A recent U.S. Tax Court decision has challenged a long-accepted understanding of how the 60-day IRA rollover rules work. In Bobrow v. Commissioner, the court ruled that the once-per-year rollover rule applies in aggregate to all of a taxpayer’s IRA accounts and not on an account by account basis. This position is inconsistent with the IRS’ own Publication 590 and proposed regulations written better than 30 years ago. Due to the significance of this decision, we felt it important to highlight the key points you need to know to steer clear of problem areas with IRA rollovers going forward.
Withdrawals from IRA accounts are normally taxable but the standard rollover rule of IRC Sec. 408(d)(3)(A) stipulates that as long as the funds are rolled over within 60 days, the distribution will not be taxable. To prevent abuse, IRC Sec. 408(d)(3)(B) applies a limitation whereby the 60-day rollover rule cannot be utilized more than once in a one-year period (measured as 365 days from the date that the first distribution occurred).
Historically, this rollover rule has been applied on an account-by-account basis. For example, if an individual has two IRA accounts and takes a distribution from IRA # 1 that is rolled over into a new IRA account (IRA # 3), then no further rollovers can occur from IRA # 1 or IRA # 3 during the next year since both accounts have already participated in one rollover in a one-year period. The rollover from IRA # 1 into IRA # 3, however, has never prevented a taxpayer from making a tax-free rollover from IRA # 2 into any other traditional IRA, during this same one-year period – at least until the Bobrow decision.
The IRS issues Publication 590 annually to assist taxpayers in preparing their individual income tax returns. The example cited above has been in Publication 590 for better than 20 years and is based on language in IRS proposed regulations introduced in 1981. Soon after the court’s decision, the IRS issued Announcement 2014-15 which adopted this less taxpayer-friendly interpretation of the IRA rollover rules. The IRS also announced that they plan to revise Publication 590 in the near future.
The IRS has acknowledged that because this was a significant departure from the standard view on the IRC Sec. 408(d)(3)(B) rollover limitation – including the IRS’ own position – no new regulations will take effect before January 1, 2015. In addition, the IRS has declared that it will not pursue the Bobrow interpretation for any rollover that involves an IRA distribution occurring before January 1, 2015.
Why did the tax court decide the Bobrow case the way it did? Most likely, it was to prevent taxpayers from using IRA funds as a form of temporary loan – one that could be chained together through a sequence of IRA rollovers. The prior interpretation of the IRA rollover rules could have provided taxpayers with several different IRA accounts the ability to stretch their IRA loans out over extended periods of time. Tax-free use of a taxpayer’s IRA funds was certainly not the original intent of Congress when IRA accounts were first introduced back in 1974. It is likely the IRS felt the rollover limitation rule of IRC Sec. 408(d)(3)(B) was being abused by the taxpayers in the Bobrow case enabling them to use their various IRA accounts for multiple short-term loans. The taxpayers were, in essence, attempting to “game” the system.
What this means for you
The bottom line for taxpayers is that beginning on January 1, 2015 the IRA rollover rule will now apply aggregated across all IRA accounts of the taxpayer. This means the once-per-year rollover limitation is not just a per-IRA limitation but a per-taxpayer limitation (i.e., a taxpayer can only do one rollover across any/all of his IRA accounts during a 365-day period).
If a taxpayer attempts to make more that one IRA-to-IRA rollover within a 365-day period, the consequences could be severe. The second (third, fourth, etc.) rollover within the 365-day period will be considered a distribution which, for traditional IRAs, will generally be subject to income tax and, if the IRA owner is under 59 ½ years of age, the 10% penalty. For Roth IRAs, the distribution may be subject to income tax and/or the 10% penalty. And if that’s not bad enough, subsequent distributions erroneously “rolled over” during the 365-day period could result in excess contributions in the receiving account, subject to the 6% excess contribution penalty for each year they remain in the account.
What doesn’t count toward the once-per-year IRA rollover rule
a) Trustee-to-Trustee IRA Transfers – This is the best way for IRA money to be moved from one IRA to another. The funds go directly from one custodian to another without the account owner having an opportunity to use the funds while they are outside the IRA. When IRA funds are moved this way, there is no 60-day deadline and the once-per-year rule does not apply. IRA owners may make as many trustee-to-trustee transfers as they desire, and at any time.
b) Plan-to-IRA Rollovers – The once-per-year rollover rule is an IRA-to-IRA and Roth IRA-to-Roth IRA rule. So, if a taxpayer makes a rollover that is not between two IRAs or two Roth IRAs, it does not count as a rollover for purposes of the once-per-year rule. For example, if a taxpayer rolls over money from their 401(k) to an IRA on January 25th of year 1 and then rolls that money via a 60-day rollover to another IRA on March 10th of the same year, the once-per-year rule has not been violated.
c) IRA-to-Qualified Plan Rollovers – Similar to the Plan-to-IRA rollover exclusion outlined above, IRA-to-Qualified Plan rollovers also do not count as rollovers for purposes of the once-per-year rollover rule.
d) Roth IRA Conversions – If money is converted from an IRA or employer plan to a Roth IRA, the conversion – which is technically a rollover – does not count as a rollover for purposes of the once-per-year rule.
If you are considering an IRA rollover, make sure it will meet the applicable rules and survive IRS scrutiny. We are here to assist you in determining the best course of action and to answer any questions. Contact us at (719) 630-1186.