons. These reasons could include, but are not limited to: The client may be changing banking or wealth management relationships; the client may desire to consolidate various accounts that may be spread across various institutions and locations; or the client may be looking for different investment options.
Regardless of the reason for moving the funds, taxpayers should be aware of the income tax consequences when they receive preretirement funds. Taxpayers need to be aware of these rules so they are not caught by surprise, can plan to avoid currently paying income tax and the 10% addition to tax for premature distributions, and continue to benefit from tax-deferred growth.
Generally, a distribution from a retirement plan is taxable to the recipient as ordinary income in the year that it is received. Under Sec. 72(t), the recipient also could be subject to a 10% early withdrawal penalty if the distribution is received before the recipient reaches age 59½. Congress does provide relief under Secs. 402(c)(3) and 408(d)(3) to exclude from gross income retirement plan distributions for which taxpayers can complete a "rollover" of their funds.
Taxpayers can take advantage of the guidance in Rev. Proc. 2003-16 and, more recently, the "self-certification" procedures in Rev. Proc. 2016-47 to avoid this penalty if something goes wrong when trying to complete a rollover.
Direct and indirect rollovers
A rollover occurs when the taxpayer withdraws cash and/or other property from one eligible retirement plan and deposits the funds in whole or in part into another eligible retirement plan within 60 days of receipt of the funds. Sec. 402(c)(8)(B) contains the list of what is considered an eligible retirement plan: an individual retirement account (IRA), an individual retirement annuity, a qualified pension, a profit sharing or stock bonus plan, a Sec. 403(a) annuity, a governmental Sec. 457 plan, and a Sec. 403(b) annuity.
Once the taxpayer determines that where the funds are to be deposited is an eligible "destination," the taxpayer must next decide which type of rollover he or she intends to complete. There are two main types of rollovers. The first type of rollover is a direct rollover (also known as a trustee-to-trustee transfer when receiving a distribution from an IRA). Sec. 401(a)(31) requires that a qualified trust provide for the direct transfer of eligible rollover distributions. (Similar rules apply for the other eligible retirement plans mentioned above.) With this type of rollover, the participant's funds "stay within the system." The plan administrator and/or the financial institution holding the funds make the payment directly from the current retirement plan/IRA to another retirement plan/IRA. The second type of rollover is an indirect rollover in which the distribution from the retirement plan/IRA is made directly to the taxpayer, who then must deposit all or a part of the funds into another IRA or retirement plan within 60 days of receipt.
If a recipient elects not to do a complete direct rollover, Sec. 3405(c) provides that the payer of a designated distribution that is an eligible rollover distribution must withhold from the distribution an amount equal to 20% of the distribution. The withholding is mandatory for indirect rollovers from qualified plans (indirect rollovers from IRAs are not subject to this withholding rule). Direct rollovers, on the other hand, are exempt from the mandatory withholding rules. One significant consideration for an indirect rollover is the mandatory withholding rules. If the taxpayer wants to defer tax on the entire taxable portion, he or she must add funds from other sources equal to the amount withheld.
One thing taxpayers will need to keep top of mind is that not all distributions are eligible rollover distributions. Sec. 402(c)(4) defines an eligible rollover distribution as any distribution from a qualified plan to an employee of part or all of the employee's account balance that is not one of the following:
- A distribution that is part of a series of substantially equal periodic payments (to meet this element, the payments must be made at least once a year over either (1) the life or life expectancy of the employee or the joint lives (or joint life expectancies) of the employee and the employee's designated beneficiary, or (2) for a specified period of 10 years or more);
- A distribution that is a required minimum distribution (RMD) (only the RMD amount for the tax year is not eligible for rollover treatment under this rule—an amount exceeding the RMD would qualify);
- A distribution that is a hardship distribution;
- Loans treated as a distribution;
- A distribution of excess contributions and related earnings;
- Withdrawals electing out of automatic contribution arrangements;
- Distributions to pay for accident, health, or life insurance;
- Dividends on employer securities; or
- S corporation allocations treated as deemed distributions.
When rolling over a distribution, taxpayers have the option to either roll over the entire distribution or roll over an amount less than the entire distribution. The taxpayer needs to consider that any amounts not rolled over are taxable as ordinary income.
Most taxpayers and tax professionals operate under the provisions contained in Sec. 7503 for acts that must be performed with the IRS. This Code section provides that when the deadline to perform an act (such as filing a tax return) falls on a weekend or legal holiday, that act is considered to have been performed timely if it is performed on the next day that is not a weekend or holiday. Taxpayers and tax professionals should keep in mind that completing a rollover of an eligible rollover distribution is not an act that is performed with the IRS. Rather it is an act performed with a financial institution, so the extension that is provided when the deadline falls on a weekend or holiday is not similarly extended.
Relief from failure to complete an eligible rollover
Even with the best of intentions, sometimes a taxpayer's desire to complete an eligible rollover gets derailed, and the 60-day window to complete the transaction is missed. Rev. Proc. 2003-16 walks taxpayers through their two options. The choice of which option to select depends on the reason the rollover was not completed timely.
Under this revenue procedure, the IRS will grant automatic waivers of the 60-day rule when the sole reason for missing the deadline is that the financial institution made an error. Under this circumstance, (1) the financial institution must have received the funds on behalf of a taxpayer before the expiration of the 60-day rollover period; (2) the taxpayer must have followed all procedures required by the financial institution for depositing funds into an eligible retirement plan within the 60-day rollover period; (3) the taxpayer must have given instructions to the institution to deposit the funds into an eligible retirement plan and, solely due to the financial institution's error, the funds were not deposited into an eligible retirement plan within the 60-day rollover period. Automatic approval is granted if the funds are deposited into an eligible retirement plan within one year from the beginning of the 60-day rollover period and, if the financial institution had deposited the funds as originally instructed, it would have been a valid rollover.
Before 2016, a taxpayer's only option, if he or she did not fall under the qualifications for automatic approval, was to apply for a hardship exception. The IRS has authority to waive the 60-day rollover requirement in cases where "the failure to waive such requirement would be against equity or good conscience" including casualty, disaster, or other events beyond the reasonable control of the taxpayer (death, disability, hospitalization, incarceration, postal error, restrictions imposed by a foreign country, etc.). The IRS considers all relevant facts and circumstances when determining whether to grant a waiver. When using this option, taxpayers are required to follow the same procedures as those to obtain letter rulings and pay a user fee of $10,000 (see Rev. Proc. 2017-4).
Rev. Proc. 2016-47 and 'self-certification'
With the issuance of Rev. Proc. 2016-47, the IRS established a "self-certification" option for taxpayers who have missed the 60-day rollover period for rollovers occurring on or after Aug. 24, 2016. Under this option, taxpayers can make a written certification to a plan administrator or an IRA trustee that a contribution satisfies the following conditions:
1. The IRS has not previously denied a waiver request with respect to a rollover of all or part of a distribution to which the contribution relates.
2. The taxpayer missed the deadline due to one or more of the following reasons:
- An error was committed by a financial institution;
- The distribution check was misplaced;
- The distribution was deposited into and remained in an account the taxpayer thought was an eligible retirement plan;
- The taxpayer's principal residence was severely damaged;
- A member of the taxpayer's family died;
- The taxpayer or a member of the taxpayer's family was seriously ill;
- The taxpayer was incarcerated;
- Restrictions were imposed by a foreign country;
- A postal error occurred;
- The distribution was made on account of a levy under Sec. 6331, and the proceeds of the levy have been returned to the taxpayer; or
- The party making the distribution to which the rollover related delayed providing the information that the receiving plan or IRS required to complete the rollover despite the taxpayer's reasonable efforts to obtain the information.
3. The contribution to the plan or IRA was made as soon as practical after the reason or reasons for missing the deadline that had prevented the taxpayer from making the contribution. This condition is considered satisfied if the contribution is made within 30 days after the reason occurred.
A taxpayer must use either the model letter provided within the revenue procedure (word for word) or may use a letter that is substantially similar in all material respects. Once received, a plan administrator or IRA trustee may rely on the taxpayer's self-certification unless he or she possesses actual knowledge to the contrary. The mere act of the taxpayer's completing the self-certification is not a waiver by the IRS of the 60-day rollover requirement. However, the taxpayer may report the contribution as a valid rollover unless later informed otherwise by the IRS. In an examination, the IRS may consider whether a taxpayer's contribution meets the requirements of the waiver. The taxpayer should keep a copy of the self-certification in his or her files so it can be produced in the case of an audit.
Options for preserving tax deferral
With the introduction of a third option available to taxpayers who miss the 60-day rollover period, the IRS has removed most, if not all, of the barriers that may have prevented them from preserving the tax-deferred treatment of retirement funds. Along with the 60-day window to complete a rollover, taxpayers should consider various other factors, including the mandatory withholding requirement, differences between the types of rollovers, and that beginning in 2015, a taxpayer can make only one rollover from an IRA to another IRA in any 12-month period regardless of the number of IRAs he or she owns (trustee-to-trustee transfers are not limited). With proper planning, taxpayers can continue to save for the future and benefit from tax-deferred growth of their retirement savings.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.