Rollover Rules

Taxpayers are allowed to make one tax-free IRA rollover per year.  IRS Publication 590 states that the rule applies per IRA.  An example will make this clear.  Assume that a taxpayer owns IRA 1 and IRA 2.  He takes a distribution from IRA 1 and rolls it into IRA 3.  According to Publication 590, taxpayer is not permitted another tax-free rollover from either IRA 1 or IRA 3 for one year.  However, the taxpayer is permitted to roll a distribution from IRA 2 into IRA 3. 

As it turns out, Publication 590 is wrong.  The Tax Court recently decided that the rule applies on a per taxpayer basis, not a per IRA basis.  The issue came up when a couple tried to tack a series of IRA rollovers together to create a six-month loan for themselves. Husband withdrew $65,064 from his traditional IRA on April 14, 2008, and another $65,064 from his rollover IRA on June 6, 2008.  On June 10, 2008, $65,064 was returned to the traditional IRA. Wife withdrew $65,064 from her IRA on July 31, 2008.  On August 4, within 60 days of the husband’s June 6 withdrawal, the $65,064 was redeposited in the rollover IRA.  Wife made a partial redeposit of $40,000 to her IRA on September 30. The couple treated all of these transactions as nontaxable rollovers, and they reported no taxable IRA distributions.

The plan failed on several fronts, according to the Tax Court. Although the couple assumed that the rollover restrictions apply on a per account basis, instead they apply per taxpayer.  The tax code is not ambiguous on the question. So only Husband’s first rollover was tax free; the second was not.  Wife is entitled to her own rollover, but here the mistake was more prosaic.  One might assume that September 30 is within 60 days of July 31, but it is not. In fact, that is the 61st day, so Wife’s partial redeposit did not reduce the taxes on her withdrawal either.  These were premature distributions, subject to the 10% penalty tax. Failure to report the distributions as taxable led to a significant understatement of tax liability, triggering another 20% penalty. All in all, perhaps the “short-term loan” from the IRAs wasn’t such a good idea.

IRS Response

The taxpayers in this case did not assert that they had relied upon Publication 590 or upon the Proposed IRS Regulations that are consistent with it. Their case would have been stronger had they made that point, but it might have made little difference.  The language of IRS Publications for the public is not binding upon the tax agency in litigation. The words of the statute control, and the Tax Court found those words to be unambiguous.  Still, it seems rather harsh for the couple to pay such large penalties when they interpreted the Tax Code the same way that the IRS professionals did.

The IRS acknowledged in a recent announcement the error in Publication 590 and in the Regulations. Changes will be made, consistent with the Court’s ruling. However, the changes won’t take effect until 2015.  The comments that the IRS received indicated that IRA trustees will have to change their procedures and processing, and these changes will take time to implement.

Taxpayers do have a better alternative for consolidating several IRAs into one. A trustee-to-trustee transfer is not considered a “rollover,” even though it accomplishes the same thing. The 60-day rule and the once-a-year rule only are triggered if the IRA owner receives a check as part of the process.

(April 2014)

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