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Rollover Roulette: Rollover, Direct Rollover, Direct Payment, Direct Transfer or Transfer (Part 2: Potential Horrible Consequences)

The movement of monies between eligible retirement plans and eligible IRAs can be free from federal income tax—how great is that! However, if an individual “dials” the “rollover roulette wheel” and lands on the wrong term (read Part 1 of this series for a handy table of rollover terms), horrible federal income tax consequences may follow for the individual. Plan and IRA professionals need to be careful when dealing with “rollovers”—whether in plan and IRA materials or in conversations with plan participants or IRA owners—to use the correct terms.

A prime example of the horrible federal income tax consequences that can happen if the wrong term is used occurs when someone inherits Uncle Ned’s $500,000 401(k) account or Aunt Susie’s $1 million IRA and takes a distribution of the monies thinking that he or she has 60-days to roll over the monies to an eligible inherited IRA. This is a big and often costly mistake. A plan or IRA beneficiary (except for the decedent’s spouse) can never do a “rollover” where the beneficiary takes a distribution of the monies inherited from the eligible retirement plan or IRA and rolls over the monies in 60 days to an inherited IRA or anywhere else. “Rollovers” are only available to plan participants and IRA owners and their surviving spouses. Once the monies are distributed from the plan or IRA to the beneficiary they are taxable to the beneficiary and generally cannot be returned to the decedent’s plan or IRA or moved to an inherited IRA. It goes without saying that these inherited monies can never be placed in the beneficiary’s own plan or IRA! The distribution will be reported to the IRS on Form 1099-R and if the beneficiary does not include the distribution as taxable income on his or her federal income tax return, the beneficiary may well face IRS audit and tax penalties. 

The only way that a beneficiary may move inherited eligible retirement plan monies to an inherited IRA is through a “direct trustee-to-trustee transfer.” In a “direct trustee-to-trustee transfer” the monies go directly from the plan to the inherited IRA. The only way that a beneficiary may move inherited IRA monies to an inherited IRA is through a “transfer.” A “transfer” is similar to a “direct trustee-to-trustee transfer” in that the monies go directly from the IRA custodian or trustee to the inherited IRA.

An eligible retirement plan participant can run into trouble if he or she thinks a “direct rollover” is the same thing as a “rollover.” A “direct rollover” is available only to plan participants (and their surviving spouses) and requires that the monies be paid directly to the plan participant’s new employer’s eligible retirement plan or IRA. A “direct rollover” is not subject to the 60-day rule. If the plan participant takes a distribution of the monies and contributes the monies to his or her new employer’s eligible retirement plan or IRA after the 60-day period has expired, the distribution will be taxable and generally may not be returned to the plan or moved to another plan or IRA. The distribution will be reported to the IRS on Form 1099-R, and if the participant does not include the distribution as taxable income on his or her federal income tax return, the participant could face IRS audit and tax penalties.

An IRA owner can also run into trouble if he or she confuses a “rollover” with a “transfer” and, as a result, does more than one rollover between IRAs in a 12-month period. Rollovers between IRAs are limited to one in a 12-month period, while “transfers” are unlimited. The IRA owner who violates the 12-month rule will have taxable income on the improper rollover, and the rollover may be subject to the 6% excise tax on excess contributions to IRAs and the 10% early withdrawal penalty. Yikes!

Finally, a “direct rollover” or “rollover” is not to be confused with a “direct payment.” A “direct payment” is a term used on the Form 1099-R to describe the movement of monies directly from an IRA to an eligible retirement plan.

Bottom line: “rollover” terminology is confusing (no kidding!), so plan and IRA professionals always need to be careful when dealing with “rollover” terminology.

Part 1 - The Terms

Copyright © 2017 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

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About this Author

Vivian S. McCardell, Morgan Lewis, Retirement Benefits Attorney, IRA Lawyer
Of Counsel

Vivian S. McCardell counsels clients on individual retirement accounts and annuities (IRAs) and similar products offered by financial institutions and broker-dealers, as well as qualified and nonqualified retirement plans. She helps clients address issues with nonbank custodians and trustees and other service providers. Additionally, Vivian advises clients on compliance with the US Internal Revenue Code, the US Employee Retirement Income Security Act (ERISA), and other federal and state laws that affect IRAs, and qualified and nonqualified retirement plans.

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