7 IRA Distribution Mistakes to Avoid

Most people know the rules about contributing money to IRAs and 401(k)s, but relatively few know important rules about taking distributions.The result is expensive mistakes, resulting in unnecessary taxes and penalties. This month, I review seven retirement account distribution mistakes that frequently are made and reduce the after-tax value of the accounts.

Early distribution blunders.

Congress created the tax benefits of IRAs and 401(k)s to encourage people to save for retirement. It also created a penalty for distributing money from an IRA too early. In most cases, a distribution before age 59½ is too early.

Take a distribution before that age, and you’ll have to include the distribution in gross income (if it’s from a traditional IRA or 401(k)), plus, you’ll owe a penalty equal to 10% of the amount distributed.Fortunately, there are 15 exceptions to the 10% penalty. Some apply only to IRAs, some only to 401(k)s, and most to both. Most of the exceptions are obvious or fairly narrow. The penalty isn’t imposed when a distribution is made after the death or disability of the account owner.

A qualified first-time home buyer can take up to a $10,000 distribution from an IRA but not a 401(k). A penalty-free distribution from either type of account also can be taken to pay for unreimbursed medical expenses that exceed 10% of adjusted gross income.I won’t cover all the exceptions. You can find all the exceptions on the IRS website by searching for “exceptions to tax on early distributions.”

But you should know about one flexible exception, the substantially equal series of payments.

To avoid the penalty, you have to take substantially equal annual payments for at least five years or until you reach age 59½, whichever occurs later. Of course, you can’t use this exception to avoid the 10% penalty when you want to take a large lump sum. But the rules for a substantially equal series of payments are flexible enough that it can fit the needs of many people who need cash from their retirement accounts.

This exception is more complicated than it sounds, because you have some flexibility in choosing how to compute the amounts of each of the payments. The IRS lists three methods you can use, plus allows you to use any reasonable method.To compute the payments, you need to establish a life expectancy for you, and two of the methods require you also to select an interest rate that is within IRS guidelines.

The IRS does allow a one-time change in how the distributions are computed in some circumstances.

But in general, if you change the method of computing the distribution after the first distribution is taken, you retroactively lose the exception to the penalty.

You can find all the details to the exception, including your options for computing the annual distributions, by searching the IRS web site for “FAQs regarding substantially equal periodic payments.”

Most people, however, need to work with a tax advisor to ensure the computations are correct and meet their cash flow needs.Rollovers are another major exception to the 10% penalty that I discuss next.The 60-day rollover. Many people tout this as the tax-free 60-day IRA loan. You can receive a distribution from an IRA or 401(k). Then, you have up to 60 days to return the distribution to the account or deposit it in another qualified retirement plan. When you meet the 60-day deadline, the distribution isn’t included in gross income and you don’t owe a 10% penalty for taking an early distribution.

There are details in the rollover rules that many people miss, so the IRS collects a lot of taxes and penalties.You must roll over the amount of the gross distribution. The IRA or 401(k) often is required to withhold 20% of the distribution amount for income taxes, so you’ll receive only 80% of the gross distribution. You have to find that other 20% from other resources and roll over 100% of the gross distribution within 60 days.

Another rule that traps people is you can use the 60-day exception only once every 12 months. That limit is per taxpayer, not per account. Also, the limit is once per 12 months, not once per calendar year. If you used the 60-day rollover in October, you can’t use it again until after 12 months have passed.The 60-day rollover rule isn’t available when someone other than a spouse inherits an IRA.

Any distribution you receive from the inherited IRA is taxable on receipt; you can’t return it to the IRA or roll it over to another qualified retirement account.

Suppose you receive property, such as mutual fund shares, as the distribution instead of cash or check.

In that case, to do a valid rollover you have to deposit the identical property within 60 days. You cannot, for example, deposit money equal to the value of the shares on the date of the distribution.The 60-day rollover rule is fraught with technical details. It is better to have a rollover done from one custodian or trustee to another. When you need a short-term source of cash, there usually are less risky ways to obtain the money.

The hasty beneficiary.

Many IRA beneficiaries make quick decisions that trigger extra taxes. An inherited IRA can’t be rolled over to another IRA of the beneficiary or a new IRA in the beneficiary’s name. That would be treated as a complete distribution of the inherited IRA and have to be included in gross income. Instead, the inherited IRA has to be retitled.

The new name of the IRA must include the name of the de-ceased owner, the fact that he or she is deceased, and that the IRA is “for the benefit of ” (or FBO) the beneficiary.If the beneficiary wants to transfer the IRA to another custodian, it has to be retitled and then rolled over by the custodians to a new IRA with the identical title of the retitled inherited IRA.

The rollover must be custodian to custodian. When a beneficiary receives any distribution, it is taxed and can’t be rolled over to an IRA. Forgotten beneficiary distributions. Under the SECURE Act, IRAs that are inherited after 2019 must be distributed within 10 years, except in a few cases. The IRA can be distributed in any pattern the beneficiary wants, as long as it is fully distributed by the end of 10 years.

This rule applies to both traditional IRAs and Roth IRAs.

Beneficiaries who inherited IRAs before 2020 must take at least required minimum distributions (RMDs) each year. (The RMDs are suspended for 2020.) Failure to take at least an RMD will cause a penalty of 50% of the amount that should have been distributed but wasn’t.

When more than one beneficiary inherits an IRA jointly, the assets can be split into separate IRAs for each of them. The split is tax-free. Split-ting the IRA avoids arguments over investments and distributions.The spouse as beneficiary.

A spouse who inherits an IRA has several options. Many spouses don’t realize this, so they don’t optimize the after-tax value. The 10-year distribution requirement of the SECURE Act doesn’t apply to IRAs inherited by a spouse.

A spouse can get a “fresh start” by rolling over the IRA to a new IRA or one he or she already has. The IRA is in the surviving spouse’s name and will be treated as a separate, original IRA of the surviving spouse without reference to the deceased spouse’s IRA.

Or the surviving spouse can treat the IRA the same as one inherited by a non-spouse but without the 10-year distribution requirement.

The surviving spouse might want this option when he or she is under age 59½ and needs distributions from the IRA. The 10% early distribution won’t apply when the IRA is treated as a non-spouse inherited IRA. But a fresh start IRA is treated as the surviving spouse’s own IRA, so the 10% early distribution penalty will be imposed unless one of the exceptions applies.

The surviving spouse also has the option of initially treating the IRA as one inherited by a non-spouse and then later (say, after age 59½) rolling it over to fresh start IRA. There is no deadline for taking the fresh start option.

Maximizing net unrealized appreciation (NUA).

Many 401(k) accounts hold employer stock in addition to other investments. This stock is allowed special tax treatment.The 401(k) account owner can have the non-stock portion of the account rolled over by the custodian to an IRA. That would be a tax-free roll-over.

At the same time, the employer stock can be distributed, or rolled over, to a taxable account of the employee. In that case, tax on gains in the stock won’t be imposed until the stock is sold.

And the gains will be capital gains, not ordinary income.For this to work, the entire 401(k) balance must be distributed or rolled over within a calendar year. That’s a requirement many people miss. Failing to have the entire 401(k) distributed within the same calendar year can trigger taxes.

Failure to keep up.

The tax law changes frequently, especially regarding IRAs and 401(k)s. Also, new research regularly shows new ways to maximize the after-tax benefits of retirement plans.

Those who keep up with the changes make their accounts last years longer, sometimes much longer. Those who don’t follow the changes pay a lot of money in unnecessary taxes and penalties.