Individuals are permitted to roll over amounts in one IRA to another IRA only once in a 12 month period. The rollover must be completed within 60 days. A tax lawyer at a major New York law firm recently tripped on this rule to his detriment. The tax lawyer had several different IRAs. He took rollover distributions from two of them and redeposited the amounts within 60 days. The IRS claimed that the second rollover was invalid because it was made within 12 months of the first rollover, thereby resulting in a distribution of the amount. The tax lawyer claimed that the 12 month rule should apply separately to each IRA. The IRS countered that all IRAs should be treated as a single IRA for this purpose and the tax court agreed. Therefore, the lawyer had to include in income the amount of the second rollover distribution since it was not a proper rollover.
A few other points relating to the decision:
· Because the amount of the failed rollover exceeded 10% of the lawyer’s gross income for the year, the lawyer was also subject to a substantial underpayment penalty of 20% of the amount involved. The substantial understatement penalty is not imposed if the taxpayer has substantial authority for the tax position taken or if the taxpayer discloses the position to the IRS. The lawyer claimed that because he was an experienced tax practitioner and had analyzed the issues he had substantial authority for his position. The tax court judge looked at it differently and essentially said that because of his tax knowledge the tax lawyer should have known better and so was liable.
· Although not mentioned in the court’s opinion, in its Publication 590, Individual Retirement Arrangements for use in preparing 2013 tax returns, the IRS embraces the tax lawyer’s position regarding the 12 month limit on rollovers. The Publication gives the example of an individual rolling amounts from IRA-1 into IRA-3 and being unable for 12 months to make any additional rollover from either IRA-1 or IRA-3. However, according to the Publication, that rollover “does not prevent you from making a tax-free rollover from IRA-2 into any other traditional IRA.” The outcome of the case – particularly with respect to the imposition of penalties – may have been different had the tax lawyer brought this publication to the attention of the court.
· The attorney’s wife had also made a rollover from a single IRA. She deposited the money in a rollover IRA on the 61st day after she took the IRA distribution. That, of course, is one day after the 60 day limit. Her rollover too was declared invalid so the couple’s taxable income was increased by her failed rollover as well as his failed rollover. Because she was not yet 59½, she also had to pay the additional 10% tax imposed on early withdrawals from IRAs.
· The IRS automatically waives the 60 day rule in circumstances where a financial institution has been properly directed regarding a rollover, but fails to follow that direction. There is also a private letter ruling program where under limited circumstances (e.g., death, disability, foreign government restrictions), the IRS will waive the 60 day limit on completing a rollover. The taxpayer must request the IRS to issue the ruling and must pay a user fee, the amount of which relates to the size of the rollover. For 2014, the user fee ranges from $500 to $3,000. The attorneys’ wife had not made such a waiver request.
· The court opinion did not discuss another possible result of the failed rollover. Because the tax lawyer had in fact deposited the money in an IRA, and because the amount deposited was well in excess of the annual contribution limit for an IRA, the amount of the rollover could be considered an excess contribution to the IRA. Excess contributions, if not removed from an IRA by the tax return due date for the year in which the amounts were contributed, result in a 6% excise tax for each year that the excess remains in the IRA. In addition, the excess amount will also be subject to tax when it is distributed from the IRA. In other words, if the excess is not corrected in a timely fashion, the taxpayer will pay tax twice on the excess contribution – once when the deduction is disallowed and once when the taxpayer takes a distribution from the IRA. This is in addition to the annual 6% excise tax on the excess contribution.
The moral of the story: Pay close attention to the rollover rules because the IRS strictly enforces them. Remember, however, that the IRA rollover limits can be avoided by using direct transfers where an IRA custodian works with another custodian to move an account from one institution to another. IRA holders who use the direct transfer approach will not run afoul of the rollover limits.