Rollover Rule Change Will Cause Trouble

Rollover Rule Change Will Cause Trouble

Following the Bobrow Case, the risk of using IRA-to-IRA rollovers (versus direct transfers) is even greater than before.

Natalie Choate, 05/09/2014

A change in the IRA rollover rules starting in 2015 will cause trouble for clients, planners, and plan administrators. Beginning with distributions in 2015, the IRS will enforce the one IRA-to-IRA-rollover-per-12-months rule without regard to whether the distributions came from the same or different accounts. Publication 590 will be amended to reflect this change.

Normally, a retirement plan distribution can be "rolled over" into the same or another retirement plan within 60 days. The effect of the "rollover" is to "erase" the distribution so it is not taxable. There are exceptions to this tax-free treatment, of course--not every distribution can be rolled over. One of the exceptions applies to IRA-to-IRA rollovers: The Code says an IRA distribution cannot be rolled over tax-free to an IRA if any other IRA distribution received within the preceding 12 months was rolled over tax-free to an IRA. In other words if you do an IRA-to-IRA rollover, you cannot roll over, to any IRA, another IRA distribution received within 12 months after the first distribution. Presumably the purpose of this rule is to prevent someone from keeping his IRA money continuously outside of the IRA using a series of tax-free rollovers.

The IRS has always interpreted this provision a little more leniently than the literal words of the Code. The IRS has said (in IRS Publication 590 and in a proposed regulation) that you CAN roll over, to an IRA, a second IRA distribution within 12 months PROVIDED that the subsequent distribution came from an account that was not involved in the first rollover. In other words, if you got a distribution from IRA #1 and rolled it over tax-free to IRA #2, and then you received a distribution from IRA #3, you could roll over the distribution from IRA #3 to an IRA even if you received it less than 12 months after the distribution from IRA #1.

But in a recent case, the IRS went after an IRA owner who tried to take advantage of this account-by-account rule. And both the IRS and the taxpayer lost!

Mr. Bobrow was a tax attorney who represented himself in this Tax Court case. He had two IRAs at Fidelity, IRA #1 and IRA #2. His wife had one IRA there (IRA #3). They also had two taxable accounts there: husband's individual account and a joint account.

On April 14, 2008, Mr. Bobrow withdrew $65,064 from IRA #1. The opinion doesn't say what happened to this money, but the implication is he spent it. On June 6, 2008, he withdrew $65,064 from IRA #2. On June 10, 2008 he transferred $65,064 from his individual (taxable) account to IRA #1, thereby (he believed) completing a tax-free rollover of the April 14, 2008, distribution from IRA #1. On July 31, 2008, Mrs. Bobrow took $65,064 out of her IRA (#3). On Aug. 4, 2008, the couple transferred $65,064 from their joint account to husband's IRA #2, thereby (they believed) effectively completing a tax-free rollover of the June 6, 2008 distribution.

There was dispute about whether and when the third distribution (the distribution to wife from her IRA #3) was "rolled back" into wife's IRA. That seems to have been a factual dispute about amounts and dates, not of interest to the rest of the world.

The main bone of contention, of wider interest, concerned husband's two purported rollovers. The IRS contended that the June 10, 2008, deposit of $65,064 to one of husband's IRAs was an effective rollover of his second IRA distribution June 6, 2008), and that the IRA contribution of Aug. 4, 2008 was an ineffective late rollover of the first IRA distribution on April 14, 2008). In other words the IRS tried to re-assign what deposit matched which distribution.

I am not aware of any other situation in which the IRS has tried to "overrule" the taxpayer's decision as to which distribution is being rolled over. But as it happens, the Court ignored this IRS argument; the Court accepted Mr. Bobrow's decision regarding which distribution he was rolling over when.

Instead, the Court decided the case against Mr. Bobrow based on the "plain language" of the Code (backed up by legislative history, said the Court) to the effect that, regardless of how many IRAs a person has, and regardless of whether distributions come from the same account or different accounts, an individual cannot roll over, to an IRA, more than one distribution received within a 12-month period. Because of that rule, Mr. Bobrow's purported rollover (on Aug. 4, 2008) of the second distribution (June 6, 2008) was no good. Therefore the second IRA distribution was fully includible in his gross income. Oh, and it was also subject to the 10% penalty because he was under age 59 1/2. And a 20% accuracy penalty was also imposed because the couple could produce no "substantial authority" supporting their position that the once-per-12-months limit applied on an account-by-account basis. An IRS Publication is not substantial authority!

So the IRS went to court and, in a way, lost twice. Though the IRS technically won the case and Mr. Bobrow lost (because his second purported rollover was invalidated), the Court rejected the IRS' re-assignment of the deposits attempt AND threw out the IRS' account-by-account rule.

The IRS has announced that it will follow this decision, revise Publication 590, and withdraw its proposed regulation. But since this is a big change for IRA owners, IRA providers, and advisors, the IRS will not enforce the new rule for distributions prior to 2015. Amazingly, after the case ended, the IRS even let Mr. Bobrow use the account-by-account rule for his pre-2015 rollovers; since the Court did not adopt the IRS' theory of reassigning which rollover was matched with which distribution, the IRS conceded that Mr. Bobrow's rollovers were "legal" under the IRS' own Publication 590 rule! Is there any other instance where the IRS won a case against a taxpayer then conceded to the taxpayer and gave him his money back in the end anyway?

The once-per-year rule is a trap for the unwary. For one thing, it's not always clear what a "distribution" is--if you request a cashout of your IRA and the IRA provider sends you two separate checks a month apart, is that one distribution or two? Also, consider "Granny" who has her IRA in six-month CDs. Most banks treat each CD as a separate new IRA, which they then close and distribute when the CD matures. If Granny has multiple CDs in IRAs that close out within 12 months of each other, she won't be able to roll over any but the first one.

The way to avoid getting into trouble with this rule is to always use direct IRA-to-IRA transfers instead of "60-day rollovers." There is no numerical limit on IRA-to-IRA transfers. Direct transfers have always been safer than 60-day rollovers, and now the risks of using rollovers are even greater than before.