Slow your roll(over): IRS adopts new rule on IRA indirect rollovers

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Taxes remain one of the certainties in life but a new interpretation by the Internal Revenue Service could have clients – and lawyers – paying even more if they aren’t careful.

For years, taxpayers have had the luxury of conducting multiple indirect rollovers from one individual retirement account to another on an IRA-by-IRA basis. But earlier this year, a U.S. tax court interpreted the tax code to limit the frequency of such transactions to one per 365-day period – despite an IRS publication stating otherwise. Now the IRS has announced its intention to embrace the new interpretation, flipping its own position, beginning Jan. 1, 2015.

“This is the biggest IRA ruling we’ve had in years,” said Ed Slott, a CPA in Rockville Centre, N.Y. “The danger is that people won’t realize what they’ve done until it’s too late and they are facing taxes on their entire life savings. This is a potentially fatal mistake.”

J. Peter Glaws IV of Washington, D.C., agreed. The change itself is straightforward and makes sense based on the language of the statute, he said; the real trap waits for those unaware of the new interpretation and caught off guard by the consequences.

The situation also provides an important reminder for tax attorneys not to place too much faith in IRS publications, which are not considered binding precedent, said Washington, D.C.-based Adam Cohen. Or as the tax court wrote, “Taxpayers rely on IRS guidance at their own peril.”

“The lesson this raises is that even though the IRS had issued a publication on the issue, if lawyers read through the statute and the interpretation feels too good to be true, it may be,” Cohen said. “If you don’t have an actual regulation to rely on, relying on a publication is not the safest route. You do not want to be the test case.”

Pushing the envelope

Section 408(d) of the Internal Revenue Code requires that most distributions from individual retirement accounts are subject to taxation in the year of the distribution. Section 408(d)(3) creates an exception for indirect rollovers, where the account holder receives a check and returns the same amount – essentially giving taxpayers a 60-day window to use the cash as long as the same amount is deposited within the time period in a new account.

But Section 408(d)(3)(B) provides that this exception “does not apply to any amount described in subparagraph (A)(i) received by an individual from an individual retirement account or individual retirement annuity if at any time during the one-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an individual retirement account or an individual retirement annuity which was not includable in his gross income because of the application of this paragraph.”

Previously, the IRS took the view in Publication 590 and proposed regulations that the statutory language would be applied on an IRA-by-IRA basis. So a taxpayer with four IRAs was permitted to roll each into a new IRA over the course of a given 12-month period, for example.

But in January, the U.S. tax court took a stricter view of the statute in Bobrow v. Commissioner. In that case, a tax attorney and his wife made multiple IRA-to-IRA rollovers in a single year. Although he argued his actions were permissible, the tax court disagreed.

“The plain language of Section 408(d)(3)(B) is not specific to any single IRA maintained by an individual but instead applies to all IRAs maintained by a taxpayer,” according to the court’s decision. “Had Congress intended to allow individuals to take nontaxable distributions from multiple IRAs per year, we believe Section 408(d)(3)(B) would have been worded differently.”

Rejecting its prior Publication, the IRS jumped on the Tax Court’s bandwagon, issuing Announcement 2014-15 that it intends to follow the court’s interpretation, regardless of the outcome in the Bobrow case. Bobrow filed a motion for reconsideration, which the court already has rejected.

Publication 590 will be revised to reflect the change, the agency said in its announcement. However, recognizing the administrative challenges facing IRA trustees to accommodate the changes, the IRS said it will not apply the new interpretation to distributions that occur before Jan. 1, 2015.

Why the about-face? Some attorneys speculated that it was a case of one person spoiling the party for the rest of the group, with Bobrow and his wife pushing the envelope too far for the court to let it go unchecked.

The provision was intended to help individuals who need to switch their IRA plans, Slott explained, perhaps because they changed jobs, hired a new financial advisor or need to divide an account because of a divorce. It was certainly not meant to allow people a short-term, 60-day loan of their own retirement account, he added, which some taxpayers were apparently doing.

Traps and danger signs

While the IRS’ interpretation is clear going forward, there are several traps for the unwary, practitioners cautioned, and the change itself remains under the radar and unknown to many attorneys.

A trusts and estates lawyer may advise a client to divide an existing IRA into separate IRAs for her three children for financial planning reasons. While the first rollover would be fine, the client would face taxes on the next two. IRAs are big bargaining chips in divorces these days, Slott noted, and a spouse attempting to split his IRA with his soon-to-be-ex-wife could end up paying the tax on the money if changed his own account at the same time or made a rollover within the prior 12 months.

And although one rollover is allowed per year, the time period is measured from the date of the first rollover – not a standard calendar year. Anyone advising or considering such a transfer “needs to know where that money has been and what it has done for the last 365 days,” Slott said. “There are a lot of traps and danger signs.”

Don’t take the IRS enforcement delay as a signal to make multiple rollovers before Jan. 1, Glaws said, which could trigger the agency’s attention. “Conform your advice to the new interpretation even though it’s not official for another six months,” he suggested. “It’s safer that way.”

Cohen noted that even with the seemingly straightforward rule, some questions remain. “It’s not clear if this rule impacts a situation where a taxpayer aggregates traditional IRAs with different types and flavors of IRAs like Roth, Simple and SEP IRAs,” he explained. The agency will likely issue guidance on such issues, but it may not be out by the end of the year before the new interpretation takes effect, Cohen said.

Given the uncertainties and potential pitfalls, Slott advised taxpayers to stick to direct transfers as a safer alternative. “The bottom line: do trustee-to-trustee transfers,” he said. “You can do it as often as possible and it’s always tax-free.”

For those that do elect to use the indirect rollover route, just be aware of the limitations and the consequences. “This issue is still under the radar,” Slott noted. “The impact is still to come as more people get burned by it but planning can be done to prevent the damage.”