Rolling over funds to an IRA helps consolidate your retirement assets, widen your investment options and even reduce your fees. However, taking a distribution from another retirement account to roll into an IRA can have negative tax consequences if you don't follow the rollover rules.
Taxes Deferred Until Distribution
When you successfully complete a rollover, you won't have to pay any taxes on the distribution until you permanently withdraw the money at a later date. However, the IRS allows just 60 days from the time you take the distribution from the other retirement account to get the money into the IRA. If you don't finish the rollover in time, the distribution is permanent and you'll owe taxes in the year that you took the money out.
Even if you pinky-promise to complete the rollover, you still have 20 percent of the distribution withheld for federal income taxes. For example, if take out $30,000 to roll over, you're only going to receive a check for $24,000. However, you're still responsible for putting $30,000 into the IRA to complete the rollover. As long as you do so, you won't owe any taxes until you take distributions and you'll get the amount withheld back when you file your tax return.
If you only complete part of the rollover, you'll pay taxes on the portion not rolled over in the year of the distribution and taxes on the remainder when you take distributions. For example, assume you take a $30,000 distribution and have $6,000 withheld. If you only deposit $24,000, the $6,000 not deposited is taxable that year, but the $24,000 is tax-free until you take a distribution from the rollover IRA.
In addition to income taxes, if you're under 59 1/2 when you do a partial rollover, the portion you withdraw is also hit with the 10 percent penalty unless you qualify for an early withdrawal exception. Unfortunately, having money withheld during the rollover isn't an exception. Examples of exceptions include medical expenses exceeding 7.5 percent (10 percent in 2013), post-secondary educational expenses and up to $10,000 to buy a first home. You also avoid the penalty if you suffer a permanent disability.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."