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The “one rollover per year” rule for IRAs

Posted Monday, February 17, 2014 by John S. Palmer

Taxpayers may make only one tax-free IRA rollover per year, no matter how many IRAs he or she has, according to a January 28th decision by the U.S. Tax Court.

Section 408(d) of the Internal Revenue Code generally provides that distributions from an individual retirement plan are subject to income tax. However, no tax will be due on the amount reinvested in a qualified retirement plan within 60 days.

To prevent taxpayers from abusing this rollover privilege, Congress included a provision in Section 408(d) stating that tax will be due on any amount received by an individual from an IRA or individual retirement annuity if within one year of that distribution the individual received any other distribution from an individual retirement account or an individual retirement annuity that was treated as a tax-free rollover.

In the early 1990’s, the Tax Court issued a pair of decisions, both entitled Martin v. Commissioner, involving the same involving a taxpayer who withdrew funds from one IRA and rolled them over into a second IRA. Within one year of that rollover, the taxpayer made two withdrawals from the second IRA and re-deposited the funds within 60 days. The Tax Court held that these latter withdrawals did not qualify as tax-free rollovers.

In the decision handed down last month (Bobrow v. Commissioner, decided 1/28/2014), a husband (who also happened to be an attorney specializing in tax law) and his wife received distributions from 3 IRAs (two in his name, one in hers) over a 6 month period. Each distribution was for $65,064, and this amount was re-deposited into each IRA about two months after each distribution. The withdrawals and repayments overlapped each other; for example, the husband received $65,064 from his second IRA just before re-depositing that amount back into his first IRA.

The couple asserted that the “one rollover per year” provision of Section 408(d) means one rollover per IRA per year, and that therefore no tax was owed on any of these IRA distributions. They also argued the Martin decisions did not apply, because they involved a taxpayer who received multiple distributions from a single IRA, whereas the husband took a single distribution from his two IRAs. In the court’s words, the couple argued that 408(d) permits a taxpayer to make a tax-free rollover “yearly with regard to each IRA he or she maintains” and “prohibits taxpayers only from taking multiple [tax free] distributions from the same IRA within one year.”

The Tax Court disagreed, and said that the plain language of Section 408(d) “limits the frequency with which a taxpayer may elect to make a nontaxable rollover contribution. By its terms, the one-year limitation…is not specific to any single IRA maintained by an individual but instead applies to all IRAs maintained by a taxpayer.” The court noted that the limitation on tax-free rollovers was adopted to prevent taxpayers from “repeatedly shifting nontaxable income in and out of retirement accounts” and concluded that Congress would have worded the statute differently had it “intended to allow individuals to take nontaxable distributions from multiple IRAs per year.” Therefore, “[r]egardless of how many IRAs he or she maintains, a taxpayer may make only one nontaxable rollover contribution within each one-year period.”

The court found that the husband’s second rollover was taxable; the fact that he received the distribution from the second IRA before the first rollover was complete was immaterial. The wife’s rollover was also taxable, because she failed to complete it within 60 days (the funds were re-deposited on day 61) and she did not produce evidence demonstrating that the delay was due to an error by the financial institution.

To add insult to injury, the couple was hit with an additional 20% accuracy-related penalty for substantially understating the tax due on their income tax return. The court declined to waive this penalty because the couple did not demonstrate to the court’s satisfaction that they had acted “with reasonable cause and good faith.” Although the husband claimed the transactions were done based on his analysis of Section 408(d), the court said his “expertise as an attorney specializing in tax law” should actually have put him on notice that the plain language of Section 408(d) prohibited more than one tax-free rollover per year, regardless of how many IRAs the taxpayer owns.

Taxpayers who simply want to transfer funds between IRAs, perhaps for consolidation purposes, or use funds in one or more IRAs to create a new IRA (such as a special type of IRA annuity used for Medicaid eligibility purposes, commonly referred to in elder law circles as a “single premium immediate annuity”) should consider a direct transfer of assets between IRA custodians, if possible; such custodian-to-custodian transfers are not subject to Section 408(d)’s limitation on tax-free rollovers, because the funds never come under the direct control of the individual account holder.

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