Rollover IRAs vs Direct Transfers

Moving retirement money between accounts looks like one transaction. Under the tax code it is at least three different ones, each with different rules, deadlines, and trap doors. Getting the mechanic right is worth between zero and 50% of the balance — depending on which mistake you make.

The four ways to move retirement money

• Direct trustee-to-trustee transfer. Custodian A wires the money to Custodian B; you never touch it. No tax withholding, no reporting, no 60-day clock, no one-per-year limit. The default safe choice.
• Direct rollover. A 401(k)-to-IRA (or IRA-to-IRA, or 401(k)-to-401(k)) movement in which the check is made payable to the receiving custodian "for benefit of" you. No withholding, no 60-day clock. Reported on Form 1099-R with code G.
• Indirect (60-day) rollover. The distributing custodian sends the money to you personally. You have 60 days to deposit it into a qualifying retirement account. Withholding rules apply. Reported with code 1 or 7 plus your Form 5498 showing the rollover deposit.
• Conversion. A Traditional-to-Roth movement, always taxable, sometimes accomplished via any of the above mechanisms.

The 20% mandatory withholding on indirect rollovers from employer plans

Under IRC §3405(c), an indirect rollover from a 401(k), 403(b), or 457(b) requires the plan administrator to withhold 20% for federal income tax. If you want to roll over the full balance, you must come up with the 20% from outside money within the 60-day window. Otherwise the unrecovered 20% is treated as a taxable distribution and (if you are under 59½) subject to the 10% early-withdrawal penalty.

Worked example: $100,000 in your 401(k). Indirect rollover means the plan sends you $80,000 and withholds $20,000 for the IRS. To complete a full rollover, you deposit $100,000 into your IRA — meaning you need $20,000 from somewhere else. You get the $20,000 back as a refund when you file the next year, but in the meantime it has been advanced from your own pocket.

The 20% withholding does not apply to direct rollovers or trustee-to-trustee transfers.

The one-rollover-per-year rule for IRAs

IRC §408(d)(3)(B), as interpreted by Bobrow v. Commissioner (T.C. Memo 2014-21), limits indirect IRA-to-IRA rollovers to one per 12-month period across all your IRAs. A second indirect rollover within 12 months is treated as a taxable distribution.

The rule does not apply to direct trustee-to-trustee transfers between IRAs (which can happen as often as you want), to conversions from Traditional to Roth, or to rollovers from a 401(k) to an IRA.

The 60-day clock

The 60-day window starts the day after you receive the distribution. Miss it and the entire amount is taxed (plus the 10% penalty if applicable). The IRS will waive the 60-day rule for certain hardships under §402(c)(3)(B), including bank error, military service, hospital stay, and death of a family member — see Rev. Proc. 2016-47 for the self-certification procedure.

The lump-sum distribution complication

If your 401(k) contains employer stock and you might want to use the Net Unrealized Appreciation strategy, do not roll the entire balance to an IRA first. NUA requires a lump-sum distribution where the employer stock goes in-kind to a taxable account — see our NUA article.

Common mistakes

• Defaulting to "send me the check." The 20% withholding and the 60-day clock are both avoided by saying "wire the money directly to the receiving custodian." Always ask for trustee-to-trustee.
• Two indirect IRA rollovers in 12 months. A common mistake when consolidating accounts. The second one is taxable. Use direct transfers when consolidating.
• Confusing Form 1099-R code G with code 1. Code G is a direct rollover and means no tax. Code 1 is an early distribution. If your 1099-R shows the wrong code, contact the custodian for a corrected form before filing.
• Rolling a 457(b) to an IRA without considering the §72(t) consequence. The 457(b) is uniquely exempt from the 10% early-withdrawal penalty; the IRA is not. Once rolled, the protection is gone.

Sources

• Internal Revenue Code §408(d)(3), rollover rules (Cornell LII): law.cornell.edu/uscode/text/26/408
• Internal Revenue Code §3405(c), mandatory withholding on employer-plan distributions: law.cornell.edu/uscode/text/26/3405
• Bobrow v. Commissioner, T.C. Memo 2014-21 (one-rollover-per-year rule): ustaxcourt.gov
• IRS Revenue Procedure 2016-47, self-certification for 60-day rollover waiver: irs.gov/pub/irs-drop/rp-16-47.pdf
• IRS Publication 590-A, Contributions to IRAs, rollover discussion: irs.gov/forms-pubs/about-publication-590-a

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