Common IRA Rollover Mistakes

Have you thought about rolling your traditional IRAs from one financial institution to another? Maybe you're looking for higher returns, more investment selections or better service. If you roll over your traditional IRA, there are some common mistakes you should avoid. “IRA rules can be tricky and some have even changed over the years, so you need to be careful, otherwise you could pay income tax and penalties,” says Dan Stewart, CFA®, president, Revere Asset Management, Inc., in Dallas, Texas.

In this article, we'll give you an overview of IRA rollover rules and discuss how to avoid breaking them.

After you receive the funds from your IRA, you have 60 days to complete the rollover to another IRA. “That’s 60 days, not two months. I’ve seen mistakes happen,” says Marguerita M. Cheng, CFP®, CEO, Blue Ocean Global Wealth, Gaithersburg, Maryland. If you do not complete the rollover within the time allowed—or do not receive a waiver or extension of the 60-day period from the Internal Revenue Service (IRS)—the amount will be treated as ordinary income by the IRS.

That means you must include the amount as income on your tax return, and any taxable amounts will be taxed at your current, ordinary income tax rate. Plus, if you were not 59.5 years old when the distribution occurred, you'll face a 10% penalty on the withdrawal. (For more, see: Exceptions to the 60-Day Retirement Account Rollover Rule.)

For one year after you distribute assets from your IRA and roll over any part of that amount, you cannot make another tax-free rollover of any IRA. “The downside to this is some banks may charge to issue a check to another bank of custodian when you are moving your IRA. This limit on IRA-to-IRA rollovers does not apply to eligible rollover distributions from an employer plan. Therefore, you can roll over more than one distribution from the same qualified plan, 403(b) or 457(b) account within a year. This one-year limit also does not apply to rollovers from Traditional IRAs to Roth IRAs (i.e. Roth conversions.)

You are allowed to make tax-free rollovers from your IRAs at any age, but if you are 70.5 or older, you cannot roll over your annual required minimum distribution (RMD) because it would be considered an excess contribution. (To read more, see: How to Correct Ineligible (Excess) IRA Contributions.)

If you are required to take an RMD each year, be sure to remove the current year’s RMD amount from your IRA before implementing the rollover.

Your rollover from one IRA to another IRA must consist of the same property. This means you cannot take cash distributions from your IRA, purchase other assets with the cash, then roll over those assets into a new (or the same) IRA. Should this occur, the IRS would consider the cash distribution from the IRA as ordinary income. Here is a hypothetical example of how someone might violate the same property rule:

An entrepreneur, aged 57, has decided to roll over her IRA from one financial institution to another. However, she wants to use her IRA assets to purchase shares of a certain company's stock. She takes a portion of the funds she received from her IRA, buys the shares and places the remaining cash in a new IRA. Then, she deposits the shares of the stock she purchased into the same IRA to receive tax-deferred treatment.

The IRS would deem the portion of the distribution used to purchase the stock as ordinary income; therefore, the entrepreneur would owe taxes at her current, ordinary income tax rate on any taxable portion of the stocks that were rolled over. And, because she is younger than 59.5, the IRS would assess a 10% penalty on any taxable portion of the amount used to purchase the stocks.

If you are simply moving your IRA from one financial institution to another and you do not need to use the funds, you should consider using the transfer method instead of a rollover. A transfer is non-reportable and can be done an unlimited number of times during any period. “A transfer removes the withdrawal process of the rollover, which ensures the assets go directly to their end account and investors remove the risk associated with the 60-day rule,” says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, California, and author of “The 12-Step Recovery Program for Active Investors.”

“In my opinion, a direct transfer is the most optimal solution to move funds from one IRA to another,” says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Florida.

You can roll over funds from any of your own traditional IRAs, but you can also roll over funds to your traditional IRA from the following retirement plans:

• A traditional IRA you inherit from your deceased spouse,
• A qualified plan,
• A tax-sheltered annuity plan, or
• A government deferred-compensation plan (section 457 plan)

If rollover eligible amounts from qualified plans, 403(b) plans or governmental 457 plans are paid to you instead of processed as a direct rollover to an eligible retirement plan, the payor must withhold 20% of the amount distributed to you. Of course, you will receive credit for the taxes that were withheld. However, if you decide to roll over the total distribution, you will need to make up the 20%, out of pocket.

If you want to avoid the withholding and the associated reporting requirements, a direct rollover is the method that should be used to effectuate your rollover from your qualified plan, 403(b) plan or governmental 457 plan account. A direct rollover is reportable, but not taxable. Plus, there is no 60-day window to worry about. Be sure to check with your plan administrator and IRA custodian regarding their documentation and operational requirements for processing a direct rollover on your behalf.

You might be able to move funds in the other direction, too. That is, you may be able to take a distribution from your IRA and roll it into a qualified plan. Your employer is not required to accept such rollovers, so check with your plan's administrator before you distribute the assets from your IRA. Certain amounts, such as nontaxable amounts and RMDs, cannot be rolled from an IRA to a qualified plan. 

(For related reading, see: Tips for Moving Retirement Plan Assets.)