The Self Directed IRA Rollover – A Complete How-To Guide
What Does a Self-Directed IRA Rollover Accomplish?
Let’s start with the basics. A Self Directed IRA rollover is the process where funds are transferred from an existing retirement account into a self-directed account. The purpose of the Self Directed IRA rollover is to maintain the tax-advantaged status of the retirement funds. Without the concept of a rollover, then any time funds were taken out of the first account, they would be considered a distribution. Talk about creating paperwork! Luckily the IRS allows for the funds to keep their tax-advantaged status as long as they are rolled over in a timely manner.
Two Types of Self Directed IRA Rollovers: Direct and Indirect
If you are rolling over funds into a Self Directed IRA, that can happen as a direct rollover or an indirect rollover. A direct rollover is when the funds are transferred directly from the existing retirement account into a Self Directed IRA. An indirect rollover works in a two-step process. First the funds are distributed to the account holder. Then the account holder has 60 days to place them in a Self Directed IRA.
Which Type of Rollover is The Better Route for Self-Directed Investing?
Normally when you have two financial options, each has pros and cons. Depending on the details of the situation, either one or the other is more appropriate. That is not the case here. In almost all cases a direct rollover is going to be preferable. The reason for this is that an indirect rollover comes with a long list of additional requirements. We will deal with these requirements in more detail later, but for now here is a quick overview:
- The 60-day Rule – From the time the account holder receives the distribution from the first retirement account, they have 60 days to place it in a Self Directed IRA. Failure to do so will cause the funds to be classified as a distribution with relevant tax consequences.
- Tax Withholding – An indirect rollover has a government-mandated 20% withholding charge. This money is returned to the account holder as a tax credit after they file taxes that year. Before that, though, the funds must be replaced in the retirement account with other available funds. That way the withheld amount will not be counted as a distribution.
- Only One Per Year – An account holder can only make one indirect rollover per year between two different IRA accounts.
With the above points in mind, a direct rollover to a Self Directed IRA is almost always the better option. The few cases where it would make sense to do an indirect rollover include:
- When the fees associated with the direct Self Directed IRA rollover are too high.
- When there is an urgency to fund the new account and the indirect rollover may be quicker.
- When the account holder needs the funds for something else and plans on replacing them within 60 days.
Direct Rollover v. Transfer
When transferring funds directly from a retirement account to a Self Directed IRA, the process can have different names. A transfer refers to moving funds in between two similar accounts. This could be from a Traditional IRA to a Traditional IRA, a Roth IRA to a Roth IRA, or between two qualified plans. A direct rollover refers to funds being moved between two different kinds of accounts, e.g. from a 401(k) to a Self Directed IRA. In either case there are no taxes due, but there are differences in the process.
One of the key differences between a transfer and a direct rollover is whether the event is reportable. A transfer from a standard IRA to a Self Directed IRA will not require any IRS reporting. This is not the case for a direct rollover into a Self Directed IRA. The institution that is sending the funds will have to file IRS Form 1099-R. The account receiving the funds will file IRS Form 5498. Additionally, the account holder will have to properly note the rollover on their tax return.
Another difference between a transfer and a direct rollover is whether or not the process can be used for a Required Minimum Distribution. RMDs may be included in a transfer but they may not be included in a direct rollover.
Self Directed IRA Indirect Rollover: The Once-a-Year Rule
The IRS limits certain IRA rollover actions to once a year. This can have major consequences for an account holder who is looking to combine accounts. Similarly, it can affect somebody counting on the availability of the funds. Since many Self Directed IRA accounts are initially funded via rollover, it is vital to understand this rule.
Simply put, if an account holder possesses multiple IRA accounts, they may only make one rollover between them per year. In other words, it is the account holder who is limited by this rule. Irrelevant of how many IRA accounts they own, they may never make more than one rollover per year.
The consequences of breaking the Once-a-Year Rule can be quite costly. Some of the possible penalties include:
- If an account holder illegally makes an additional rollover, it is counted as a taxable distribution.
- If that account holder is under 59 ½, there can be a 10% early withdrawal penalty.
- Additionally, the rollover will be considered an excess contribution and subject to an annual 6% penalty.
The Once-a-Year Rule applies to indirect rollovers from one IRA to another IRA. However, there are many exceptions. Situations which permit more than one Self Directed IRA rollover per year include:
- Rollovers involving a qualified plan (like a 401(k)) – If the account holder is rolling over from a qualified plan to an IRA, from an IRA to a qualified plan, or between qualified plans, there are no limitations on rollovers.
- Roth conversions – An account holder may convert any number of Traditional IRA accounts into Roth accounts.
- Direct transfers – An account holder may make unlimited trustee-to-trustee transfers.
What Taxes Are Withheld in a Self Directed IRA Indirect Rollover?
If you are doing an indirect rollover, the original custodian is required to withhold taxes. If the indirect rollover is from one IRA to another, then the withholding is 10%. If the indirect rollover is between a qualified retirement plan (e.g. 401(k)) and a Self Directed IRA, the withholding is 20%. This amount will be reflected in the tax records as taxes that were paid by the account holder.
This mandatory withholding is not just a paperwork issue. The Self Directed IRA account holder will actually need to pay back the funds that are being withheld. If they don’t, then the withheld funds will be counted as a distribution and be taxed. This is true even though the account holder never actually received those funds.
In cases where withholding occurs, the funds are not lost. The withheld amount comes back in the form of a tax refund. If the original retirement account is a Roth, then these rules do not apply. This is because distributions from a Roth are not taxable and no withholding is necessary.
Self Directed IRA Indirect Rollover: The 60-Day Rule
The indirect rollover process starts with the Self Directed IRA account holder receiving the funds from the original account. These funds could be a check made out to the account holder or they could be deposited directly in an unrelated account. Either way, the account holder must use this money to fund a retirement account within 60 days. If they are not placed in a new retirement account, they will lose their tax-advantaged status.
The time window for this rollover is tightly defined. The 60-day period begins the day after the account holder receives the distribution. At this point the funds must be placed in the Self Directed IRA by day 60. This is a hard deadline. The funds must be in the account and not just “in the mail.”
Are there exceptions to the 60-Day Rule?
60 days is enough time to rollover funds, but it is certainly not a lot of time. The IRS has to walk a fine line. On the one hand, they have to give people enough time to perform the Self Directed IRA rollover. On the other, they don’t want people to use retirement funds for personal purposes. The more access that an account holder has to their funds, the less likely they will be saved for retirement. 60 days is considered a good compromise. It allows for the needs of the rollover but without the allure of unlimited access.
Even with the rigidity of the 60-day rule, there are still a number of exceptions. Sometimes circumstance beyond the account holder’s control force them to miss the 60-day window. The IRS acknowledges this and allows for account holders to request a Personal Letter Ruling (PLR) for their specific situation. In 2016, the process became easier for account holders when the IRS allowed self-certification.
The IRS allowed administrators, trustees, and custodians to accept late contributions, even past the 60-day window. As long as the following two requirements were met, the funds would continue to have tax-deferred status.
- The account holder had to provide a Model Letter about their situation. This letter contained the amount of the contribution and the specific reason why the 60-day window was missed.
- The trustee or custodian could not have any facts that prove what is stated in the letter as false.
The reasons that the IRS allows for a delayed contribution include:
- Institutional error – The financial institution who was responsible for sending out the check or accepting it did not do so in a timely manner.
- Lost check – The initial distribution check was lost and it required additional time to request another one.
- Wrong account – The distribution check was mistakenly put into the wrong account (i.e. not a retirement account).
- Extreme personal circumstances – These include loss of a family member, illness, and damage to a personal residence.
- Foreign restrictions – The process was slowed down due to unusual foreign restrictions.
- Postal error – The distribution was lost or delivered to the wrong address.
When a Self Directed IRA account holder files a Model Letter, the rollover can continue in a normal manner. Just keep in mind, though, that the IRS will review the letter after the fact. If the letter or the reasons given are found to be false, the IRS can change the status of the funds and consider them a full distribution.
The Same Property Rule
The Same Property Rule is one that is especially relevant for a Self Directed IRA rollover. This rule states that the rollover must consist of the same type of property that was initially distributed. The way to break the rule is to distribute one type of property and then use the account money to fund a different type of property. For example, if an account holder gets a distribution of cash from the first retirement account (as will usually be the case), then they must contribute cash as the final step of the rollover.
Although that sounds like it should always happen, in a Self Directed IRA, the account holder may have a different strategy. They might want to take that cash and buy an investment property with it. They would then contribute the property to the new Self Directed IRA. This would be in violation of the Same Property Rule. Instead, the account holder must first roll over the cash to the Self Directed IRA account. Then they can use it from there to purchase the property. Breaking this rule would turn the distribution into a taxable event.
A Self Directed IRA rollover can be performed fairly easily to open your investing options. A financial professional can help you choose the right kind of rollover (direct, indirect, or transfer) based on the original account and your investing strategy. When performing the Self Directed IRA rollover, just keep in mind the 60-Day Rule and the Same Property Rule to avoid an unwanted distribution.
Do you want to learn more about the process of a Self Directed IRA Rollover? Schedule a call to speak with one of our IRA Specialists.