In financial services, “rollover” can refer to the reinvestment of funds from a maturing security into a new one, or the transfer of assets from a qualified retirement account to another without the occurrence of a taxable event.
For the purposes of retirement planning, “rollover” usually refers to the transfer of assets from a retirement account to another one, so that will be the focus of this
article.
There are several different possible rollover scenarios, but the most popular one is the rollover from a 401(k) account to another 401(k) or IRA. This is because a person’s 401(k) is tied to their employer, so when employment ends, many people wish to take their assets from that employer’s plan and either consolidate them with other existing accounts or add them to the account they have with their new employer.
How a Rollover Works
Rollovers are allowed to accommodate investors who want to move their retirement planning accounts from one custodian to another. Common rollover scenarios are individual retirement accounts (IRAs) that are rolled over to other IRAs, and 401(k)’s that are rolled over into IRAs.
The tax treatment of the account that is being rolled over and the new account must the same. A person couldn’t roll a Roth IRA into a traditional IRA, nor could they roll a non-qualified annuity into an IRA, for example.
Types of Rollovers
There are two types of rollovers: direct (sometimes called a trustee-to-trustee transfer) and indirect.
In a direct rollover, the custodian of one account sends a check (or more commonly today, a wire transfer) to the custodian of the account being transferred to. There are usually no tax consequences in a direct rollover.
An indirect rollover is a little more complicated, and it involves the possibility of taxes being due if the rules are not followed. In an indirect rollover, the custodian of the existing account sends a check for the account value to the account owner. The account owner then takes the funds and deposits them into the new account.
The account owner has only 60 days from the date the funds from the old account are dispersed to re-invest them with another qualified account. Failure to do so will result in income tax being due on the amount not invested. If the investor is under age 59½, a 10% penalty tax will apply in addition to income tax.
1035 Exchanges
As stated earlier, rollovers can only be made with qualified retirement planning accounts. For insurance products that are non-qualified (funded with money that has already been taxed), however, Section 1035 of the Internal Revenue Code allows for a similar transfer of funds. This is commonly referred to as a 1035 Exchange.
1035 exchanges may be made from a non-qualified annuity to another non-qualified annuity. They may also be made from a non-qualified annuity to a life insurance policy.
1035 exchanges must be made directly; there is no such thing as an indirect 1035 exchange. Once a life insurance policy or non-qualified annuity has been surrendered, there is no re-investing the proceeds without a taxable event.
