Change to IRA rollover rule creates tax trap for the unwary

The IRS is changing its position on the one-per-12-month IRA rollover rule starting in 2015—further limiting the number of rollovers an individual may make—and creating a potential tax trap for the unwary that could cost them dearly.

This change comes on the heels of a U.S. Tax Court ruling earlier this year in Bobrow v. Commissioner, in which the Tax Court ruled that taxpayers are limited to one IRA rollover per 12-month period, regardless of the number of IRAs they hold. This ruling raised red flags in the industry as it conflicted with the long-standing IRS position on the one-per-12-month rollover rule. For more than 30 years, the IRS had based its position on a proposed Treasury regulation (1.408-4(b)(4)(ii)) and had publicly stated that a taxpayer is generally permitted to roll over one IRA distribution per 12-month period for every IRA owned by the taxpayer. The IRS provided detailed examples in Publication 590, Individual Retirement Arrangements (IRAs), that supported this interpretation, which taxpayers and tax advisers have relied on for years.

In response to the Tax Court ruling, the IRS announced that it is changing its interpretation of the one-per-12 month IRA rollover rule to be consistent with the Tax Court’s ruling in Bobrow v. Commissioner. The IRS subsequently released Announcement 2014-15, indicating that it will apply the Tax Court’s interpretation of the ruling to IRA distributions taken on or after January 1, 2015. For IRA distributions taken in 2014 and earlier years, taxpayers may roll over one distribution per IRA that they own during any 12-month period. Taxpayers may continue to make unlimited trustee-to-trustee IRA transfers.

As with any major change, many questions remain unanswered, and further IRS guidance is anticipated. The IRS has withdrawn proposed Treasury regulation 1.408-4(b(4)(ii) and has stated that it intends to issue new proposed regulations to reflect its new interpretation that the one-per-12-month rollover rule applies on a taxpayer basis, rather than an IRA basis. Publication 590 also will be updated to reflect the new interpretation. However, no new guidance has been issued since Announcement 2014-15 was released on March 20, 2014.

Rollovers to IRAs overwhelmingly outweigh new IRA contributions in terms of dollars, with an average 2012 rollover amount of $71,447, compared with the average 2012 IRA contribution amount of $3,904, according to data from the Employee Benefits Research Institute. Given the sizeable dollar amount of rollover transactions, and the frequency with which they occur, taxpayers could wind up with some hefty tax bills if they inadvertently violate the new IRS interpretation of the one-per-12-month IRA rollover rule.

Consider the case of an IRA owner, age 62, who has Traditional IRAs at three different financial organizations, each with a balance of $70,000. The IRA owner wants to consolidate all three IRAs into a new IRA at your credit union. Under current rules, provided that the IRA assets had not been rolled over in the previous 12-month period, the IRA owner could take a distribution from all three IRAs, and then roll over the assets into an IRA at your credit union within 60 days of the date of distribution. But if the distributions occur on or after January 1, 2015, only one of the three distributions will be eligible for rollover, and the IRA owner would need to treat the other two distributions as taxable income. Even in the lower tax brackets, adding $140,000 to taxable income would result in a substantial tax bill.

Credit unions should review the IRA rollover rule changes now and be prepared to answer questions from IRA owners when the change becomes effective. And, since IRA owners frequently roll over IRA assets with no advance notice, you should inform them of the IRA rollover rule change so they can plan ahead, especially if they are considering an IRA-to-IRA rollover in 2015.

Although this is a significant change in the IRA rules, the IRS is not requiring IRA trustees and custodians to amend existing IRA agreements at this time. However, it may be in your best interest—and the best interest of your IRA owners—to amend your existing IRA agreements. The current rules have been in place for so long that many IRA owners may continue to make multiple rollovers, without even realizing they are violating the new one-per-12-month rule. This can result in negative tax consequences for your IRA owners. And if you haven’t advised them of the rule change, negative member relations issues for your credit union.

Dennis Zuehlke

Dennis Zuehlke

Dennis is Compliance Manager for Ascensus. Mr. Zuehlke provides clients with technical support on tax-advantaged accounts (including individual retirement accounts, health savings accounts, simplified employee pension plans, and Coverdell education ... Web: Details

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