IRA Rollover Taxes & Penalties
Congress authorized individual retirement accounts to encourage people to save toward their own retirement. Whether you choose a traditional IRA or a Roth IRA, your investments in the account grow without incurring a current income tax liability. While all IRAs are custodial or trustee accounts, you are not locked into a single custodian. You can roll your funds over to a different custodial account, but if you don't meet the IRS's deadline you'll get hit with taxes and a penalty.
You can invest your IRA money is almost any kind of investment other than life insurance or collectibles, but your IRA account must be held by a custodian or trustee. The custodian or trustee can be a financial institution such as a bank, insurance company, mutual fund or investments brokerage firm. There is no requirement for you to keep all of your IRA money with only one custodian or trustee. You can have as many IRA accounts with as many different custodians or trustees as you wish. If your current custodian no longer meets your needs, you are free to move your IRA to a different custodian.
Taxes and Penalties
Congress intended IRA contributions to be used for retirement purposes. If you take your money out of your IRA before it is qualified, you risk a substantial tax penalty. Nonqualified distributions from your traditional IRA are taxed as ordinary income and are subject to an additional tax penalty of 10 percent of the amount withdrawn. You can avoid both the taxes and the tax penalty by rolling your distribution over into another IRA.
To avoid taxes and a tax penalty on your IRA withdrawal, you must roll the funds over into another IRA or qualified retirement plan within 60 days. Your old IRA trustee is required to withhold 20 percent of any distribution it makes directly to you and send it to the IRS for income taxes. The IRS considers that 20 percent to be a taxable distribution. You must contribute enough to your new IRA to cover the 20 percent withholding, or that amount will be taxed as ordinary income and will be subject to the 10 percent early withdrawal penalty. Once you've done an IRA rollover, you must wait one year before you can do another rollover.
You can move your retirement assets from one IRA account to a new IRA account though a trustee-to-trustee transfer. The assets are transferred directly from your old trustee to your new trustee without you ever taking possession of the funds. Since you didn't take possession of any of your retirement assets, there is no taxable event. You will not incur any tax liability, there is no tax withholding and no tax penalty. While some people refer to this transaction as a rollover, the IRS does not consider trustee-to-trustee transfers to be as such. Transfers are not subject to the same one-year waiting period as IRA rollover transactions.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.