As sure as the sun rises every morning you stand a good chance of encountering a taxpayer who has violated the one rollover a year rule for IRAs. This article includes how that rule is applied, exceptions to the rule and the tax consequences.
Background - This rule is actually the result of a 2014 tax court case, Bobrow v. Commissioner (TC Memo 2014-21), where the court took the position that the once-per-year IRA rollover limitation of Code Sec 408(d)(3)(B) applies on an aggregate basis, meaning that an individual could not make an IRA-to-IRA rollover if he or she had made such a rollover involving any of the individual’s IRAs in the preceding 1-year period. The IRS, which in its publications had previously interpreted the law to apply the once per year rollover separately to each IRA of an individual, subsequently in Announcement 2014-15 adopted the court’s reading of the law.
SEPs & SIMPLES - In Announcement 2014-32 the IRS clarified that the once per 12-month period rollover limitation also applies to SEPs and SIMPLE plans, but not qualified plans.
One Year Measurement - The one-year period is measured based on the date a distribution is received. If the second distribution is received before the same date one year later, it is a disqualified rollover (IRC Sec. 408(d)(3)(B)).
Example – Jack takes a distribution from his IRA on June 30 of year one and subsequently rolls over the distribution within the 60-day rollover period. Jack must wait until June 30 of year two before another distribution is eligible for a rollover. Any additional distributions taken during the one-year waiting period would be taxable.
Example – A taxpayer received a distribution from his IRA with Chase Bank in February, which he immediately rolled into a new IRA with Wells Fargo. Then in May he took a distribution from the Wells Fargo IRA and rolled it back into the IRA at Wells within 60 days. Even though he rolled the exact amount back into the same institution within 60 days, the distribution from Chase had started the running of the one-year waiting period. Thus his second distribution was in violation of the 1-year waiting period and was a taxable distribution. The redeposit of what he thought was a rollover was actually a contribution to the IRA.
Exceptions – The following are not treated as rollovers:
Direct Transfers – As long as IRA funds are transferred directly between trustees the transaction is not considered a rollover. A taxpayer can make as many direct transfers in a year as he or she wants.
Roth Conversions – Traditional IRA to Roth IRA conversions are not treated as rollovers.
Distributions From Qualified Plans - For purposes of the one-year waiting period, a distribution from a qualified plan that is rolled over to an IRA is not treated as a rollover from an IRA (Reg § 1.402(c)-2, Q&A 16). Since 408(d)(3)(B) only applies to IRA to IRA rollovers, an IRA to a qualified plan rollover is not subject to the one year rule.
Failed Financial Institution - An IRA distribution made from a failed financial institution by the Federal Deposit Insurance Corporation (FDIC) as receiver is disregarded for purposes of applying the one-rollover-per-year limitation, provided: (1) neither the failed financial institution nor the depositor initiated the distribution, and (2) no financial institution has assumed the IRAs of the failed financial institution.
Tax Consequences – When the one-year rule is violated any distribution after the first distribution made within the one-year waiting period will not be treated as a rollover, with the following tax consequences:
- Traditional IRA - In the case of a traditional IRA the entire distribution will be taxable, and if the taxpayer is under age 59.5 at the time of the distribution the 10% early distribution penalty will apply. Of course, if some of the contributions to the traditional IRA were designated nondeductible, a portion of the distribution will be nontaxable as computed on Form 8606.
- Roth IRA - In the case of a Roth IRA that is a:
- Non-Qualified Distribution – A distribution from a Roth IRA that has not met the five-year aging requirements would be a non-qualified distribution and the earnings would be taxable. Of course the original contributions are never taxable based on a specific distribution sequence, which is contributions, then conversions from traditional IRAs or rollovers from qualified plans (first the part that was taxed when the funds went into the Roth and then the nontaxable part), and lastly earnings. The 10% early distribution penalty applies to any amount attributable to the part of the conversion or rollover amount, which had to be include in income at the time of the conversion or rollover (recapture amount).
- Qualified Distribution –No tax or penalty applies if a distribution from a Roth IRA is a “qualified distribution,” which is a distribution made after the 5-year aging period is met and the taxpayer is:
- age 59.5 or older,
- deceased, or
- qualifies for the first-time homebuyer exception (maximum $10,000).
The subsequent disqualified rollover – The disqualified rollover amount would be treated as a new IRA contribution subject to the normal annual contribution and AGI limitations. Thus it could create an excess contribution, which is subject annually (except for the year of the distribution) to a 6% excess contribution penalty.
Excess Contribution Remedies – There are a couple of remedies available for a disqualified rollover:
- Corrective Distribution – The excess contribution and the interest attributable to it can be withdrawn by the extended due date of the return for the year the distribution is made, thus undoing the rollover. The distribution that resulted in a disqualified rollover is subject to tax as outlined earlier depending upon whether it was a traditional or Roth IRA. The earnings attributable to funds withdrawn are taxable. However, the annual 6% excess contribution penalty is avoided ( 408(d)(4)).
- Contributions In Future Years – The excess contribution could be left in the IRA and can be treated as an IRA contribution in a later year. However, until the excess contribution is fully absorbed as eligible future contributions, the annual 6% excess contribution penalty will apply.
Mitigating The Early Withdrawal Penalty – Although there are a number of exceptions to the under age 59½ early distribution penalty, the following might be used to avoid or mitigate early withdrawal penalty associated with a disqualified rollover:
- Contributions Returned Before the Due Date - If the taxpayer already made an IRA contribution for the tax year, it can be withdrawn tax-free by the extended due date of the tax return provided:
- Taxpayer did not take a deduction for the contributions withdrawn, and
- The taxpayer also withdraws any interest or other income earned on the contributions, and
- The taxpayer includes in income, for the year in which the withdrawal was made, any earnings on the contributions withdrawn.
Medical Insurance Exception - The amount that is exempt from the penalty is the amount the taxpayer paid during the year for medical insurance for the taxpayer, spouse, and dependents. To qualify for this exception, the taxpayer:
- Must have lost his/her job,
- Received unemployment compensation for 12 consecutive weeks,
- Made IRA withdrawals during the year he/she received unemployment or in the following year, and
- Made the withdrawals no later than 60 days after being reemployed.
Higher Education Expense Exception - The part not subject to the penalty is generally the amount that is not more than the qualified higher education expenses for the taxpayer, spouse or children or grandchildren for the year at an eligible educational institution.