A potentially important rule clarification regarding IRA rollovers occurred recently, and the ruling could end up biting unaware investors.
The rule change involves the fairly common and somewhat straight forward process called an IRA rollover.
A rollover occurs when money inside a retirement plan such as a 401(k) is transferred by a specific process to an individual retirement plan or IRA. This process often occurs after an employee terminates at the company which sponsored the retirement plan,
A rollover will involve a check generated from the employer retirement plan, very often made payable to the new IRA, being sent to the individual who must then “redeposit” this check into the new IRA account within 60 days.
When done correctly (and there are a few pitfalls) the rollover transaction does not trigger a taxable event and the funds rolled over to the IRA maintain a tax deferred status.
There is also a follow-up step to this process where I believe some of the potential trouble could come from when the new rule goes into effect. The follow up step involves a tax form called a 1099-r, and another called form 5498.
Form 1099-r is generated by the trustee of the employer sponsored retirement plan showing the IRS the money was distributed from the plan.
Form 5498 is generated by the new IRA custodian and used by the individual to show the IRS the proper redeposit of the funds. The reporting of these forms on the individual’s tax return is the final step to the rollover process.
If this all sounds miserably complicated, it’s not, and most rollovers go off without a hitch. The new rule addresses how often an individual can do a rollover transaction.
The current understanding is an individual can execute one rollover a year for every IRA plan they have. The once per year per IRA rule allows some flexibility and when managed properly is unlikely to create a tax trap.
The new ruling states an individual may only execute one IRA rollover a year, regardless of the number of IRA accounts the individual has, which is quite a bit more restrictive.
To complicate things even a bit more, there is another transaction known as an IRA trustee to trustee transfer, which kind of looks like a rollover but does not involve the check and redeposit process of a rollover. The ruling does not impact the trustee transfer process, and these transactions are not limited to one per year.
The trouble I see with the new ruling is with the 1099-r and 5498 process. IRA custodians have gotten into the practice of sending a 1099-r for both rollovers and trustee transfers, leaving it up to the individual participant to report the transaction properly. Going forward I believe pitfalls will occur with this follow up part of the process, those using common consumer tax software will need to be particularly careful.
The new ruling doesn’t take effect yet, but mistakes in this regard can be difficult to fix and magnificently expensive. If you need help, get advice.