What Tax Rules Apply to an IRA Rollover?

Moving retirement savings from one account to another can allow you to keep the money invested without immediately recognizing taxable income. This often comes up after leaving an employer, when you may decide to move money from a workplace retirement plan into an IRA. The tax treatment depends on the accounts involved and how the transaction is completed. Having the money sent to the receiving retirement account can reduce the withholding and deadline issues that arise when a distribution is paid to you first. Speaking with a financial advisor can help provide clarity when weighing IRA rollover decisions.

How the IRS Taxes IRA Rollovers

Taking money out of a 401(k) or IRA can produce taxable income when the distribution includes money that has not previously been taxed. A qualifying rollover allows eligible retirement funds to move into another retirement account without treating the transaction as a current taxable distribution.

For example, someone leaving a job might move eligible 401(k) savings into a traditional IRA. Depending on the receiving plan’s rules, another option may be to move the balance into a new employer’s retirement plan. These transactions generally continue the tax-deferred treatment of pretax savings rather than converting them into currently taxable income.

The tax result changes when pretax retirement money is moved into a Roth IRA. Because Roth accounts generally hold after-tax dollars, previously untaxed amounts converted to a Roth are ordinarily included in taxable income for the year of the conversion.

How the money moves also matters. With a direct rollover, the distribution is directed to the new IRA or retirement plan rather than paid to you for personal use. This approach generally avoids the mandatory federal income tax withholding that can apply when an eligible workplace plan distribution is made payable to the account owner.

An indirect rollover puts the distribution in your hands first. You ordinarily have 60 days after receiving eligible funds to place them in another qualifying retirement account. An eligible workplace plan distribution paid directly to you generally has 20% withheld for federal income taxes. If you want the entire distribution to qualify for rollover treatment, you would need to replace that withheld amount with money from another source before the deadline.

Any eligible amount that is not rolled over generally becomes a distribution for tax purposes. Pretax funds can be included in gross income. Someone younger than 59½ may also owe a 10% additional tax unless an exception applies.

A separate restriction applies to certain IRA transactions. The one-rollover-per-year rule generally limits an individual to one 60-day rollover involving IRAs in any 12-month period, regardless of how many IRAs the individual owns. It does not apply to direct trustee-to-trustee IRA transfers, Roth conversions or rollovers involving an employer retirement plan.

How a Typical 401(k)-to-IRA Rollover Works

Suppose a 42-year-old worker leaves an employer with $100,000 of pretax money in a 401(k) and chooses to have the eligible distribution paid directly to him or her before moving it to a traditional IRA. Assuming the full balance is eligible for rollover, 20% federal withholding would generally reduce the check to $80,000.

Depositing only that $80,000 into the IRA within 60 days would leave $20,000 outside the rollover. That $20,000 would generally be taxable as a distribution. At age 42, the saver could also owe a $2,000 additional tax, equal to 10% of the amount not rolled over, unless an early-distribution exception applies. The $20,000 originally withheld would be credited toward the person’s federal income tax liability.

The saver could instead use $20,000 from other funds and deposit a total of $100,000 into the IRA before the deadline. Doing so would allow the entire eligible 401(k) distribution to receive rollover treatment. The tax withholding would still be reported as federal income tax paid and could affect the amount owed or refunded when the saver files a return.

The annual IRA rollover restriction would not apply to this example because the money originated in a 401(k).

Strategies to Minimize IRA Rollover Taxes

One way to reduce the possibility of an unexpected tax bill is to have eligible retirement funds sent directly to the account receiving them. For workplace plan distributions, this generally avoids the 20% withholding that applies when eligible rollover money is instead paid to you. For money moving between IRAs, a trustee-to-trustee transfer also avoids the 60-day rollover process and is not subject to the one-rollover-per-year limit.

It is also important to identify what can actually be moved. Certain distributions are not eligible for rollover treatment, including required minimum distributions and hardship distributions. Some substantially equal periodic payments and other specified distributions are also excluded.

The type of destination account should be considered as well. Moving pretax assets into another pretax account generally postpones taxation until later distributions. Moving those assets into a Roth IRA generally accelerates taxation because the untaxed portion of the conversion becomes income for the year.

What Happens If You Miss the 60-Day Deadline?

A late rollover can turn what was intended as an account transfer into a taxable distribution, but relief may be available in some circumstances. The IRS provides procedures that can allow the 60-day requirement to be waived when a taxpayer meets specific conditions.

One option is self-certification. Certain events, such as an error by a financial institution, serious illness, postal problems or a misplaced distribution check, may qualify. The taxpayer generally must complete the rollover promptly after the problem preventing the deposit has been resolved.

Self-certification is provided to the financial institution receiving the late rollover. It does not amount to advance IRS approval. If the transaction is later reviewed, the IRS can determine whether the circumstances actually qualified for a waiver. Other avenues for relief can include an automatic waiver in limited cases or requesting an IRS ruling.

Because a missed deadline can affect both income taxes and the 10% additional tax for some younger savers, keeping records showing when the distribution was received, what caused the delay and when the rollover was completed can be important.

Bottom Line

IRA rollover taxes depend on where the retirement money starts, where it goes and how it gets there. Moving eligible pretax savings directly into another qualifying pretax retirement account generally allows taxation to be postponed. Receiving the money yourself introduces additional requirements, including the 60-day deadline and, for many workplace plan distributions, 20% federal withholding. Roth conversions and amounts that fail to qualify for rollover treatment can create current taxable income, making it important to check the applicable rules before moving retirement assets.

Tips for Retirement Planning

• A financial advisor may identify opportunities to reduce associated taxes and penalties when doing an IRA rollover. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Get an idea about whether you’re saving enough to pay for a comfortable retirement with the help of SmartAsset’s retirement calculator.

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