When transferring retirement accounts, the question of which is best: direct or indirect is a common one.
The IRS lays out the rules on how to accomplish both options. Violating those rules will cost you money in taxes, penalties, and loss of growth of these assets.
I write and answer investor questions for Investopedia because they try to keep things simple.
Here is a modified version of the article to help answer the question, which is best – direct vs. indirect rollovers?
The indirect rollover is the 60-day rollover.
In this transaction, the existing custodian sends the distribution from your retirement account directly to you. You then have 60 days to deposit the money into another qualified retirement account (IRA, 401(k), etc.).
If the proceeds are from a former employer’s plan, there is a mandatory 20% withholding for taxes.
Here is how Investopedia defines an indirect rollover.
You must complete the rollover by the end of the 60-days. It’s not good enough to have sent the check before the end of the period.
The rollover is considered complete when the new custodian deposits your funds into the new account. When you miss the deadline, the entire account value will be subject to taxes.
For those under age 59 ½, the 10% early withdrawal penalty would apply.
When transferring funds from a traditional or Roth IRA, there is a limit of one IRA rollover per twelve-month period.
That twelve-months is not based on a calendar year. It is a 365-day period that starts the day of your first distribution.
For this rule, traditional and Roth IRAs are combined. A rollover from either account type counts as the one rollover per year.
Here's an example
John takes a distribution from an IRA and decides to roll it over in November 2017. He completes the rollover by December 2017.
If John has another IRA, he can roll it over any time in 2018 and not violate the once a year rule.
However, John cannot roll over any other distributions in 2018 from the account he rolled over in 2017 or the one where he transferred the money. He would have to wait 365 days from the date he deposited the funds into the new IRA.
The indirect rollover is inefficient and complicated. There are severe penalties for noncompliance.
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The direct rollover
The direct rollover is a trustee to trustee transfer. It does not have the complications and limitations of the 60-day rollover.
In a trustee to trustee transfer, the funds from the existing retirement account go directly to the new custodian.
When the transfer is from one employer plan to a new employer plan, the funds go directly to the trustees/custodians of the new employer plan.
If a rollover to an IRA, money is sent directly to the IRA custodian. If sent via check, the check is made payable to XYZ Company, custodian for the IRA of John Q. Public.
In this way, the money would not go to the IRA or retirement account holder. As such, the 60-day rule does not apply.
No mandatory tax withholding
If the funds are from a company retirement plan, there is no mandatory 20% tax withholding since the money does not go directly to the account holder.
There is no once a year limit applied to direct rollovers. You can make as many direct transfers as you want within a twelve-month period.
The direct rollover rule applies to rollovers from employer plans to IRAs, from IRAs to plan rollovers, and to Roth IRA conversions.
Even though a Roth conversion is considered a rollover, and even if considered a 60-day indirect rollover, it does not count for the once per year rule.
That rule applies only to like-to-like accounts (IRA to IRA, Roth to Roth, etc.). Since a Roth IRA is not like a traditional IRA, the rule does not apply.
In most cases, the direct rollover is the best option. There is no once per year limit, there is no tax withholding, it is less work, and much more efficient.
As always, you should consider your personal situation when making this important decision.
To see what the IRS says about rollovers go to their page, Rollovers of Retirement Plan and IRA Distributions.
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