Including a Look at the CARES Act
According to a Government Accountability Office report released in 2019, Americans between the ages of 25 and 55 make early withdrawals of about $69 billion from their retirement savings accounts per year.
That figure was before the coronavirus and its economic impact, which has included high unemployment rates and signs of a potential recession looming.
And while the recently-passed CARES Act has loosened the rules for early withdrawals and loans from retirement accounts, it can still be easy to misstep when withdrawing or rolling over funds from one account to another.
Here are three common mistakes you might make if you’re not completely aware and mindful of the rules when rolling over funds from retirement savings.
When evaluating how you should proceed with your retirement savings, you should review the specific terms of your plans or accounts. No generalization made in any article will be more accurate than the actual guidelines defined there in the paperwork. Consult directly with a financial professional to review your particular situation.
Please note that where applicable, we’ve included the short-term effects from the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
Common Rollover Mistake #1: Missing your 60-day deadline
The IRS puts strict limits on how long you are allowed to hold your own money outside of retirement accounts before penalties and taxes start to accrue. This is aptly named the “60-day rule,” referring to the timeline involved. This rule lends itself to one of the most common mistakes a person can make when rolling funds between retirement accounts.
Let’s say you leave your job, because of economic hardship or otherwise, and that you had a 401(k) with that employer. Upon leaving them, you find that you’re going to have to cover the administrative fees to keep your 401(k) going while also, of course, losing any employer-matched contributions you might have enjoyed while at that job.
You then decide to roll your funds into an IRA. You may choose an indirect rollover if you’re a bit strapped for cash, because it effectively gives you a free loan of your money for up to 60 days.
But when you elect to have your previous plan cut you a check for your full amount, the clock starts ticking. You have 60 days to move that money into a new retirement account. This might seem like a long time, but two months can quickly fly by. It is very common for people to make the mistake of missing this deadline.
According to Andrew Meadows of Ubiquity Retirement + Savings, it often takes 30 days just to process a rollover. This means that half of those 60 days are already eaten up by bureaucracy. It’s very easy to lose the other 30 days to finding a new job, settling into one (if you’re lucky), or readjusting your schedule due to the change in employment.
If you don’t make back the money you “borrowed,” you’re left unable to move the full amount of 401(k) funds you withdrew into a new retirement account within the sixty days.
The IRS penalty for not completing a rollover of tax-deferred funds between accounts in time is stiff. You will be taxed the full amount at your ordinary income rate for that year. On top of that, you will face penalties that vary by plan, such as the 10% penalty for an early IRA withdrawal if you’re less than 59½ years of age.
It gets worse. On top of all of this, if you elect to receive a check from your old 401(k) or IRA, your 401(k) plan administrator or IRA custodian is mandated to withhold 20% of it (unless from a Roth account) for taxes even if you intend to rollover the full amount into another tax-deferred account. The only way to make up for this is to add outside money of equal amount when you fund your new account, and then you’ll be reimbursed.
The CARES Act effectively extended the 60-day rule for any distributions taken between February 1, 2020, and May 15, 2020, to July 15, 2020. However, the once-per-year rule for IRAs still applies: you can only carry out one IRA rollover per 365-day period.
Common Rollover Mistake #2: Rolling over different assets
The second common mistake when rolling over funds is to buy other assets with them while you hold them, and then try to transfer those into your retirement account. For instance, if you take a check to close out an old account, you can’t go out on your own and buy a few stocks you like and then put those in your new account. The IRS sees that transaction as voiding the tax-deferred status of the funds.
This is because transactions to change the property or assets you roll over between one account and another creates taxable events.
This rule is called the “same property rule.” Even if you are rolling funds into a self-directed IRA, where you’d be allowed to hold the assets you want to buy, you can’t do that on your own. There is a process of transferring the funds from eligible accounts, and then buying the assets, all done with professionals like a custodian who know how to carry this out and document it properly.
The IRS will both tax that money spent on investments and penalize you if you are younger than 59½. You must be careful and consult with professionals before carrying out transactions involving your retirement savings; it’s relatively easy to slip up and have no way to fix your mistake without a large tax bill and penalty.
This same property rule hasn’t been altered by the CARES Act.
Common Rollover Mistake #3: Trying to roll over RMDs
When you hit 72 years old, you are required to begin taking distributions from your retirement accounts. These required minimum distributions, or RMDs, are taxed at your ordinary income tax rate. If you have no need for that income just yet, you might think you can just roll them into another tax-deferred account—you can’t.
The IRS has specifically excluded RMDs from rollovers. You must take them, and you must pay taxes on them. Obviously, this rule only applies to people older than 72, with the age cut-off formerly 70½ prior to the passage of the SECURE Act.
It is also worth noting that this also doesn’t apply to Roth accounts. Roth 401(k)s do technically have RMDs. But, since distributions from a Roth account are tax-free, there’s no need to scramble and roll it over. Roth IRA owners are not required to take distributions at any age.
This too has been eased under the new stimulus bill, somewhat. RMDs, under the CARES Act, are eliminated for the year 2020. In 2021, you’ll still have to take your RMDs if you are over the age of 72.
As we noted earlier, if you have already taken an RMD, if it falls between February 1 and May 15 of this year, you can return it to your retirement account by July 15 (effectively, an extension of the 60-day rule), although you won’t be able to do this again for 365 days.
Preventing These Mistakes
As implied above, there is an easy way to avoid most mistakes made when rolling over funds between retirement accounts: use a direct transfer. Most financial professionals would agree that if you are trying to move funds around, a direct transfer is the way to go.
Taking a step back, there are two types of rollovers: indirect rollovers and direct ones. Indirect ones are what we’ve discussed so far, where you take possession of assets from your old account before placing them into the new one. As you might guess, a direct rollover, or transfer, is when those assets and funds are sent directly from your old account into your new one.
A direct transfer simplifies the problems we noted. For instance, if you don’t hold the money for even a day, you simply cannot run afoul of the 60-day rule. There is also no mandatory 20% withholding attached to direct transfers. The full amount can be moved directly into the destination retirement account, passed directly between plan administrators or custodians.
Likewise, if you never take possession of those funds, you cannot mistakenly change their form. You can’t buy stocks, precious metals, real estate, or anything else with those funds outside of an account. So, again, you can’t run afoul of the same property rule.
Now, since RMDs are required for most accounts, a direct transfer doesn’t really help much to prevent mistakes there. But if you always opt for transfers over indirect rollovers, you might not be tempted to try and roll over your RMDs.
The main takeaways here are:
- Don’t waste any time rolling over funds
- Don’t buy anything with those funds during the rollover process
- Aim to keep your RMDs clear of any rollovers
The only way to keep completely clear of making mistakes when you rollover retirement funds is to opt for direct transfers when you can.
Final note on the CARES Act: as with any piece of legislation, especially one directly involving tax consequences and that reads 880 pages long, the CARES Act might be a burden to read and interpret yourself.
Here are a few sources that might help you digest the full impact of its effect on retirement accounts, especially related to these common mistakes: