Handle Your IRA Rollovers with Care

There are many good reasons for rolling over funds from one IRA to another — or from a 401(k) plan or other employer retirement plan to an IRA. Perhaps you wish to consolidate retirement savings into one account. Or maybe you are moving funds from one account into another that offers more attractive investment options. Whatever the reason, care should be taken to avoid triggering unnecessary taxes and penalties.

Direct vs. indirect rollovers

Generally, there are two ways to move funds from an employer plan to an IRA or from one IRA to another: a direct transfer or an indirect rollover. With a direct rollover, you ask the plan administrator or the financial institution holding your IRA to move the money directly to another IRA in a trustee-to-trustee transfer. Because you never touch the money, direct transfers have no tax consequences. With an indirect rollover, you withdraw funds from your retirement plan or IRA and deposit them into another IRA. There is no tax on indirect transfers if you complete the rollover within 60 days.

Direct transfers are almost always preferable. First, there is no risk of violating the 60-day rule. While completing a rollover within 60 days seems like a simple proposition, you would be surprised how often people miss the deadline. Plus, direct transfers are not subject to the one-rollover-per-year rule (see below), which often trips people up and triggers unexpected taxes and penalties.

Another drawback of indirect rollovers is that typically taxes will be withheld from your distribution. So, if you want to roll over the full amount of the distribution, you will need to use other funds to cover the shortfall.

For example, suppose Monica receives a $10,000 distribution from her 401(k) plan that is eligible for a rollover. Her employer withholds 20% of the distribution ($2,000) for income taxes and pays Monica $8,000. Monica wants to roll over the full $10,000, so she withdraws $2,000 from her savings account and deposits it, along with the $8,000 check from her employer, in an IRA. If she rolls over only $8,000, she will owe income tax on the remaining $2,000 and may have to pay a 10% early withdrawal penalty. (No withholding is required for direct transfers.)

Common rollover mistakes

As previously noted, it is common for people to miss the 60-day deadline for indirect rollovers, triggering unwelcome taxes and penalties. However, an even more dangerous mistake is making multiple indirect rollovers in one year.

The “one-rollover-per-year” rule is trickier than it sounds. For one thing, it prohibits you from making more than one indirect rollover in any 12-month period. Many people mistakenly believe that the rule is applied on a calendar-year basis, but if you perform an indirect rollover in December of one year and another in January of the following year, you will violate the rule.

Another potential trap is that the rule applies on an aggregate basis. This means you cannot make more than one tax-free indirect rollover in a 12-month period, even if they involve different IRAs. For purposes of the one-rollover-per-year rule, all of your IRAs — including Simplified Employee Pension (SEP) and Savings Incentive Match Plans for Employees (SIMPLE) IRAs as well as traditional and Roth IRAs — are treated as a single IRA. However, the rule does not apply to:

• Rollovers from traditional IRAs to Roth IRAs (conversions);
• Trustee-to-trustee transfers to another IRA;
• IRA-to-plan rollovers;
• Plan-to-IRA rollovers; or
• Plan-to-plan rollovers.

The consequences of violating the one-rollover-per-year rule are harsh. If you receive a distribution from an IRA of previously untaxed amounts, and you performed a rollover within the preceding 12 months, you will have to include the distribution in your gross income. In this case you may be subject to a 10% early withdrawal penalty. What’s more, if you deposit the distributed amounts in another (or even the same) IRA, they may be treated as an excess contribution and subject to an excise tax of 6% per year until you withdraw them.

Turn to your advisor

The safest approach is to avoid indirect rollovers and use direct rollovers, which are not subject to the one-rollover-per-year rule. Contact your advisor if you have questions about rolling over an IRA account.

Matching Roth contributions: potential pitfalls

The SECURE 2.0 Act added an option for employees who receive matching contributions from their employers to their 401(k) plans or other qualified plans. If your plan allows, you can choose to receive employer matches as after-tax Roth contributions. To avoid unpleasant surprises, however, assess the impact of such contributions on your tax bill. After-tax contributions increase your income for the year, but your employer may not automatically withhold the necessary extra taxes.

Suppose your salary is $150,000, and your employer makes matching contributions to your 401(k) account equal to 6% of your salary ($9,000). Assuming you are in the 24% tax bracket, you would end up owing an extra $2,160 in federal income tax for the year ($9,000 x 24%) if you opt to take the employer match as a Roth contribution. Plus, you might also owe extra state income tax. To avoid underpayment penalties, consider increasing your withholdings or quarterly estimated tax payments to cover the additional tax liability.

Watch out for fake charities

When there is a natural disaster or other tragic event, fake charities usually appear, ready to take advantage of your generosity and compassion for those in need. The cost of donating to an illegitimate charity can be high. Not only will your intended recipients be deprived of your donations, but you also can lose valuable tax deductions. Plus, fake charities may attempt to obtain sensitive personal and financial information they can exploit to steal your identity.

Many fake charities use names that are similar to those of legitimate charities, so it is important to be diligent to avoid being duped. The IRS urges taxpayers to resist pressure tactics and take the time to vet charitable organizations before you donate. Consider using resources like the IRS’s Tax-Exempt Organization Search (TEOS) tool. The IRS also advises taxpayers to avoid charities that ask for donations via gift card or wire transfer. Instead, pay by credit card or check, and do not provide your Social Security number or other unnecessary personal or financial information.

Are you eligible for the self-employed health insurance deduction?

If you are self-employed, you may be able to deduct 100% of the health insurance premiums you pay for you and your family. It makes no difference whether you purchase the insurance in your own name or your business purchases it. Keep in mind that the deduction cannot exceed the net income you earn from your business. Also, the deduction is unavailable if you are eligible to participate in a health insurance plan subsidized by an employer of you or your spouse.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.