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Avoiding The IRA Rollover Crackdown

To avoid current tax and penalties on money transferred to an IRA from a 401(k) or other tax-qualified retirement plan, you must complete a rollover within 60 days. During the past few years, the IRS has granted waivers to that rule when extenuating circumstances delayed the transfer. But new tax rulings appear to reduce your chances of special dispensation.

Normally, a distribution from a tax-qualified, employer-sponsored retirement plan such as a 401(k) or 403(b) is considered income, taxable at ordinary income rates. Moreover, if you’re not yet age 59½, you’ll be assessed a 10% penalty on the distribution, unless a special exception applies. And finally, your employer will withhold 20% of the distribution and send the money to the IRS to help pay taxes you may owe.

You can sidestep all or most of those issues by transferring the funds to a traditional IRA within 60 days. You have two choices for doing this.

The preferred method is via a “trustee-to-trustee” transfer, where you arrange for your employer to transfer your existing retirement plan to a new rollover IRA that you’ve opened. Since you never touch the funds, it avoids the 20% tax withholding and the possibility of missing the 60-day deadline.

If you take a check from your employer and deposit the full amount of the distribution in an IRA within that 60-day window, you’ll avoid a penalty, but your employer will still withhold that 20%. While you’ll get that back when you file your taxes, you have to come up with the cash before then in order to deposit, as required, the full amount of the plan’s pre-transfer value into your new IRA.

A 2002 tax law change allows the IRS to grant a waiver if you have a good reason for missing that 60-day deadline. If you can show the delay was the fault of the financial institution receiving the funds, for example, you’re off the hook. But in less clear-cut cases, the IRS will decide based on the circumstances. And after being lenient about waivers for several years, the agency appears to have adopted a tougher stance. That’s clear in two recent private rulings.

In the first, a widower received his deceased wife’s interest in a 403(b) plan. After the plan administrator withheld tax, the husband failed to deposit the balance in an IRA within 60 days. He wrongly believed the withholding absolved his tax liability. The IRS turned down his request for a waiver.

The second ruling involved a retired IRA owner who wanted to transfer funds to an IRA with a provider closer to his new home. But the funds instead went to a non-IRA account, and the account owner failed to move the money into another IRA in time. Again, the IRS nixed the waiver request.

These rulings underscore the need for careful handling of retirement plan transfers. Please give us a call before you make any moves.