A surprising Tax Court case has shut down a tax planning technique that savvy retirement-savers have been using for years. Under the new case (Bobrow, TC Memo 2014-21), the once-a-year limit on IRA rollovers is applied to all IRAs you own, not each one separately, directly contradicting the IRS' own interpretation of the rules. Thus, you can no longer use IRA funds interest-free for 60 days without any penalty.
But there's still a small window of opportunity if you need it. Although the IRS intends to follow the approach decided in the new case, it has announced it won't implement the rule change until January 1, 2015, to give IRA owners and trustees time to adjust. It has also withdrawn proposed regulations on this point.
Here are the basic rules: Generally, you don't owe any tax on the transfer of funds from one IRA to another as long as the rollover is completed within 60 days. In effect, this gives you 60 days to use the IRA funds for any purpose as long as you redeposit the same amount in an IRA before the 60 days are up. It's like getting an interest-fee loan from the IRS.
The IRA custodian is required to automatically withhold tax on the transfer in case you don't complete the rollover in time. Therefore, you must recoup the withheld amount when you file your tax return for the year of the rollover.
If you fail to complete a timely rollover, you'll be hit with ordinary income tax on the taxable amount (i.e., the portion representing deductible contributions and earnings), plus you may have to pay a 10 percent penalty tax on this amount if you're under age 59½. For instance, if you are age 50, withdraw $10,000 from an IRA and you're in the 25 percent tax bracket, failing to meet the rollover deadline will cost you a total of $3,500 in tax ($2,500 + $1,000 penalty).
The IRS restricts rollovers to one use within a 12-month period, but it previously applied this limit to each IRA, not all your collective IRAs. This position was spelled out in IRS Publication 590, Individual Retirement Accounts. Now, based on the new Tax Court case, the IRS has decreed that:
- You must include in gross income any previously untaxed amounts distributed from an IRA if you made an IRA-to-IRA rollover in the preceding 12 months.
- You may be subject to the 10 percent early withdrawal tax on the amount you include in gross income.
In addition, if you pay these amounts into another (or the same) IRA, they may be treated as excess contributions and can be taxed at 6 percent per year as long as they remain in the IRA.
Note that these changes don't affect trustee-to-trustee transfers of funds from one IRA to another where your hands never touch the money. Technically, these transfers do not constitute rollovers, so they are exempt from the once-a-year limit.
Inform your clients about the latest developments. If a client wants to use the rollover technique for multiple IRAs, he or she can still benefit from this option for the rest of this year.