A distribution from an IRA isn't taken lightly by the IRS and shouldn't be by the investor, either. If a person takes out money by mistake, the IRS does give a break and lets them redeposit that amount back into the IRA within 60 days, called a 60-day rollover. Even if it's put back into the same IRA, it's reported as a rollover on Form 1040 or Form 1040A when filling out a tax return. Form 1099-R is also included here. It's considered a rollover and distribution when the money is redeposited into the account.
The Rule in Regards to a Retirement Plan or IRA Distribution
Using a rollover to transfer money from a retirement account to another retirement account is tricky. The 60-day rollover rule is essential to follow here. That means a person must deposit all the funds in a new account within 60 days.
Most people feel that it is a time bomb. However, if cash is needed right now and retirement funds are considered the best choice, this rule can be used and be advantageous.
Ultimately, a retirement plan or IRA distribution can not be taxable if put back within 60 days. The rollover distribution can also go into another IRA rollover within the same time period.
Direct/Indirect Rollovers
Most rollovers occur without anyone touching the money. If someone leaves their job, they can do an eligible rollover into a traditional IRA from the 401K. The 401K plan administrator needs to do a direct rollover to transfer that money into the IRA rollovers designated by the employee. This also can happen with a new 401K plan from a new job. It's called a direct rollover because it avoids the hassle, and there is no taxable amount with this eligible rollover.
It's also possible to receive a check in the name of the new IRA or 401K account. That gets forwarded to the employer's plan administrator or the financial institution that holds the IRA. Most people feel that the last option adds a step, but it's sometimes necessary because the old plan administrator can't handle the process. Still, this is a direct rollover. There is no taxable amount because the funds were never in the employee's possession.
Sometimes, it is necessary to take control of the funds. The goal is to transfer the money into the account personally. These are indirect rollovers. Most retirement plans rely heavily on them. Generally, the plan administrator liquidates the assets and mails a check to the person or deposits it directly to the financial institution.
Applying the Rule
Typically, the rollover rule only comes into play with an indirect rollover. The IRS refers to it as a 60-day rollover. That means the person has 60 days from the moment they receive the distribution to roll it into another IRA or retirement plan. If that doesn't happen within 60 days, the IRS figures this distribution is a withdrawal. For those who are under 59.5 years old, this is an early withdrawal. That means the person has income taxes for the entire distribution. Plus, there's a penalty of 10 percent if the person is less than 59.5 years old.
Therefore, most financial advisors and tax advisors recommend doing a direct rollover. There are fewer problems with mistakes and delays. There's plausible deniability if :
The money immediately goes into an account OR
The check is made to the distribution account and not the person
Therefore, it's considered an eligible rollover. No tax must be paid because the distribution was added to the account in 60 days.
One way to get money from an IRA before turning 59.5 years old is to use Rule 72(t). It exempts a person from the usual withdrawal penalties if the funds are taken based on a specific schedule. This lasts five years or until the person turns 59.5 (whichever takes longer).
Using It for Loans
Though most people don't want to risk their retirement plan, it is possible to take the distribution and use it as a loan. Since there's a ticking clock, an indirect rollover seems like a poor choice. However, the funds may need to be detoured from the account. The IRS says that a person has 60 days to deposit the money into a new IRA or the same one. This provision gives the IRA owner an option to use the funds as a short-term loan on the distribution.
Remember, any money that isn't put back is the taxable amount. Therefore, it is best to take out just what's needed and put the rest of the distribution into the IRA.
This strategy works with various IRAs, though not all of them. Typically, 401K plans allow a person to borrow funds and pay themselves back with interest. Regardless, the rollover rule is a great way to borrow distribution amounts on a normally untouchable IRA. It's interest-free and short-term.
Just have the administrator cut a check and spend the money as needed. Redeposit it in 60 days to avoid having a taxable amount on taxes the following year.
Avoid Taxes (Indirect Rollovers)
There are tax implications here. When the 401K plan administrator or an IRA custodian writes the check, they automatically withhold some of it for taxes. This is often 20 percent of the total distribution. Therefore, the amount received might be less than originally thought.
When taking a large distribution from your IRA ($10,000), the custodian withholds taxes. If $8,000 is redeposited within 60 days and goes back into the retirement plan, taxes are still owed on the $2,000 the custodian withheld. However, it is possible to make up the rest from other sources and put the entire amount back in so that tax isn't owed.
Report Indirect Rollovers
There are three different tax reporting scenarios. From the example above:
If the distribution amount is completely redeposited and the $2,000 difference is made up all within the 60 days, it is reported as a rollover and is not taxable.
If the $8,000 is redeposited but not the withheld amount, that $2,000 is reported as income. There is also the 10 percent penalty for taking out the distribution early.
If none of the money is redeposited in 60 days, the person must report the full $10,000 as taxable income and the $2,000 as paid. The penalty for being under 59.5 years old is also a report that must be made unless an exception is granted.
Bottom Line
Clearly, an IRA rollover can be a good thing, especially when it happens directly. There's no reason to pay tax on it because the distribution is not touched by the owner. However, if the distribution is to be used for a loan, care is necessary. This could affect the person's retirement plan and require them to pay significant tax amounts the following year.
Most retirement plans are to be left untouched, but there are always loopholes. It's best to talk to a financial advisor to get the help needed. A tax advisor can assist with filling out forms, what to do with the 1099-R, and figuring out if certain things like if tithing is tax deductible. Be careful with the distribution amounts and practice safe spending habits.
Disclosures:
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Stratos Wealth Partners, LTD., a registered investment advisor. Stratos Wealth Partners, LTD. The Kelley Financial Group, LLC are separate entities from LPL Financial.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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