Tax Consequences of Ineligible Rollovers to an IRA

Extra taxes and penalties apply to ineligible rollover contributions to an IRA.
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Rolling money into an individual retirement arrangement helps you consolidate your existing retirement accounts and use a wider range of investments. However, making an ineligible rollover can cost you in more ways than one. Ineligible rollovers include if you complete the rollover more than 60 days after taking the distribution, or if you took a hardship distribution that is never eligible to be rolled over.

Taxes on Distribution

An ineligible rollover has the same tax impact on the withdrawal as if you didn’t roll over the money in the first place: Your distribution counts as a permanent distribution. As a result, you’re liable for any taxes owed on the distribution. For example, if you took a hardship distribution from your 401(k) plan and tried to roll it into your IRA, the hardship distribution would count as taxable income when you filed your tax return for the year.

Early Withdrawal Penalties

If you’re under 59 1/2 when you took the money out, you’ll also owe the 10 percent additional tax penalty on early withdrawals on the taxable portion of the withdrawal. For example, if your $10,000 withdrawal is fully taxable, you have to pay a $1,000 tax penalty on top of any income taxes that you owe on the distribution. An ineligible rollover is not an exemption to the penalty, but you may qualify for another exemption, depending on your circumstances.

Excess Contribution Penalties

If you make an ineligible rollover, you have to treat the contribution to the IRA as part of your annual contribution, subject to your annual contribution limits. For example, if your annual contribution limit is $6,000 and you contribute $10,000 of an ineligible rollover, you've made an excess contribution of $4,000. The IRS penalizes excess contributions with a 6 percent penalty per year that the excess goes uncorrected. For example, if the year after you made the ineligible rollover you didn't have any compensation and therefore couldn't contribute, the $4,000 would still be an excess contribution and you'd pay the 6 percent penalty again.

Correcting Excess Contributions

You can avoid the excess contributions penalty on your ineligible rollover to an IRA if you act quickly enough. As long as you remove the excess contribution, plus any accumulation, before your tax filing deadline, you won't owe the excess contribution penalty. If the contribution lost money, you only have to remove what's left. For example, if you contributed an extra $5,000 and when you remove it the value decreased to $4,800, you only have to withdraw $4,800. Unfortunately, this won't undo the taxes and potential early withdrawal penalties on the original distribution.

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