A specific type of individual retirement account rollover method previously allowed by the Internal Revenue Service has been penalized by the U.S. Tax Court. The result is an IRS rewrite of the tax code for next year. Starting January 1, 2015, taxpayers will be allowed only one of these tax-free rollovers of an IRA every 365 days — regardless of how many IRAs they may have.
The defendant in the court case is a prominent tax lawyer. He and his wife were penalized for following a strategy the IRS has allowed for decades and describes in its own Publication 590, Individual Retirement Arrangements.
Why the change?
All of this came about because the 60-day IRA rollover protocol was too vague and allowed for a loophole interpretation that was too tempting to resist. It’s relatively rare for IRA account holders to gamble with their financial future. Most often those who used the rollover inappropriately did so to fund business cash flow, college tuition bills and other big-ticket cash shortages.
The maneuver was a red flag and sparked the new rules, which are expected to apply to all without exception. It means that if you take a 60-day rollover check and return the funds a day late, you will face huge losses for the privilege. At the least, if the money is not redeposited in another IRA within 60 days, and you are younger than 59½, you will pay a 10 percent penalty and the withdrawal will likely be subject to income taxes.
First we’ll look at the resulting new IRS rules for retirement and their impact on taxpayers. Take a look at the 10 most important lessons you should learn:
After January 1, 2015, don’t do more than one 60-day IRA rollover in a 365 day period (not calendar year), even if the transactions involve different IRAs. In the wake of this court ruling, the IRS has now established new criteria for rollovers.
If you’re using a rollover to borrow money from your IRA, don’t expect the IRS to look the other way. To the tax man, such ploys appear to be back door attempts at getting short-term, interest-free loans.
A Tax Court judge is likely to hold you to a higher standard if you are a CPA, tax lawyer, or otherwise should be familiar with the tax code.
Whenever possible, move IRA money only in a trustee to trustee transfer. Such transfers do not count against the 60-day rollover provision.
If you receive a distribution from an IRA or 401(k) — even one that qualifies for a rollover and isn’t taxable — be sure to fill out lines 15A and 15B on your 1040 reporting the distribution and the taxable part, since these distributions are reported to the IRS.
If you take a distribution before age 59½, even if you believe it exempt from the 10 percent penalty for early withdrawals, attach IRS Form 5329. You plug in a code on the form to explain why. The form is required and full disclosure helps protect you against penalties.
Whenever you do a 60-day rollover, track it diligently and keep copies of any instructions to your IRA trustee, in case something goes wrong.
Don’t miscount the days on your calendar when doing a 60-day rollover. Some months have 31 days.
If you miss the 60-day deadline and enough money is at stake, consult an expert on IRAs. Have them ask for a private ruling from the IRS, allowing you a dispensation from the 60 day rule.
Last but foremost, an ordinary taxpayer cannot use the IRS publications to win a fight with an IRS auditor.
The most direct impact of the new IRS rules for retirement will be on one small group of IRA investors with high net worth who have structured their portfolios into a series of IRAs. Their strategy for these multiple IRAs with high values is to separate each from the other so that a mistake made in one account won’t affect their entire holdings.
An important distinction to the new rules is that there are still no limits on rolling over IRAs and Roth IRAs from one institution to another. That’s called a “trustee to trustee transfer,” and you can still do that as often as you want. You can also shift money among different types of retirement accounts — from a 401(k) to a Roth IRA for example — without complications. But it’s always wise to consult with financial and tax advisers to assure that you follow the guidelines and learn of any potential tax implications.
There’s an interesting IRS backstory to this issue. A specific provision of the tax code allowed IRA owners to withdraw funds from an IRA without having the money taxed or subjected to the 10 percent early withdrawal penalty so long as they redeposited the cash, or rolled it over to a different IRA, within 60 days after the date of withdrawal. When it was first adopted in 1974, taxpayers had to wait three years to use the opportunity again. In 1978, Congress shortened that waiting period to one year.
The IRS doesn’t dispute that the previous proposed regulations allowed the strategy and IRA custodians understood them to. The IRS as much as admitted this when it issued a notice stating that it intends to adopt the Tax Court decision and limit 60-day rollovers to one per taxpayer a year. Apparently, the January 1, 2015 launch was to give IRA custodians time to adjust.
How does this impact the average American?
Perhaps the biggest impact on everyday Americans is that, while this ruling may not apply broadly, it’s likely not the last widely accepted tax strategy will be overturned. In the future, there may be other commonly held perceptions about the tax code that go up in smoke and could affect far more people. And simply relying on common-language publications from the IRS to guide your tax strategies will not be a defense in court.