LET ME TELL YOU about Alvan Bobrow. His tale—and specifically his lawsuit—are important for every investor to understand. That’s because the legal loophole he sought to exploit is now a pothole for everyone else.
The first thing to know about Bobrow: He’s a tax attorney and, back in 2008, he had a clever idea. In need of cash, he took a $65,000 distribution—the technical term for a withdrawal—from his IRA. Ordinarily, a distribution from an IRA (unless it’s a Roth IRA or includes nondeductible contributions) is treated entirely as taxable income. For those younger than age 59½, an additional 10% penalty may also apply. But Bobrow knew a way to sidestep these taxes: He took advantage of the 60-day rollover rule.
To understand the rule, imagine you have an IRA at investment firm A and you wish to move it to firm B. To facilitate transfers like this, the 60-day rule permits you to take your money out of firm A and temporarily hold it in your bank account, before depositing it again at firm B. But to prevent taxpayers from abusing the rule, the IRS permits only one such move in any 12-month period. In other words, the IRS will allow you to take money out of an IRA without paying any tax, but only for 60 days at a time and only once per year.
But Bobrow saw a loophole: The way the rule was written, it appeared that the once-per-year limitation applied on an account-by-account basis. This would allow a taxpayer with multiple IRA accounts to daisy-chain together multiple 60-day periods, resulting in the tax-free use of IRA funds for much longer than 60 days.
Because Bobrow and his wife had several IRA accounts, that’s exactly what they did. In April 2008, Bobrow took a distribution from his first account and deposited the funds in his bank. Then, in June, he took a distribution from a second IRA and used it to pay back the first IRA. In July, he did the same thing again, taking funds from a third IRA and using it to pay back the second IRA before the 60-day clock ran out. Finally, on Sept. 30, he restored the funds to the third account. In the end, he was able to hold onto about $65,000 of IRA money on a tax-free basis for more than five months. This was far longer than the 60-day rule allowed, but Bobrow believed he was in the clear because each of his 60-day withdrawals came from a different account.
Problem is, he made a few missteps. Among them: His final deposit was a day late, coming in on day 61. That little error caused the IRS to take a closer look—and that’s when things went downhill for Bobrow. Because he missed the deadline, the IRS deemed the distribution taxable. It also assessed a penalty of more than $10,000.
Bobrow decided to challenge the penalty. He sued the IRS in Tax Court but was unsuccessful. The court agreed with the IRS that Bobrow violated the 60-day rule because of the extra day. But the ruling went further: The court also deemed Bobrow’s daisy-chaining maneuver to have been illegal. Prior to this ruling, everyone—including the IRS—had assumed that the once-per-year rule applied on an account-by-account basis. But the Tax Court ruled that it applied to all of a taxpayer’s IRAs in aggregate. In other words, in the view of the court, taxpayers should be allowed only one rollover per year, regardless of how many accounts they might have. In issuing this ruling, the Tax Court effectively changed the law, and the IRS now enforces the modified rule.
The bottom line: Investors need to be very careful when moving retirement funds. Whether you’re moving money from a 401(k) or 403(b) to an IRA, or between IRAs, it’s critical to avoid running afoul of both the 60-day and once-per-year rules.
Fortunately, there’s an easy solution: Whenever you transfer funds among accounts, the custodian will give you a choice between a direct transfer and an indirect transfer. With an indirect transfer, the custodian writes you a check, which you can deposit in your bank account—for up to 60 days. That’s what the Bobrows did, and I don’t recommend it.
Instead, you want to choose a direct transfer. With this option, the funds are never in your possession. The old custodian either writes a check payable to the new custodian or sends an electronic transfer directly to the new custodian. Either way, since the funds never enter your bank account—which is the IRS’s primary concern—the 60-day rule doesn’t apply, and nor does the once-per-year rule. Because of that, I always recommend direct transfers.
Note: In some cases, even with a direct transfer, the old custodian will send a check to you and ask you to forward it to the new custodian. That’s no problem, as long as the check is payable to the new custodian. It still qualifies as a direct transfer.
Below are some common questions on this topic:
Do these rules apply to Roth IRAs? Yes. Even if a distribution from a Roth isn’t taxable, you still want to be careful in handling Roth funds. Violating the rules would mean the loss of future tax-free growth.
Does the once-per-year rule apply to Roth conversions? No. Because conversions are intended to be taxable, the IRS doesn’t limit their frequency.
In Bobrow’s case, he was penalized for being just a day late. Is the IRS really that unforgiving? In the Bobrow case, the extra day was just the trigger that caused the audit. Examiners found other issues with his transactions. In reality, the IRS offers a lot of leniency with the 60-day rule. There is, however, no flexibility with the once-per-year rule.
What’s the difference between a rollover and a transfer? In practical terms, they’re synonymous. In technical terms, it’s called a transfer when you move funds between accounts that are of the same type—between two IRAs, for example, or between two 401(k)s. On the other hand, it’s called a rollover when you move money from one type of account to another—from, say, a 401(k) to an IRA. There are some differences between the rules governing rollovers and transfers. But either way, the key is to always choose the direct option.
I have a handful of retirement accounts scattered across different custodians. Can I use transfers or rollovers to combine them? In a lot of cases, you can combine accounts, but it depends on the type of account. The IRS provides a useful visual guide. This is a good starting point but, as always, consider consulting an accountant.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.