What Is an Eligible Rollover Distribution?
An eligible rollover distribution is a distribution from one qualified retirement plan that is able to be rolled over or transferred to another eligible plan. By rolling over the funds in the plan to another type of individual retirement account (IRA), the participant avoids paying taxes on the distribution. However, the Internal Revenue Service (IRS) imposes penalties on rollovers that result in a distribution for those who are not yet qualified to take distributions.
- An eligible rollover distribution is a distribution from a qualified retirement plan that can be rolled over or transferred to another plan.
- By rolling over the funds in the plan to another type of IRA, the participant avoids paying taxes on the distribution.
- However, the IRS imposes penalties on rollovers that result in a distribution for those who are not yet qualified to take distributions.
Understanding Eligible Rollover Distributions
Often, an eligible rollover distribution occurs when an individual moves from one employer to another. The rollover rules allow the individual to bring their prior assets to their new employer's retirement plan.
Qualified plans are approved retirement plans by the IRS so that participants can benefit from their tax benefits. Employers may offer a qualified plan for their employees, and there are various types of plans, but they typically fall into one of two categories. A defined-benefit (DB) plan is similar to a pension in which the employer makes contributions for the employee and is solely responsible for the funds being there for the employees in retirement. A defined-contribution (DC) plan is a plan in which the employee makes contributions, and the employer deposits a matching contribution up to a certain percentage of the employee's salary. A 401(k) is a popular example of a defined-contribution plan.
While defined-benefit plans give employees a guaranteed payout, defined-contribution plan distributions depend on how well an employee saves and invests on their own, as well as what the employer may contribute. When employees leave their job or retire, they can take their money with them and transfer the funds into another IRA–called a rollover.
Both defined-benefit and defined-contribution plans allow for an eligible rollover distribution. However, if the IRS rules for rollover distributions are not followed explicitly, participants can face hefty tax penalties.
Types of Eligible Rollover Distributions
The IRS allows a few ways in which an individual can transfer their retirement money.
A direct rollover is when the employer’s plan administrator transfers the money directly to the new rollover IRA. A direct rollover can be done via a check made out to the new retirement account and given to the employee to deposit into the new account. No taxes would be taken out since the check is made out to the retirement account. However, the employee is responsible for making the deposit.
The safest direct rollover method is for the employee to do a trustee-to-trustee transfer in which the two financial institutions organize the transfer. After the employee authorizes the transfer, the original plan administrator would coordinate the transfer with the receiving financial institution where the new retirement account is located. No taxes would be withheld from the IRS since the employee would not be receiving the funds.
An employee also has the option to transfer the funds via an indirect rollover in which a check–made out to the employee–would be given to the employee to deposit into the new retirement account. The employee would have 60 days in which to make the deposit; otherwise, it would be considered a taxable distribution. As a result, the IRS calls this a 60-day rollover.
However, the IRS authorizes the plan administrator to withhold 20% of the money in the account. The 20% would be paid back to the employee after filing their annual taxes. Essentially, the 20% is the IRS taking money upfront in the event the employee doesn't deposit the money into a retirement account and ensures the IRS gets paid its taxes.
The critical component is that the employee must deposit the full amount of the distribution even though 20% was withheld. In other words, the employee must come up with an additional 20% within 60 days. If the employee doesn't come up with the difference so that 100% of the distribution is rolled over, taxes and potential penalties could apply on the amount that wasn't rolled over.
Eligible Rollover Distribution and Taxation
When rolling over funds from one account to another, it’s important to understand the corresponding rules and regulations so as not to incur any unexpected taxes or penalties. For example, in an IRA rollover, either via a direct transfer or by check, in many cases, a one-rollover-per-year grace period exists (although this does not always apply to rollovers between traditional IRAs and Roth IRAs). Those who violate this grace period could be liable to report any additional IRA-to-IRA transfers as gross income in the tax year when the rollover occurs.
As stated earlier, no taxes are withheld for direct transfers. However, if the account holder receives a check made out to them in which they will later personally deposit into their IRA, the IRS insists upon the 20% withholding penalty. Regardless if the employee intends to deposit the check into an IRA at a later date, the 20% withholding still applies. At tax time, this amount appears as tax paid by the tax filer.
A withdrawal from a traditional IRA or Roth IRA will incur a 10% withholding unless the individual opts for the withholding or does a direct rollover via a trustee-to-trustee transfer. For individuals who receive a check made out to them and fail to make a deposit into a qualified IRA account within the 60-day window, the money is taxable at the employee's ordinary income tax rate. Also, if the employee is under the age of 59½, there will be a non-refundable tax penalty of 10% in addition to paying income taxes on the distributed amount.
Types of Qualified Plans
Types of qualified plans include IRA and 403(b) plans. While an IRA is for a wide range of individuals and can be employer-sponsored, a 403(b) plan is specific to employees of public schools, tax-exempt organizations, and certain ministers.
Other types of qualified plans include:
- Profit-sharing plans
- Money purchase plans
- Target benefit plans
- Employee stock ownership (ESOP) plans
- Keogh (HR-10)
- Simplified Employee Pension (SEP)
- Savings Incentive Match Plan for Employees (SIMPLE)
You can read a comprehensive guide to common qualified plan requirements on the IRS website. The guide also breaks down the plans by who is eligible, types of employers that sponsor the plans, and any risks or concerns that investors might have before entering into a plan agreement.
Example of an Eligible Rollover Distribution
Let's say as an example, that Jane is 50 years old and is leaving her company for another job and decides that she wants to transfer her retirement money, totaling $100,000, from her former employer to an eligible IRA account.
Jane opts for a direct rollover with a trustee-to-trustee transfer. Jane's plan administrator for her 401(k) arranges the transfer of funds to Jane's new IRA account, which she established. As a result, Jane's new IRA receives $100,000 or 100% of the distribution with no taxes and no penalties taken out.
If Jane decided to receive a check paid directly to her for the IRA funds, instead of the direct rollover, she would have 60 days to deposit the funds into her new IRA. Jane's employer would withhold 20% or $20,000 from the check, which would count as paid taxes when Jane files her taxes at the end of the tax year.
Jane would need to deposit $100,000 in 60 days in order to meet the criteria for an eligible rollover distribution, meaning she would need to come up with $20,000 from her own savings to make up for the 20% that was withheld. If she does and deposits $100,000 into her new IRA, the rollover distribution would be tax-free, and no penalties would apply.
If Jane deposited the $80,000 into her new IRA and failed to come up with the $20,000 that was withheld, the $80,000 would be considered a nontaxable rollover, and there would be no penalties. However, the $20,000 would be considered a premature withdrawal because Jane is under the age of 59½. As a result, the $20,000 would be subject to a 10% penalty tax (for $2,000) and the $20,000 would be taxed as ordinary income based on her marginal tax rate. State income taxes might also apply to the $20,000, depending on where Jane lived and the state's specific tax rates.