Unfortunately, many Thrift Savings Plan (TSP) participants and federal employees who have traditional IRAs frequently do not perform proper rollovers of their accounts.
When ineligible rollovers occur, two bad things may happen.
First, the funds withdrawn to perform a rollover are usually taxable and possibly subject to the IRS 10 percent early distribution penalty.
Second, the funds rolled over are considered “excess” contributions and possibly subject to the IRS 6 percent excess contribution penalty. Besides the 6 percent excess contribution and 10 early withdrawal IRS penalties that may have to be paid, regular federal and state income taxes will have to be paid.
The following are the 10 most significant TSP and IRA rollover violations and errors that employees and annuitants should avoid:
1. Violations of the once-per-year IRA rollover rule
Under the IRS basic rollover rule, an IRA owner does not have to include in income any IRA proceeds distributed to the IRA owner provided the owner deposits the IRA proceeds into another IRA or into a qualified retirement plan (such as the TSP) within 60 days of receiving the IRA proceeds. Under a Tax Court ruling and new IRS regulations that took effect on Jan. 1, 2015, individuals are permitted to perform one IRA rollover every 12 months. If more than one rollover is performed within a 12 month period, then the amounts rolled over in the second or more rollovers performed during the 12 month period must be included in income. The IRA owner may also be subject to a 10 percent early withdrawal penalty with respect to the amounts included in income due to the disallowed rollovers if the IRA owner is younger than age 59.5. Note 12 months means any 12 month period (365 days) and not necessarily the calendar year. Direct (“trustee-to-trustee”) transfers have no limitations regarding the number of direct transfers performed in any 12 month period. Finally, the once-per-year rollover rule does not apply to rollovers of TSP funds to IRAs. This includes rollovers of traditional TSP to traditional IRAs and Roth TSP to Roth IRAs. Note that under the new TSP withdrawal rules taking effect on Sep. 15, 2019, a TSP participant who has retired from federal service may perform an unlimited number of rollovers to IRAs.
2. Missing the 60 day rollover deadline
Without a waiver or extension of the 60 day rollover period, amounts not rolled over within the 60 day period do not qualify for tax-free rollover treatment. Instead, the amounts not rolled over must be treated as a taxable distribution from the IRA or qualified retirement plan such as the TSP. These amounts are taxable in the year distributed, even if the 60 day period expires in the next calendar year. There may be a 10 percent early withdrawal penalty if the IRA owner is younger than age 59.5. The following example illustrates:
Jack received a distribution from his deductible traditional IRA on November 25, 2018. Jack does not rollover his deductible traditional IRA proceeds to another traditional within the 60 day period ending January 24, 2019. The IRA distribution is therefore fully taxable to Jack for tax year 2018 (not 2019) even though the 60 day period did not expire until calendar year 2019.
3. Rolling over distributions from inherited IRAs to a non-spouse beneficiary’s own IRA
A non-spouse beneficiary cannot treat an inherited IRA as his or her own IRA. This means that a non-spouse beneficiary can never request a rollover of inherited IRA or qualified retirement plan assets into their own IRA. The inherited funds must be moved to what is called an “inherited” IRA (also known as a “death” IRA) as direct transfers. Also, a non-spouse beneficiary cannot make any contributions to the inherited IRA or rollover any distributions into the inherited IRA.
4. Rolling over required minimum distributions (RMDs)
For individuals age 70.5 and older and who own traditional IRAs, two important rules must be kept in mind. First required minimum distributions (RMDs) must be taken each year from their traditional IRAs – even if the individuals are still working – starting the year the IRA owner becomes age 70.5. Second, if the IRA owner has retired from federal service, he or she must take RMDs from the TSP or any other qualified retirement plan the individual may have participated in the past. But here is the second rule that TSP participants, other qualified retirement plan and traditional IRA owners must keep in mind: RMDs can never be rolled over.
A common error happens when a traditional IRA owner over age 70.5 converts his or her traditional IRA to a Roth IRA. Included in the converted traditional IRA is the year’s traditional IRA RMD. When this happens, the RMD converted to a Roth IRA is considered an excess contribution to the converted Roth IRA and subject to the IRS 6 percent excess contribution penalty. But once the annual RMD from the traditional IRA is satisfied, then any traditional IRA balance remaining is available to be converted to a Roth IRA.
5. Rolling over after-taxed traditional IRA funds to the TSP
After-taxed traditional IRA funds should not be rolled into the traditional TSP via TSP Form TSP-60. Only pre-taxed traditional IRA funds should be transferred into the traditional TSP. Before-taxed traditional IRA funds consist of deductible IRA contributions and accrued earnings. After-taxed traditional IRA funds consist of contributions that were not deducted on one’s tax return. The after-taxed contributions were therefore considered the traditional IRA’s “cost basis”, as shown using IRS Form 8606 to report any nondeductible contribution made to the traditional IRA in any year. Also, Roth IRA funds are not permitted to be rolled over into the Roth TSP.
6. Rolling over traditional TSP hardship withdrawals to a traditional IRA
The TSP allows participants with TSP accounts to take hardship withdrawals if they are approved. But note the following with respect to TSP hardship withdrawals: (1) A TSP hardship withdrawal must be applied for and approved by the TSP Service Office for a limited number of reasons; (2) TSP hardship withdrawals are not loans and are therefore not paid back. In fact, a participant who is younger than age 59.5 will pay federal and state income tax on the amount withdrawn and a 10 percent IRS early withdrawal penalty; and (3) TSP hardship withdrawals cannot be rolled over to a traditional IRA.
7. Deemed distributions from a defaulted TSP loan not paid off or rolled over to a traditional IRA within 90 days
In general, a defaulted (unpaid) TSP loan is considered a “deemed distribution” and the TSP will report the outstanding loan to the TSP participant on Form 1099-R with a Code L in Box 7 in the year of default. A deemed distribution is taxable income and may be subject to a 10 percent early withdrawal penalty. An employee who retires from federal service with an outstanding TSP loan has 90 days to pay off the loan in order to avoid taxation, or within 90 days rollover the outstanding loan amount to a traditional IRA.
8. Rolling over 72(t) distributions into a traditional IRA
72(t) distributions are a series of early (pre age 59.5) withdrawals that are set up to avoid the IRS’ pre-age 59.5 10 percent early withdrawal penalty. But to qualify for the penalty exception, the IRA withdrawals must consist of a series of substantially equal periodic payments. The IRA owner must be committed to a plan of withdrawals according to the rules set out in Internal Revenue Code Section 72(t)(2)(A). The IRA owner can begin a 72(t) payment schedule from an IRA at any age, even if the owner is still working.
There are several rules associated with 72(t) payment schedules, the two most important of which are:
(1) The payments must continue for at least five years or age 59.5, whichever period is longer; and
(2) the IRA distributions cannot be rolled over into another IRA. If either of these rules is violated, then federal and state income taxes must be paid (and the 10 percent early withdrawal penalty will apply to all distributions taken prior to age 59.5) on all prior distributions. This is known as the “recapture” penalty. The “recapture” penalty will also be triggered if IRA funds from one IRA are rolled over to another IRA that is subject to an active 72(t) payment schedule. In other words, IRA funds cannot be rolled into, nor rolled out of, an IRA that has an active 72(t) payment schedule.
9. Same type of investment asset must be rolled back into an IRA that was rolled out of another IRA
If an individual withdraws cash from an IRA for the purpose of a rollover, then only cash can be rolled over into another IRA. If an individual rolls over stock from an IRA, then only that stock can be rolled over into another IRA. For traditional IRA to traditional IRA or Roth IRA to Roth IRA 60 day rollovers, the same property received is the property that must be rolled over. For example, an IRA owner could not receive a distribution of cash and then rollover shares of stock that he or she purchased with that cash. An IRA owner cannot receive a distribution of XYZ company stock and rollover an equivalent value in shares of ABC company stock.
10. Withdrawing IRA funds in case of a divorce settlement rather than a direct transfer
When traditional IRA funds are withdrawn as part of a divorce settlement, those funds are taxable and cannot be rolled over to the ex-spouse’s traditional IRA. If the IRA funds are withdrawn, then the spouse who owns them and who intends to put these funds in the soon-to-be ex-spouse’s traditional IRA will pay federal and state income taxes on the amount withdrawn. If the spouse is younger than age 59.5, a 10 percent early withdrawal penalty will be added.
In summary, federal employees and annuitants and their financial advisors should hopefully better understand the rules regarding which retirement funds can and cannot be rolled over, important deadlines for rollovers, and when a direct or “trustee to trustee” transfer must be performed rather than a rollover or a withdrawal. By fully understanding these rules, employees and annuitants will be able to help preserve their traditional IRAs, Roth IRAs, TSP, and other qualified retirement accounts and not have to pay any unnecessary taxes and IRS penalties.