Indirect IRA Rollovers. Change is Coming
A recent Tax Court ruling makes the use of indirect rollovers from one IRA to another a risky proposition. To ensure no trouble with the IRS, rollovers of this type should probably be handled directly by financial trustees. Here is what you need to know.
Topline: When rolling over funds from one IRA to another (typically Traditional IRAs, Roth IRAs, SEP IRAs and Simple IRAs), it is best to use a direct rollover versus an indirect rollover. As confirmed in a recent tax court ruling, taxpayers are limited to ONE INDIRECT rollover per 12 months. This limit applies no matter how many IRA accounts you own.
Many taxpayers have numerous Individual Retirement Accounts (IRAs). You can move funds from one qualifying account to another without paying taxes on the rollover as long as you follow the rollover rules. If the rules are not followed, the funds are deemed a distribution and taxes plus a potential early withdrawal penalty may be owed. There are two primary methods for rolling over the funds from one account to another:
Direct Rollover. Using this method, the taxpayer never takes possession of the rollover funds. Instead, one institution transfers the funds out of one account and sends them directly to the institution that has the receiving account. Since the taxpayer never takes possession of the funds, there is little chance the IRS would see the transfer as a distribution.
Indirect Rollover. In this case, the funds are withdrawn from the IRA and sent to the account holder. The account holder then deposits the same amount into the new account. As long as the transfer takes place within 60 days, it is a valid transfer and no taxes are owed. The taxpayer bears the burden of proof that the transfer was completed within the required timeframe.
Aggregate once per year rule
In a recent court case, the IRS put their foot down on unlimited INDIRECT transfers of funds.* In their ruling they stated that a taxpayer is entitled to make one indirect transfer per 12-month period regardless of the number of IRA accounts. Any additional transfers are not valid and will be deemed a distribution from your IRA.
Why the rule?
Some taxpayers were using a number of rollovers of the same dollar amount from account to account to give themselves a short-term loan. In the tax case, the defendant removed funds from one IRA. He used the money for a couple of months. He then took the same amount from a second IRA and replaced the money originally removed from the first IRA. He then took the same amount from a third IRA to replace the funds in the second IRA. Finally, the last IRA had its funds replaced. Effectively giving him use of the funds for up to 120 days. The court ruling effectively eliminated the ability to make these kinds of transfers.
The court ruling creates a change in the IRA indirect rollover rules beginning on January 1, 2015. Effective that date, you may only conduct one indirect IRA rollover per 12 month period. IRS publications will be revised to reflect this change.
Because of this, it is best to employ a direct rollover of funds from one IRA to another using a qualified financial trustee to avoid any potential problems. This ruling does not apply to all conversions and rollovers. Please contact the financial institution receiving the rolled over funds for details on their process to ensure it is handled correctly.
*Source: T.C. Memo 2014-21 Bobrow vs Commissioner IRS