If you’re moving an IRA from one financial firm to another you have two choices. One is a rollover, which involves taking a distribution from the existing account and, within 60 days, depositing it in the new account. The other is a direct transfer, sometimes called a trustee-to-trustee transfer, where the money goes from the old firm to the new one, untouched by human hands. Other things being equal, this is the preferable choice.
It may seem as if you gain greater control, and therefore the ability to prevent possible errors, if you choose the rollover alternative. The direct transfer is handled invisibly by clerical staff at the two investment firms, leaving you without the opportunity monitor the situation. In reality, though, mistakes rarely happen in direct transfers, and when they do, the mistakes are easily corrected. Nearly all the problems occur when people choose to do a rollover, and correcting those problems can be expensive or in some cases impossible.
What can go wrong? One issue is unwanted withholding. You’re permitted but not required to have tax withheld when you withdraw money from an IRA. There’s no reason to do this in connection with a rollover, but some people make a mistake in filling out the withdrawal form. You’re trying to roll over $20,000 but you get a check for $18,000, and the rest goes to the IRS. The only way to complete the rollover for the full amount is to come up with $2,000 from some other source within the 60 days. You’ll get credit for the $2,000 withholding when you file your tax return for that year, but meanwhile the IRS is sitting on your money.
Then there’s the rule restricting you to one rollover per year. If you’ve done a rollover within the preceding 12 months and you do a new one, you’ve violated this rule and you have a bad rollover. Furthermore, you have to be careful not to do a rollover again within 12 months after this one. (Exceptions apply if the previous rollover involved different IRAs.)
By far the most frequent problem, though, is failure to complete the rollover within the 60-day window. Sixty days may seem more than adequate for the completion of this task, but an astonishing number of people miss this deadline. Illness, accidents, natural disasters, misdirected mail, simple forgetfulness — all these and more can stand in the way of successful completion of a rollover. (Just think of all the people currently stunned into inactivity by their inability to comprehend the final episode of Lost.) In appropriate cases the IRS grants relief from the costly tax consequences, but you need to find an excuse they’ll accept and go through a costly process to obtain a private letter ruling.
A rollover might save you a little money. Some financial firms charge a fee for making an outbound direct transfer, but no fee (or a smaller one) for making a cash distribution. In most cases, though, the advantages of a direct transfer, including reduced paperwork and elimination of all these potential problems, outweigh any added cost associated with that choice.