Hey IRS, you want a fight? Bring it on!

A recent IRS decision limits individuals to one IRA rollover a year in hopes of avoiding exploitation of a loophole allowing the use of retirement accounts as short-term, tax-free loans

The strategy was simple. Withdraw money from an IRA and use it to cover short-term cash needs. As long as the money was put back into the IRA within 60 days it was a tax-free transaction.

Why the change? To be blunt…abuse. IRA owners would set up multiple accounts. Withdrawals would come from one – replacement within the 60 day window would go to another. It was a vicious cycle ensuring “illiquid” and “locked away” cash was always at the ready.

Will the new 1x/yr rule curb such abuse? Unlikely. Here’s why:

Publication 590a – the very document outlawing more than one rollover per year – specifically states the rule won’t apply to Roth conversions.

Fantastic. The door has been opened to another loophole to exploit.

The downside is an extra step in the process and a bit of complexity. The upside is preservation of the short-term, tax-free loan strategy.

Consider a homeowner in between homes. Closing on the new home occurs prior to sale of the existing home. Sale proceeds are therefore unavailable for application against the new home. A liquidity crisis exists.

The homeowner would take an IRA withdrawal as per the original strategy. That cash is available to solve the liquidity crunch.

When the original home is sold rather than using the proceeds to replenish the IRA within 60 days the client would establish a Roth IRA using the home sale proceeds to fund it. Sound familiar? It should. It’s a Roth conversion.

The final step – the crucial one that removes taxes from the equation – is to recharacterize the IRA. This would need to be done on or before the due date of the income tax return for the year of the conversion. In effect the undoing of the conversion transfers the Roth balance back to a traditional IRA.

Obviously a homeowner isn’t changing residences multiple times per year so this strategy seems barely applicable. What about a business owner? Sound like a great way to meet payroll? Absolutely.

Given an IRA is a retirement tool this strategy shouldn’t be relied upon as an ongoing source of funds. Instead it should be used to cover the unexpected cash crunch.