In the tax world, as in the real world, there is often a "right way" and a "wrong way" to do things. This is particularly true concerning rollovers from a qualified retirement plan, like a 401(k) or pension or profit-sharing plan, to an IRA. If your client does things the right way, he or she can avoid any current federal income tax and continue to benefit from tax-deferred growth of assets. However, when things are done the wrong way, the penalties can be steep.
The right way: If you take a distribution from a qualified plan and roll over the funds into a traditional IRA, there's no current tax liability if the rollover is completed within 60 days. (A rollover to a Roth IRA is taxable, of course.) Begin counting off the 60 days on the day after the actual date of the distribution and end on the day of the deposit. There's no extra allowance for weekends or holidays.
The funds that you deposit into the IRA within the 60-day period aren't required to be the same exact funds you received from your plan as long as it's the same amount. In other words, you effectively can use the cash interest-free for two months, however you like, as long as you return it in time. Once the deposit is made in the IRA, the usual rules regarding IRAs will take effect. Note, for example, that required minimum distributions (RMDs) must begin after age 70 1/2.
The wrong way: If you take a distribution from a qualified plan and don't roll over the funds into a traditional IRA within 60 days, the distribution is generally taxable as ordinary income. Therefore, you could owe tax at a rate reaching up to 39.6 percent, plus a 10 percent penalty tax may be imposed if you're under age 59 1/2 (unless one of several tax law exceptions applies). In addition, the distribution counts as "modified adjusted gross income" (MAGI) for the year, which could trigger or increase the 3.8 percent surtax for certain upper-income taxpayers. The combined tax bite could as high as 53.4 percent (39.6% + 10% + 3.8%) before any state income taxes are taken into account.
The IRS may waive the penalties in extenuating circumstances—for example, when the deposit is late due to misappropriation of funds by a financial institution—but it's far better to be safe than sorry. Circle the critical date on the calendar or post an electronic reminder to ensure that you don't miss the 60-day deadline.
Best approach: If a "trustee-to-trustee transfer" is arranged, the funds will go directly from the qualified plan into the IRA without ever touching the taxpayer's hands. This is the simplest and most efficient method for effecting a rollover. Otherwise, the plan administrator is required to withhold 20 percent of the payout in federal income tax, even if you fully intend to roll over the funds to an IRA within the 60-day period. In that case, you'll have to wait until you file your tax refund to recoup the withholding. Using a trustee-to-trustee transfers avoids the withholding complication and ensures continues tax deferral for this year and beyond.