How To Avoid IRA Rollover Mistakes

By Jon L. Ten Haagen

We all make mistakes, and even little ones can be expensive. This is especially true with Individual Retirement Accounts. The laws are complex and ever-changing. There are taxes and penalties you must be aware of, because if you make a mistake, it might not be possible to undo it. To make sure you are properly prepared do your own homework and work with a qualified certified financial planner to avoid the common IRA rollover mistakes. To err is human, but let’s not.

1.         Missing the 60-day rollover deadline. There is a thing called the indirect rollover, and the IRS has specific rules for this procedure. You request funds be sent directly to you rather than another investment institution. This can be from a company retirement plan (401(k), 403(b), 457, etc.), or from an IRA you have. After you receive your funds, you have 60 days – not 59 or 61 days – to complete a rollover back into an IRA. You must replace the full amount, including the 20 percent withheld by your qualified retirement plan. If the rollover is not complete within the time allowed, the amount would be treated as ordinary income in the IRS’s eyes. You will then have to state the amount as income on your tax return and it will be taxed at your current ordinary income tax rate (this could push you into a higher bracket). Additionally, if the distribution occurs before you turn age 59.5, you may be in for a 10 percent penalty for early withdrawal. To avoid this error you should consider a direct trustee to trustee transfer of your rollover assets. This means the monies never get into your hands. Be a smart investor.

2.         Another error is to deposit rollover assets into the wrong account. The account you deposit your assets into must be eligible to receive rollover assets in order to maintain their tax deferral status. Moving assets to the wrong account (i.e., ROTH assets to a traditional IRA, or a traditional IRA into a retail account (personal account) can result in penalties and in some cases, permanent loss of future tax deferral. The error may be eligible for correction as an exception to the 60-day rule by applying for an IRS private letter ruling. The private letter ruling process can take up to nine months and cost as much as $3,000. I have had to deal with new clients who have done this and it is a long process which is very trying and costly. Avoid this by working with a knowledgeable certified financial planner.

3.         Think long and hard about whether to leave your hard earned 401(k) (or other qualified plans) in a former employer’s retirement plan! When you leave the company you worked for, you typically have the right to roll over your entire vested balance into an IRA. Here are three possible good reasons to do so:

a.         You could gain access to a much larger array of investment options. This could allow you to manage your assets more effectively.

b.         If you die, your beneficiaries may be able to take distributions over their lifetimes. This would allow for a longer period of tax deferral that could extend after your death.

c.         You can avoid the 20 percent mandatory withholding for distributions if you roll over your retirement plan to an IRA.

4.         Considering taking early withdrawals from your IRA? Failing to follow IRS Rule 72T could cost you a lot. Rule 72T allows for penalty-free withdrawals from an IRA account. The rule requires that, in order for the withdrawals to be penalty-free, they must be taken as “substantially equal periodic payments.” The amount depends on the IRA owner’s life expectancy calculated with various IRS-approved methods. Failing to calculate the proper amount and duration of the payments can lead the IRS to assess a 10 percent penalty on all amounts withdrawn. You have to continue to take these distributions for either 5 years or until you reach age 59.5. Failure can result in more penalties. Consult with a competent CFP.

Be proactive in seeking advice. IRAs are one of the largest single assets owned my many Americans. Even small mistakes can prematurely cut off the tax-deferred growth of IRAs that may be worth millions and create huge income-tax bills for those who inherit. If you are going to err, do so on the side of caution by seeking the advice of a qualified certified financial planner before you roll over or transfer your assets. There is too much at stake not to protect your hard earned funds.