- PERSONAL FINANCE
- RETIREMENT PLANNING
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What Is an Indirect Rollover?
An indirect rollover is a transfer of funds from a tax-deferred retirement account to an investor, who deposits the funds into another tax-deferred retirement account. This is in contrast to a direct rollover, where funds are moved between accounts without the involvement of the investor.
If you take a distribution via an indirect rollover, you must deposit 100% of the funds into a retirement plan or individual retirement account (IRA) within 60 days to avoid paying income tax and penalties.
KEY TAKEAWAYS
- An indirect rollover transfers funds from a tax-deferred retirement plan to an investor, who transfers the funds into another tax-deferred retirement account.
- With an indirect rollover, the full distribution amount must be redeposited into another qualified retirement account by a deadline—60 days—to avoid income taxes and penalties.
- The direct rollover protects your retirement funds from taxes and penalties, since the funds are transferred from the plan administrator to another account without the employee handling the funds.
Understanding an Indirect Rollover
A rollover of a retirement account is common when an employee changes jobs or leaves a job to start an independent business.
Most of the time, the rollover is direct, in order to eliminate any risk that the individual will lose the tax-deferred status of the account and owe an early withdrawal penalty as well as income taxes. With a direct rollover, when an employee is due to receive a distribution from a retirement plan, they will ask their employer's plan administrator to pay the funds directly to another retirement plan or an IRA. This transfer is on the employee's behalf. In other words, with a direct rollover, the employee never receives a check or the funds directly.
Though a direct rollover is more common, the employee does have the option of an indirect rollover, which means they will receive the distribution directly. In this case, the employer generally withholds 20% of the amount that is pending transfer in order to pay the taxes due. This money is returned as a tax credit for the year when the rollover process is completed.
The 60-Day Rollover Rule
An indirect rollover is also called a 60-day rollover because the full distribution amount must be redeposited into a 401(k), IRA, or other qualified retirement account within 60 days to avoid taxes and penalties.
Once the money is in the hands of the account holder, it can be used for any purpose for the full 60-day grace period. However, if the person then fails to deposit the full amount of the distribution into another retirement account, the amount not redeposited is subject to tax, and a 10% early withdrawal penalty will be imposed if the person is under the age of 59½.
You must complete the indirect rollover process within 60 days to avoid the tax penalty.
IRS Rules for Indirect Rollovers
Whether there's a good reason for using the indirect option or not, the Internal Revenue Service (IRS) has two rules that could trip up the account holder:
- Only one indirect rollover is permitted within a 12-month period. (That means any 12-month period, not a tax year.)
- The transfer must be from one account to another account and cannot be split among multiple accounts. If the funds are split into two accounts, the IRS will consider it two indirect rollovers.
Mess up either of these rules, and you're on the hook for income tax for the entire amount withdrawn, plus the 10% early distribution tax. Also, splitting the money between accounts as described above has an added penalty of its own, where you'll also owe a 6% excess contribution tax on one of the two accounts every year for as long as the account exists.
Why Use an Indirect Rollover?
Financial advisors and tax advisors pretty much unanimously advise their clients to always use the direct rollover option, not the indirect rollover.
The only reason to use the indirect rollover is if the account holder has some urgent use for the money, and it can be accomplished without risk within 60 days. For example, someone relocating for a new job may have large immediate expenses that will be reimbursed in time.
What Is an Indirect Rollover Example?
Let's say that Jamaal, who is under the age of 59½, was paid a $10,000 rollover distribution from his 401(k) plan. Jamaal's employer withheld $2,000 from the distribution, meaning Jamaal received $8,000. If Jamaal decided to roll over the funds into another IRA before the 60-day grace period, Jamaal must redeposit the full $10,000 amount into that retirement account.
If Jamaal rolls over the $8,000 that he received into a retirement account, but not the $2,000 that was withheld, the $2,000 would be considered a distribution subject to income taxes and a 10% penalty. On the other hand, the $8,000 would be considered a nontaxable distribution, and no taxes and penalties would be owed.
To avoid taxes and penalties, Jamaal would need to redeposit the full $10,000 distribution amount within 60 days, meaning he would need to come up with $2,000 from other sources.
Is There a Penalty for an Indirect Rollover?
If you complete the rollover correctly, following the IRS rules, then there is no penalty. However, it's important to note that even though the distribution will have taxes withheld, you must redeposit the full amount of the distribution within the 60-day window. Failure to do so will incur a penalty.
The Bottom Line
If not accomplished properly, an indirect rollover can leave you owing income taxes, an early withdrawal penalty, and even an excess contributions tax. Failing to meet the 60-day deadline is a common mistake.
In most cases, it's wise to avoid an indirect rollover. Make sure to consult with a financial professional to ensure that you're rolling over your funds correctly.