When it comes to retirement savings, what you don't know about IRA rollovers can cost you unexpected taxes and penalties. Whether you're changing jobs, inheriting retirement assets, or consolidating accounts, one misstep can set your retirement plans back years.
From breaking the once-per-year rule to mishandling inherited accounts, these ten costly errors can trip up even financially savvy investors.
Here's what to watch out for:
1. IRA-to-IRA Rollovers and Roth IRA-to-Roth IRA Rollovers
These types of rollovers have several potential pitfalls that can lead to unexpected tax consequences. First, many investors use 60-day rollovers instead of direct transfers, creating unnecessary risk of missing deadlines. Second, the IRS enforces a strict once-per-year rule that applies to all your IRAs and Roth IRAs combined—a rule they have no authority to waive if broken. Finally, when working with financial advisors, failing to disclose prior rollovers or not understanding exceptions to the once-per-year rule can result in costly penalties.
2. Non-Spouse Beneficiary Rollovers
The rules for non-spouse beneficiaries are strict: you cannot do rollovers from inherited IRAs. Despite this clear rule, several common mistakes occur. Some beneficiaries take lump-sum distributions when more tax-efficient options exist. Others incorrectly deposit a decedent's IRA funds into their own IRA, which is not permitted. Additionally, paying out an entire inherited IRA to a trust beneficiary without proper planning can significantly increase the tax burden unnecessarily.
3. Spousal Rollovers
Spousal beneficiaries have unique privileges but must time their actions carefully. The primary timing concern involves age: completing a spousal rollover before reaching age 59½ can restrict access to funds when needed, while forgetting to execute the rollover once reaching age 59½ represents a missed opportunity. Beyond timing issues, many surviving spouses overlook naming a successor beneficiary for the inherited IRA, creating potential complications for their own heirs down the road.
4. 401(k) Rollovers to IRAs
Employer plan rollovers require strategic decision-making to avoid costly mistakes. The first step is reviewing all available options, as an IRA rollover may not always be your best choice. If you decide to proceed, avoid taking personal receipt of funds, which triggers 20% withholding. Other critical considerations include understanding your state's creditor protection laws for IRAs, evaluating the potential Net Unrealized Appreciation (NUA) tax break for company stock, and properly allocating any after-tax contributions to a Roth IRA tax-free.
5. After-Tax Rollovers from Plans to IRAs and Roth IRAs
After-tax contributions in employer plans create special opportunities that require careful handling. Many investors miss tax-free Roth conversion opportunities because they're unaware of allocation rules that separate pre-tax and after-tax amounts. Two common errors include rolling over all funds to a traditional IRA (these rules don't apply to IRA distributions) and taking personal receipt of funds, which complicates the process and can limit your options.
6. Roth Conversions
Converting traditional IRA assets to Roth IRAs involves several potential traps. The most significant is underestimating the conversion's income tax impact, which can trigger additional taxes or cause you to lose valuable tax benefits. There are also strict limitations: Required Minimum Distributions cannot be converted, SIMPLE IRAs have a mandatory two-year waiting period before conversion, and inherited IRAs cannot be converted at all (though inherited company plan funds can be converted in some circumstances).
7. In-Plan Roth Rollovers
In-plan Roth conversions within 401(k) plans have their own set of considerations. Many participants mistakenly assume their plan doesn't offer this option without checking. If available, two key planning aspects require attention: calculating the tax impact of the conversion to avoid surprises at tax time and comparing the benefits of an in-plan conversion versus a Roth IRA conversion, as differences in rules could make one option significantly more advantageous for your specific situation.
8. The 60-Day Rollover Rule
The 60-day rollover timeline creates a narrow window where several mistakes commonly occur. Tracking the deadline is critical, as the IRS rarely grants exceptions. If receiving distributions from employer plans, prepare for mandatory 20% withholding that you'll need to make up from other sources. Other common errors include being unaware of limited self-certification procedures for late rollovers, accidentally depositing funds into non-retirement accounts, and choosing risky 60-day rollovers when direct transfers would eliminate potential problems.
9. QDRO Rollovers in Divorce
Qualified Domestic Relations Orders (QDROs) in divorce situations have specific rules that are frequently misunderstood. The most significant mistake is rolling over QDRO funds to an IRA and then taking distributions before age 59½, as this eliminates the 10% early withdrawal penalty exception that only applies to distributions taken directly from the plan. Many people also don't realize that QDROs apply exclusively to employer plans, not to IRAs, which require different handling in divorce situations.
10. Rollovers From IRAs Back to Employer Plans
When considering moving IRA funds to employer plans, several restrictions apply. Most importantly, only pre-tax funds can be rolled to employer plans—after-tax contributions (basis) must be handled separately. For optimal tax planning, consider converting remaining IRA basis to a Roth IRA. Before initiating any transfer, verify that your employer plan accepts IRA rollovers, and understand that plan assets are subject to stricter distribution rules than IRAs, potentially limiting your access to funds.
Don't Let IRA Rollover Mistakes Derail Your Retirement
The IRS doesn't offer do-overs for rollover mistakes. At JL Smith Holistic Wealth Management, we've seen how these seemingly routine transactions can permanently damage retirement plans when handled incorrectly.
Our Bucket Plan Certified® advisors provide personalized guidance to help ensure your retirement accounts transfer correctly while optimizing your tax situation. We'll help you navigate the IRS maze of regulations and deadlines that trip up so many investors and factor it into one holistic plan.
Schedule a complimentary consultation today to see how we can help you protect your hard-earned retirement savings.
This material was developed and produced by Ed Slott and Company, LLC to provide information on a topic that may be of interest. Ed Slott and Company, LLC is not affiliated with The JL Smith Group or Prosperity Capital Advisors (PCA).