The Consequences of Breaking Rollover Rules

This week’s Slott Report Mailbag looks into IRA rollovers, IRA transfers, and back-door Roth IRAs. As always, we recommend you work with a competent, educated financial advisor to keep your retirement nest egg safe and secure. You can find one in your area here.

Question:

I made the mistake of moving more than one IRA account as a roll over and not a direct transfer as I was unaware of the rule change. How do you handle this? How do I limit my expenses?

Thanks, Chuck

Answer:

You are not alone! We have been getting many questions from IRA owners who are concerned about running afoul of the now stricter once-per-year rollover rule. First, you will want to investigate whether you really have a problem. The once-per-year rollover rule limits you to one IRA rollover in a 365-day period. If you have multiple IRAs and Roth IRAs, you are still limited to one rollover. However, the rule does not apply to direct IRA transfers, rollovers between IRAs and employer plans, and conversions.

If you did violate the once-per-year rollover rule, unfortunately this is a mistake with no easy fix. You cannot go to the IRS for relief for this problem. The distribution that was improperly rolled over would considered taxable for the year it occurred and may be subject to the 10% early distribution penalty, depending on your age and whether an exception applies. The funds are considered an excess contribution in the receiving IRA and should be withdrawn to avoid the possibility of the 6% penalty applying and further negative tax consequences.

Sounds a little complicated? Your best bet is to consult with a knowledgeable tax or financial advisor to guide you through the process.

Question:

I am planning to do a back-door Roth IRA this year. My intent is to make a nondeductible contribution to an IRA and then convert those moneys. I have no existing IRAs. However, I do have a large SIMPLE IRA from a previous job. Will my SIMPLE IRA affect the taxation of my conversion?

Thank you! Sal

Answer:

The back-door Roth IRA conversion can be a good strategy to fund a Roth IRA for those who have incomes that are too high to make tax-year Roth IRA contributions. However, there are some limitations to this strategy and it sounds like you might be encountering one of them.

When you convert an IRA to a Roth IRA, a pro-rata formula applies that takes all of your IRA funds into account to determine the tax consequences of your conversion. This formula does include SIMPLE IRAs. Therefore, your conversion will be partly taxable due to your SIMPLE IRA.