Rollovers avert retirement plan distribution taxes

Taxpayers who receive distributions from qualified retirement plans or IRAs can avoid paying tax by rolling the distribution into a new plan or IRA. It is not possible to use this strategy to avoid tax on required minimum distributions.

A qualified rollover must be completed within 60 days of the distribution. It is best to use a direct rollover, where the funds transfer from one trustee to another. This ensures the 60-day period is satisfied.

For various reasons, people often receive a distribution themselves and then accept the responsibility to roll the funds within the 60 days. This sometimes doesn’t go well.

Distributions from qualified plans, 403(b) plans and 457(b) plans that are eligible for rollover, require the administrator to notify the participant 30 to 90 days before the distribution of the ability to do a direct rollover.

If the participant chooses to receive the funds directly, the plan administrator is then required to withhold 20 percent for a possible tax liability. If the distribution is eligible for rollover, this withholding is mandatory.

Qualified plan distributions not eligible for rollover and IRA distributions are generally subject to 20 percent withholding, although the participant may file Form W-4P to waive the withholding. But this exception is not available if rollover is an option.

Let’s say a plan participant chooses to take a $100,000 distribution that is eligible for rollover, but the funds are paid directly to the participant. The administrator will withhold $20,000 of this distribution.

To avoid any tax on the distribution, the participant must roll $100,000 into another plan, including an IRA. But if the participant receives only $80,000, he would need to fund the remaining $20,000 from other sources.

Let’s say the administrator failed to notify the participant of the ability to make a direct rollover. This mistake could then cause the participant to fail to satisfy the 60-day rollover period for the amount withheld.

There are many other reasons why a participant might not be able to meet the 60-day rollover period. These can include administrative mistakes (the check was lost, the rollover was made to the wrong account) or participant hardship (family member passed away).

Because the tax consequences of failing the 60-day rollover period can be severe, taxpayers had the ability to request a “letter ruling” from the IRS approving a late rollover. Such a ruling is costly ($10,000 user fee paid to the IRS and likely fees to a tax adviser).

In August 2016, the IRS released procedural rules to allow a taxpayer to “self-certify” that a late rollover is eligible for an administrative waiver by the IRS. The selfcertification is provided to the administrator of the plan accepting the late rollover. The self-certification must indicate one of 11 reasons for the late rollover that are permitted under the procedure. IRS can still challenge the late rollover, but the plan administrator can report the contribution as a late rollover.

An IRS challenge of a self-certification would be expected to be limited to assessing whether the reason given (one of the approved 11) was valid. Generally, one would expect no challenge.

The taxpayer will have three reporting issues. First, he will receive a Form 1099-R from the plan making the distribution. This will show a “gross distribution” in Box 1.

The Form 1099-R distribution must be shown in box 15a or 16a of the taxpayer’s Form 1040 for the year of the distribution. If the

distribution was rolled over, a taxable amount of zero is then shown in box 15b or 16b, with the words “Rollover” next to that box.

IRS also receives Form 5498 from the administrator of an IRA plan to which the funds were rolled. This form is used to report contributions to IRAs.

Box 2 of Form 5498 shows rollovers that were not late. A direct rollover from another plan would be shown in this box. IRS would then know that the distribution shown on the Form 1099-R was not taxable.

Late rollovers are shown in Box 13a of Form 5498. If the taxpayer used the selfcertification procedure, the code “SC” is then placed in Box 13c. IRS would then be aware of the certification and could, at its option, choose to investigate it.