When IRAs were first introduced by Congress in 1974, employees soon learned that they were an ideal place to deposit their qualified-plan money after they left an employer, as they provide both portability and greater freedom of investment selection. But a recent tax court ruling is likely to place a new restriction on rollovers between IRAs starting in 2015. On Jan. 28, 2014, the U.S. Tax Court delivered a major surprise to both taxpayers and professionals when it ruled in favor of the Internal Revenue Service in the case of Bobrow v. Commissioner of Internal Revenue.
Transfers vs. Rollovers
There are two ways to move money between IRAs and/or Individual Retirement Annuities without tax consequences. One is via a direct transfer, where the current IRA or annuity custodian simply sends the balance of the account directly to the new custodian or contract carrier, usually via electronic transfer or 1035 exchange. A rollover is a less direct method of transference, where the surrendering custodian mails the account holder a check made payable to him/her for the balance of the plan or account. The recipient must then send this amount to the new IRA account or plan custodian within 60 calendar days. If that doesn't happen, the check must be reported as a taxable distribution, with an extra penalty for those under age 59½. The new changes affect only rollovers; rules for transfers remain the same.
How Rollover Rules Changed
Section 408(d)(3) of the Internal Revenue Code previously stated that IRA and qualified plan owners were allowed one rollover per year from each plan or account. Each IRA had its own one-year time frame. A taxpayer who owned multiple IRAs or retirement annuities could move money from each account or contract to another via rollover once every 365 days without tax or penalty.
That changed with the case of Bobrow v. Commissioner. It all began when an IRS audit assessed tax against several rollovers made by Alvan Bobrow – a tax attorney himself – and his wife, Elisa, declaring that the money they withdrew from various IRAs was not re-deposited within the prescribed 60-day window. The tax court carefully reviewed all the rollovers in question and ruled that only one could keep its tax-exempt status. All the others, totaling $51,298, were reclassified as distributions.The Bobrows were hit with taxes on ordinary income, a 10% early withdrawal penalty and a whopping additional 20% penalty of $10,250 for understating the amount of tax that they owed – an enormous additional tax bill for 2008.
This decision changed rollover rules for all taxpayers. Based on it, the IRS announced in March 2014 that taxpayers will be limited to a single rollover in any 12-month period, regardless of how many IRAs or retirement annuities they own.The first rollover sets the 12-month clock going, and no other rollovers can be made to any IRA account or annuity until the time period has run out.
But You Still Have Time
The decision came as a huge - and unpleasant - surprise to both retirement savers and the tax and financial industry, which had expected the court to uphold the decades-long traditional view of a per-account limit on rollovers. It also meant that IRA custodians will have to update all of their instructional and disclosure documentation and procedures for rollovers.To ease the transition, the IRS subsequently issued Announcement 2014-15, which stated that it would exempt taxpayers who completed more than one rollover in 2014 from taxation on these transactions, and that enforcement will not begin until Jan. 1, 2015. It is also going to revise the instructions in Publication 590, Individual Retirement Arrangements (IRAs). Taxpayers who planned on rolling money over from several different accounts in 2014 can still do so, as long as they complete at least all but one of them by Dec. 31.
Direct Transfers: An Easy Alternative
Although the new rollover rule will undoubtedly be inconvenient for many retirement savers, the restriction does not apply to direct transfers. IRA and qualified-plan owners still have a convenient way to move money between retirement accounts and plans – they just have to use plan custodians instead of moving the money themselves. Many financial and tax advisors already recommend that clients use direct transfers because they are simpler and avoid problems such as the check getting lost or stolen. There are also several other exceptions to the new rollover rule. There is no limit on how many qualified plans can be rolled over into IRAs. Other exemptions include Roth conversions, first-time homebuyer distributions that become delayed or canceled, and qualified reservist distributions that are repaid within the prescribed time limit.
The Bottom Line
Although the Bobrow ruling may be overturned at some point, taxpayers who roll over money between IRAs on a regular basis should plan on switching to direct transfers by the end of 2014. The ultimate impact of this policy shift will likely be minimal, regardless of whether it turns out to be temporary or permanent. Direct transfers are generally faster and more convenient in most cases, and there is no tax or financial disadvantage to using them instead of rollovers. For more information on IRA rollovers and transfers, download Publications 575 and 590 from the IRS website at www.irs.gov or consult your tax or financial advisor.