Roll a rollover without getting rolled!

 It's an epidemic! It seems that no one can complete an IRA rollover without killing the account.

So what's the problem? IRA owners and even some financial advisers don't know how to move IRA money from one IRA or plan to another without triggering a tax or a penaltyor both.

How bad is it? It's so bad that Congress had to step in a few years ago and insert a relief provision in the Tax Code. But many advisers and their clients who mess up rollovers still don't know about this relief provision. It was buried in the 2001 Tax Act and not well publicized.

It's essential that advisers know the basic IRA rollover rules and how to use the relief provision to correct rollover errors. The best advice to advisers is to understand these rollover rules so that you don't find yourself requesting relief from the IRSbecause the agency is not always accommodating.

The general rule is that when you take a distribution from an IRA (or from other tax-deferred retirement accounts) that you intend to roll over, it must be contributed back into an IRA (or other tax-deferred retirement plan) within 60 days. If the funds aren't rolled over in 60 days, the distribution is taxable. In most cases, a 10% penalty for early withdrawal also applies if the IRA owner is younger than 591/2.

Beginning in 2002, however, the tax law allowed the IRS to grant a waiver of the 60-day rule in certain circumstances. This waiver permits taxpayers to take more time to return the funds to an IRA or other retirement account and maintain the tax deferral. In January 2003, the IRS issued Revenue Procedure 2003-16, which included guidance on applying for a 60-day rule waiver.

It's also an excellent idea for planners to familiarize themselves with the relevant procedures and other deceptively complex issues surrounding rollovers. In brief, a rollover occurs when a plan participant withdraws funds from an IRA or qualified plan and contributes those funds to the same or another IRA or plan. In the course of a trustee-to-trustee transfer (also known as a direct transfer or a direct rollover), the participant never actually receives the IRA or plan funds. They are transferred directly from one financial institution to another without the individual ever touching the money.

This is by far the best way for clients to transfer funds from one IRA or plan to another. Direct transfers eliminate the three crucial problems that rollovers triggerthe 60-day rollover rule, the once-per-year rollover rule, and the 20% man- datory withholding on all rollover distributions from plans.

One of the problems with rollovers is the terminology used to describe them. It seems that whenever IRA or qualified plan money is moved from one IRA or plan to another, we call it a rollover, even if it is in fact a direct, trustee-to-trustee transfer. Even above, I said a trustee-to-trustee transfer is sometimes referred to as a direct rollover. Given the definition of a rollover as something that is not a direct transfer, then how could anyone possibly use the term direct rollover? Yet that's how a trustee-to-trustee transfer is referred to in the IRS regulations, and I agree it's confusing.

For clarity's sake here, I won't use the term direct rollover, even though it's the official IRS term for a direct transfer. I'll stick with either direct transfer or trustee-to trustee transfer, and when I am referring to taking a distribution and contributing those funds to the same or another IRA or qualified plan, I will use the term rollover because that's what a rollover is.

With that said, the rollover rules discussed above don't apply to direct transfers. With direct transfers, there is no 60-day rollover rule and no once-a-year rollover limit. You can do an unlimited amount of trustee-to-trustee transfers in a year. Direct transfers are also exempt from the 20% mandatory withholding rule (it only applies to eligible rollover distributions from company plans, not to IRA distributions). Direct transfers remove all the problems that are associated with rollovers. Make sure that your clients do direct transfers when moving IRA or company plan money.

The point of a rollover, of course, is that when a client moves the money, it is supposed to be tax-free. But a rollover is only tax-free if the distribution is an eligible rollover distribution and if the client adheres to the two main rollover rulesthe 60-day rule and the once-per-year rollover rule. Participants have only 60 days from the date they receive their funds from the IRA to contribute them to the same or another IRA or qualified plan. Until 2002, this was a rigid and unforgiving rule, and mistakes were costly, as many taxpayers found out.

But when it passed the Economic Growth and Tax Relief Reconciliation Act of 2001, also known as EGTRRA, Congress added a provision granting the IRS the authority to waive the 60-day rule for certain hardships. It seems that rollover problems had become so rampant Congress got worried that too many people were losing their IRAs just trying to do rollovers. Relief became effective for both IRA and qualified plan distributions after 2001. Because the relief provision is a part of EGTRRA 2001, it technically sunsets after 2010. Hopefully people will learn how to do IRA and qualified plan rollovers by then.

In January 2003, the tax agency put out Revenue Procedure 2003-16, which spelled out the rules on how to apply for relief. Rev. Proc. 2003-16 basically says taxpayers can apply for a waiver of the 60-day rule by requesting a private letter ruling (PLR) from the IRS.

To date, the IRS has released over 120 rulings on this issuea huge number that shows how serious the rollover problem really is. The IRS has ruled fav-orably in most of these cases, giving taxpayers more time to complete intended rollovers instead of forcing them to suffer the costly consequences.

To make the process even easier, Rev. Proc. 2003-16 also says taxpayers can receive automatic relief (without having to request a PLR) when the delayed rollover is solely the fault of the financial institution. That is, the participant did everything else right, but the funds were not rolled over within the required 60 days. For automatic relief, the funds must be recontributed to an IRA or to a qualified plan within a year of the original distribution.

While this rollover relief provision is welcome, planners need to understand that there are limits to IRS magnanimity. A waiver certainly doesn't mean that a client never has to complete the roll-over. It means that the IRS, depending on the particular circumstances, may give participants more time to complete the roll-over if they have missed the 60-day deadline. In most of the favorable PLRs issued to date, the agency granted the taxpayers an additional 60 days from the date of the ruling to complete the rollover by contributing the funds back into an IRA or qualified plan. The relief pro- vision also remove any potential taxes and penalties on the failed rollover.

Until recently, the IRS had approved every ruling requested. In most of those cases, the taxpayers were granted relief because of errors by financial advisers and financial institutions (e.g., the funds distributed from the IRA were deposited to non-IRA accounts and not rolled over to another IRA or plan).Taxpayers seeking rulings were also granted relief for health issues, family problems, or simply not understanding the rules. But in all the cases where the IRS provided relief, the agency determined the taxpayer did intend to do a rollover, not for the distribution to be taxable income.

On April 23, 2004, the IRS issued the first PLR (200417033) in which it ruled against a taxpayer asking permission to waive the 60-day rollover requirement on a 2002 IRA distribution. In all of the other rulings, the taxpayers wanted to complete a valid rollover, and the agency bent over backwards to help them, even if they had missed the 60-day limit. In this case, however, the taxpayer withdrew IRA funds because he was out of a job, his unemployment benefits had run out, and he needed the funds to live on. After the 60 days expired, he found permanent employment and attempted to redeposit the funds into his IRA so that the previous distributions would not be taxable. The IRS denied the request, ruling the taxpayer had no intention of doing a rollover but was instead effectively using the IRA distributions as a short-term interest-free loan.

There are really two lessons to learn from this case:

* Use direct transfers (that is, trustee-to-trustee transfers) when moving retirement funds from one qualified plan or IRA to another. If a client truly intends to transfer the funds to another retirement account, he or she should arrange to have the funds transferred directly rather than rolling them over. Although many taxpayers seeking rulings ultimately got favorable ones, they still had to take the time and expense to request a PLR from the IRS.

* Don't try to use the 60-day rule to borrow from an IRA. This strategy only works if clients need short-term cash and are confident they can replace the money within the 60 days; otherwise, it is an expensive way to raise cash.

The IRS has issued several more unfavorable 60-day ruling requests. Like anything else, once the door opens there will always be taxpayers who try to use these rulings for purposes other than the relief that was intended by the law.

In PLR 20042205, for example, the IRS denied the ruling request because the IRA owner was unemployed and needed the funds for a short-term loan for 102 days. The IRS won't grant relief if a taxpayer uses the money for other purposes and then later claims he or she wanted to roll the funds over after the 60 days have passed.

In my personal favorite ruling, PLR 200422058, the IRS denied the request because the IRA owner wanted to use the relief provision to take advantage of some capital losses. He thought that he could withdraw the funds from his IRA and use his capital losses to offset the IRA distribution income. He had forgotten or never knew that IRA distribution income is ordinary income and can't be offset with capital losses.

Another key rule is that participants can roll over funds only once every 12 months. This period begins on the day the participant receives the IRA distribution, not the date it gets rolled over. For example, if your client gets an IRA distribution on June 5, 2004 and rolls it over on July 17, 2004, he can't do another rollover from that same IRA until June 5, 2005. If he rolled those same funds over again on June 12, 2005, that is fine, even though it has not yet been a year since the first rollover was completed.

Once a participant withdraws any amount from an IRA and rolls it over, he or she can't roll any of the other funds in that same IRA over within the 12-month period after the funds are received. For example, assume that your client has $500,000 in her IRA at Mutual Fund A and she rolls $1,000 of that IRA to an IRA at Bank B. She must then wait at least 12 months before she can roll over any of the remaining $499,000 from her IRA at Mutual Fund A. Moreover, she must also wait a year before she can roll the $1,000 that's now in Bank B over to yet another IRA.

Note, however, that although participants can only do a 60-day rollover once every 12 months, the rule applies separately to each IRA that they own. So if a client owns two IRAs-IRA 1 and IRA 2-he can roll over from IRA 1 to a new IRA 3, and then within the same year, he can also roll over from IRA 2 to IRA 3 or into any other IRA. In this example, however, he cannot roll over IRA money he already rolled into IRA 3 into another IRA within the same one-year period.

Since participants can use the 60-day rule only once every 12 months, those who missed the 60-day rollover rule and applied for an IRS ruling can't expect a favorable reply if they already used the 60-day rollover for the same funds during the previous 12 months. This is true even if they had legitimate reasons, like the taxpayers above.

Finally, note that the 60-day rule also applies to Roth conversions. For example, any clients who withdraw funds from a traditional IRA have 60 days to make a conversion to a Roth IRA. Once again, the better method is to make a direct trustee-to-trustee transfer, so that there is no risk of exceeding the 60-day limit. The once-every-12-months rule doesn't apply to any rollovers from traditional IRAs into Roth IRAs (Roth conversions), however.

Yes, there are lots of rules for advisers to learn, but knowing them is worth the time. Helping clients avoid their own rollover horrors may be the best service you ever provide for them.