When distributions are taken from tax-deferred retirement accounts, ordinary income taxes are due. However, sometimes funds may simply need to be moved from one retirement account to another – perhaps because an employee is retiring or switching jobs and chooses to move their 401(k) from their old employer to another 401(k), or to an IRA account, or because a client wishes to work with a new financial advisor and chooses to move all of their accounts over to the new advisor’s firm. Whatever the reason, there are specific rules for different types of money movement that financial advisors should understand to make sure their clients’ accounts are protected from unnecessary taxable distributions.
There are two categories of money movement between retirement accounts: Indirect and Direct transactions. For an Indirect Rollover, the account owner withdraws funds to be moved from the originating account and takes actual custody of the funds. The full amount of funds withdrawn must be deposited into the target account within 60 days. One caveat for Indirect Rollovers from employer-sponsored retirement plans is that there is generally a mandatory 20% withholding for Federal income taxes that the plan sponsor makes directly to the IRS, with the balance of the funds sent to the account owner. This means that, in order to avoid the tax withholding itself to be considered a taxable distribution from the account, the employee must ‘make up’ for the withheld amount by depositing funds from another source into the target account within the 60-day Indirect Rollover window. This withholding does not apply to IRA accounts, including IRA-based employer plans such as SIMPLE IRAs and SEP IRAs. Taxpayers are also limited to one Indirect Rollover between IRA or Roth IRA accounts every 365 days; any additional attempted Indirect Rollovers would be considered an account contribution and can potentially result in a 6% excess contribution penalty annually until corrected.
In addition to Indirect Rollovers, there are two types of Direct methods to move funds between accounts: Direct Rollovers and Direct Transfers. Direct Rollovers move funds between two retirement accounts, but unlike an Indirect Rollover, the funds are never in the account holder’s custody, nor is there any mandatory tax withholding. For Direct Rollovers, funds are moved from the trustee of one account directly to the trustee of the second account (where each account is a different type of accounts, e.g., 401(k) to IRA or vice versa). Direct Rollovers also have no time limit in which the transaction must take place, and there is no limit to how many Direct Rollovers can be done in a given year. While Direct Rollovers are not taxable events, they are reportable events and as such, are reported on Form 1099-R.
Similar to Direct Rollovers, Direct Transfers are made directly between the trustees of each account and don’t involve the account holder ever having custody of the funds being transferred. What distinguishes a Direct Transfer from a Direct Rollover, though, is that the accounts in a Transfer must be ‘like’ accounts (e.g., IRA to IRA, 401(k) to 401(k), etc.). Like Rollovers (including both Direct and Indirect), Like Rollovers, Transfers are not taxable events, but unlike rollovers, they are not reportable events and thus do not require submission of any forms to the IRS. Transfers are also different from Rollovers as they can accommodate funds designated as RMDs.
Ultimately, the key point is that each of the various ways funds can move between retirement accounts has its own distinct set of rules and requirements. Direct Rollovers are generally preferable over Indirect Rollovers, as they are subject to neither the 60-day time limit nor the 20% mandatory withholding, but do require to be reported to the IRS. On the other hand, Transfers do not need to be reported to the IRS and are used when an individual simply needs to change custodians or consolidate accounts involving the same kind of account.