By Jeremy Rodriguez, JD
I’m sure you’ve heard countless advisors mention that a direct transfer (or direct rollover) is the best way to move funds between IRAs or qualified retirement plans. But do you understand why? There are a number of reasons, and in this installment, we discuss some of those in greater depth.
Background: Direct Transfer vs. 60-day Rollovers
It is important to under the difference between a direct transfer (or direct rollover) and it’s alternative, a 60-day rollover (or indirect rollover).
Direct Transfer – A direct transfer and a direct rollover have identical meanings. The only difference is the tax code uses the term “direct transfer” when discussing IRAs and “direct rollovers” when addressing qualified plans. In either event, we are talking about a distribution where the funds are payable to another tax-deferred account. They are not paid to the account holder. There are two ways to directly transfer/rollover IRA and qualified plan accounts:
1. ACH/Wire Transfer – Here, the funds are wired to another qualified
account (i.e., IRA or qualified plan). The account holder never touches the funds. This is the preferred method.
2. Check Payment – In this case, the distribution is in the form of a check, but
the check is made payable to the recipient account.
- 60-day Rollovers – Similarly, the terms 60-day rollover and indirect transfer also have the same meaning. In this case, we are talking about a distribution that is payable to the individual but is redeposited to an IRA or qualified retirement plan within 60-days. Keep in mind that partial rollovers are allowed.
Benefits of a Direct Transfer
Now that you understand the difference between the two terms, we can discuss some of the reasons you should always look to a direct transfer when moving IRA or qualified plan funds if your goal is to continue tax deferral.
- Simplicity: You really can’t get much simpler than a direct transfer. With an ACH/wire transfer, the account holder never even touches the funds. That’s one less thing to worry about!
- Once-per-Year Rollover Rule: Direct transfers are exempt from this rule. That means you can do an unlimited number of direct rollovers in one-year without violating this often overlooked restriction.
- Withholding (qualified plans): Direct transfers are not subject to any withholding rules. Qualified plans are required to withhold 20% on distributions paid to the account holder that can be rolled over. That 20% is taxable income, even though it is paid to the government.
- Inherited IRAs: A direct transfer is the only way an Inherited IRA owner can transfer an Inherited IRA account to another institution. Whatever amount from the Inherited IRA that is made payable to the beneficiary becomes taxable income. Moreover, unless we are talking about an error committed by the custodian, there is no way to “fix” this mistake.
- Divorce: If IRA assets are awarded in a divorce, a direct transfer is the only way to do a non-taxable distribution of the amounts awarded to the ex-spouse.
- Timing: Unlike 60-day rollovers, direct rollovers are not subject to time constraints.
- IRS Relief: Unlike 60-day rollover issues, any problem that occurs with a direct rollover will automatically qualify for tax relief
In the end, if you are considering moving funds between IRAs or qualified plans and want to defer taxes on all, or a part, of that transaction, the lesson is clear. You should complete a direct transfer with any dollars with which you want to maintain their tax-exempt status.