How to Do an Indirect Rollover and Avoid Tax Penalties
Effectively manage your retirement funds. Learn how to perform an indirect rollover safely and avoid common tax pitfalls.
An indirect rollover involves moving funds from one retirement account to another by first receiving the distribution yourself and then depositing it into a new eligible account. This method differs from a direct rollover, where funds are transferred directly between financial institutions without you ever taking possession of the money. While direct rollovers are often simpler, understanding the indirect rollover process is important for those who choose or need to receive the funds personally before moving them to a new retirement savings vehicle.
Eligibility and Key Requirements
Before initiating an indirect rollover, understanding the specific rules governing these transactions is important to avoid potential tax consequences. Two primary rules dictate the success of an indirect rollover: the 60-day rule and the once-per-year rule for IRAs. Adhering to these requirements helps maintain the tax-deferred status of your retirement savings.
The 60-day rollover rule stipulates that you must deposit the distributed funds into another eligible retirement account within 60 days of receiving them. Missing this deadline means the distribution becomes taxable income, and if you are under age 59½, it may also incur an additional 10% early withdrawal penalty. The 60-day period begins the day after you receive the funds, whether by check or electronic transfer.
For rollovers between IRAs, the once-per-year rule applies, limiting you to only one indirect IRA-to-IRA rollover within any 12-month period. This rule applies to all IRAs you own, treating them as a single entity for this purpose, including traditional, Roth, SEP, and SIMPLE IRAs. This limitation does not apply to rollovers from employer-sponsored plans (like 401(k)s) to IRAs, nor does it apply to direct trustee-to-trustee transfers or Roth conversions.
Various retirement accounts are eligible to participate in indirect rollovers, including Traditional IRAs, Roth IRAs, 401(k)s, 403(b)s, and 457(b)s. However, certain distributions cannot be rolled over, regardless of the account type. These ineligible distributions include required minimum distributions (RMDs), hardship distributions from employer plans, and a series of substantially equal periodic payments (SEPPs). Distributions of excess contributions or loan defaults also generally cannot be rolled over.
Initiating the Distribution
The first action in an indirect rollover is requesting the distribution from your current retirement plan administrator or custodian. They will provide the necessary distribution request forms that outline the specifics of your withdrawal.
These forms typically require you to specify the amount of the distribution and your preferred method for receiving the funds, such as a check mailed to you or a direct deposit to a personal bank account. You should confirm the distribution is intended as an indirect rollover. The institution may also ask about tax withholding elections.
For distributions from employer-sponsored plans, like 401(k)s, a mandatory 20% federal income tax withholding generally applies to the distribution amount. This withholding occurs even if you intend to roll over the entire amount. For example, if you request a $10,000 distribution, you would receive a check for $8,000, with $2,000 withheld for taxes.
This withholding does not typically apply to IRA-to-IRA rollovers, though you can elect to have taxes withheld. Once forms are processed, funds will be disbursed according to your instructions. This receipt of funds marks the beginning of the 60-day period for completing the rollover.
Completing the Rollover Deposit
After receiving the distribution, deposit the funds into your new eligible retirement account within the 60-day deadline. If you do not already have an account, open a new IRA or employer plan account that can accept rollover contributions.
Contact the receiving institution’s custodian or plan administrator to initiate the rollover deposit. They will provide specific rollover contribution forms that must be completed to properly categorize the incoming funds as a rollover.
When depositing the funds, if you received a check made out to you, endorse it and deposit it into your new account. If the original distribution was an electronic transfer, transfer those funds to the new retirement account. It is crucial to ensure the full amount of the original distribution is deposited.
If 20% federal income tax was withheld from an employer-sponsored plan distribution, you must deposit the entire original distribution amount, including the withheld portion, into the new retirement account. This means you will need to use other personal funds to make up for the 20% that was withheld. For instance, if $2,000 was withheld from a $10,000 distribution, you must deposit the full $10,000 into the new account to avoid the $2,000 being considered a taxable distribution. The 20% withheld amount is not lost; it will be credited to you when you file your income taxes for the year.
Tax Obligations and Documentation
After completing an indirect rollover, accurate tax reporting and documentation are essential to demonstrate compliance with IRS regulations. The distributing institution and the receiving institution will each provide specific tax forms related to the transaction, crucial for your annual income tax filing.
The distributing institution will issue Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form reports the gross amount of your distribution in Box 1 and any federal income tax withheld in Box 4. Box 2a, “Taxable Amount,” might show the full distribution amount, but you will report it as non-taxable on your tax return if the rollover was completed correctly.
The receiving institution will later issue Form 5498, “IRA Contribution Information,” which reports the amount of the rollover contribution received into your new IRA.
When filing your federal income tax return (Form 1040), you must report the indirect rollover. The gross distribution amount from Form 1099-R, Box 1, is typically entered on line 4a for IRA distributions or line 5a for pension and annuity distributions. If you rolled over the entire amount, enter “0” on line 4b or 5b (Taxable Amount) and write “rollover” next to that line, indicating the distribution is not taxable.
If your indirect rollover involved non-deductible IRA contributions, you may need to file Form 8606, “Nondeductible IRAs.” This form tracks your basis in non-deductible contributions, which helps prevent double taxation when you eventually withdraw the funds in retirement.
Failing to complete the rollover correctly or within the 60-day timeframe can lead to tax consequences. The distribution will be considered taxable income, and if you are under age 59½, it may also be subject to an additional 10% early withdrawal penalty.