Don’t Make These Fatal Errors With IRA Rollovers

Key Takeaways

• If you have a 401(k) with an old employer and want to roll it over into an IRA, you only want to do direct transfers.
• You have to complete rollovers within 60 days. It sounds like a long time, but a lot of people miss the boat on this thing.
• The fatal error is when you move from one IRA to another. If you do a second rollover within the 365 days, it can’t go in. It would be an excess contribution and results in more penalties. The whole thing is taxable.

Christine Benz: Hi, I’m Christine Benz from Morningstar. The average person changes jobs 12 times in a lifetime, which means lots of 401(k) and IRA rollovers. Joining me to discuss how people can run into problems with rollovers is tax and IRA expert Ed Slott. He is just out with a new book called The Retirement Savings Time Bomb Ticks Louder.

Ed, thank you so much for being here.

Ed Slott: Great to be here.

How to Roll Over a 401(k) Into an IRA

Benz: Ed, let’s start by going through the steps that I need to take. Say I have a 401(k) with an old employer, I want to roll it over into an IRA. What are the things I need to do to make sure that I’m dotting my i’s and crossing my t’s?

Slott: All right. Let me get to the answer first, the solution, the spoiler at the end. Don’t do rollovers. And by rollovers, I mean, when you take the money out, you take possession, you get a check and roll it over, say, to an IRA or IRA to IRA. Do only direct transfers. So, if you’re coming out of a job, you do a direct transfer, if the company will let you do it, from your 401(k) right to your IRA without you touching the money in between. There was a famous football coach. I don’t remember who it was, but I always mention it in programs because wherever I go, they always say it’s their college coach who said it. It’s a funny thing, wherever I go. And he said, in football, when you throw the ball, three things happen and two of them are bad. So, if you go to Ohio, “Oh, Woody Hayes said that.” So, everybody says their guy said that.

Can You Rollover an IRA Without Penalty?

Well, if you do a rollover like I told you, called an indirect rollover because you’re taking possession of the money, three things happen and they’re all bad. If you do a rollover like I’m talking about—not a direct rollover, I gave you the solution first, why never to do these kinds of rollovers—if you take money from a 401(k), take the check and want to roll it to your IRA, very common.

Let’s say you have $500,000. You’ll only get $400,000. There’s mandatory 20% withholding. So, they’re going to give you a check for only $400,000. Now, you don’t lose your money. That gets credit to your federal withholding tax because it’s the law. But what if you don’t have $100,000 to complete the rollover, then that’s going to be taxable. If you do a direct transfer, that rule doesn’t apply. You have the 60-day rollover rule. You have to complete these rollovers within 60 days. It sounds like a long time, but a lot of people miss the boat on this thing. You don’t have to worry about 60 days if you would do a direct transfer. It happens instantaneously. And probably the worst one, the fatal error is when you move—and this sounds so simple—I want to move from one IRA to another. Nice and simple. That’s a once per year—it’s called the once per year IRA rollover rule—and that’s the one that gets people. It’s a fatal error. You lose your IRA because you’re only allowed to do one per year, and that throws people. Because it’s not really a year. It’s not a calendar year. It’s a fiscal year, 365 days. So, some people might say, “Well, I know about the once per year rollover rule.” So, I’m going to roll over some in December. And then January is a new year.” No. If you do a second rollover within the 365 days, you can’t do it. It can’t go in. It would be an excess contribution and results in more penalties. The whole thing is taxable.

So, in my example, let’s say the second one was the $500,000. All taxable. There’s no fix. It’s a fatal error, and the funds are no longer IRAs. It’s over. So don’t do once-per-year rollovers. So, there are cases on this all the time. But one big case that came out recently where it was a famous Hollywood guy and had these fancy attorneys and all this stuff. They blew every rule, every rollover rule. They were supposed to be Beverly Hills accountants or tax guys or attorneys. They not only blew every rule because they got assessed over a million dollars in penalties, they went to fight it in tax court, and they almost laughed them out of the court because these are black-and-white rules. They blew every rule. They created these arguments like one was on the 60-day rule. They blew that one. They said, “Well, we want to claim you have over, actually over a year to do a 60-day rollover.” There were more holes in their argument than Sonny Corleone. You know why I say that? Because it was Sonny Corleone. It was James Caan.

Benz: Wow.

Slott: In our programs, we show that clip. In The Godfather, we get shot full of holes and everything. We say, and that’s not the worst thing that happened to him—because then the IRS came in. Now, he has since died, and his estate had to pay over a million dollars in taxes and penalties because they broke the 60-day rule. They said they broke the once-per-year rule, but they probably could have got off on that because they didn’t technically do it. But there’s another rule called the same property rule. If you take money out of an IRA, it was some kind of a hedge fund, you have to return that to the new IRA. So, they couldn’t do it because the new IRA wouldn’t take it. So, they cashed it out and returned the cash. But even that was over a year late. They did everything wrong. So, they threw the book at them, and he never saw the end of it, but his beneficiaries got hit with over a million dollars of taxes. If they had just done a direct over everything, none of this would have happened.

Rules for IRA Rollovers

So, the idea is, don’t fool around with this stuff. You get one chance. And the rule applies. The once per year, that’s the fatal error, IRA to IRA, Roth IRA to Roth IRA. It does not apply, the once per year, that’s why I call it the once per year IRA rollover rule, it doesn’t apply when you move from a 401(k) to an IRA. That doesn’t count as one. Or if you go back, like some people do, they have an IRA, they roll it back to a 401(k), that doesn’t count as one. Or if you go from an IRA to a Roth IRA, that’s a Roth conversion. That doesn’t count as one. It’s just IRA to IRA, Roth IRA to Roth IRA.

But if you never want to worry about this, don’t do these indirect or 60-day rollovers, because all these bad things can happen. People think 60 days is a lot, but there are all kinds of reasons, that one you could get out of. But why go through it? You could give an excuse. “I didn’t know about the 60 days” or death, all these valid excuses, which IRS would extend the time. But why bother? Do direct transfers.

Now, some people tell me, “Well, when I’m taking money from one IRA or from a company, they won’t give me, they won’t do a direct transfer.” They don’t have to. They will make a check out. Well, if you get a check made out to you, say you’re Mary Smith, if I get a check made out to Mary Smith, that’s constructive receipt. Now you’re back in the bad kind of rollover, the 60-day rollover. If they will only make out a check, have the check made out to your receiving account, not Mary Smith—the IRA of Mary Smith, because Mary Smith can’t cash that check. That under the law counts as a direct trustee to trustee transfer, a direct rollover. And that’s the only way to move money around from IRA to IRA, or 401(k) to IRA, any which way. If you do direct transfers, you’ll never have to worry about any of this. Wouldn’t that be nice?

Benz: That would be nice. I wanted to ask about that direct trustee to trustee transfer. Does that avoid that 20% mandatory withholding?

Slott: Yes. The 20% again is only from a plan like a 401(k) to IRA. There’s no mandatory withholding IRA to IRA.

Benz: Got it. Ed, it’s always great to hear from you. Thanks for sharing your insights today.

Slott: Thank you.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Watch The New Rules for Missed RMDs for more from Christine Benz.