Financial Advice for Retirement, Social Security, IRAs and Estate Planning

IRA Mistakes & Opportunities [Case Studies]

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Individual retirement accounts (IRAs) become more complicated as balances increase and distributions are taken.

It’s good to know some key rules so you won’t trigger additional taxes and penalties or miss some grand opportunities you didn’t know were available.

Examples of people making IRA mistakes come my way almost every day in court cases, IRS rulings and from listening to people.

Gift-giving vehicles

Anyone can contribute to a person’s IRA. It doesn’t have to be the IRA owner.

The total contributions to the IRA for the year can’t exceed the annual limit, but any combination of people can contribute.

That means parents and grandparents can contribute to IRAs for youngsters. However, the youngsters must have earned income at least equal to the contributions.

When a youngster earns money, say from a summer job, you can start him or her on the road to a secure retirement by making matching contributions to an IRA.

The gifts are especially valuable when made to a Roth IRA.

The IRA contribution limit for 2017 is the lower of $5,500 and the youngster’s earned income for the year.

When your grandchild earns $4,000 at a summer job, for example, you can contribute $4,000 to her Roth IRA, if no one else contributed.

The youngster doesn’t have to wait until retirement to take the money tax-free.

The principal can be withdrawn tax-free at any time, and earnings can be withdrawn tax-free and penalty free after the IRA has been open for more than five years.

Up to $10,000 of principal and interest can be withdrawn penalty free at any time to buy a first home.

Early distributions

Distributions from an IRA before age 59½ are subject to the 10% early distribution penalty tax. When they’re from a traditional IRA, they’re also subject to income taxes.

There’s a list of exceptions to the 10% penalty, but many people don’t read the exceptions closely and end up paying the penalty.

In a recent case, a 50-year-old IRA owner learned the penalty tax is avoided when the early distributions were used to pay for medical expenses.

When her husband lost his job, she took IRA distributions and claimed exemption from the penalty.

To avoid the penalty, the distributions must be used only to pay medical expenses of the taxpayer, spouse, or a dependent.

So, any distributions exceeding medical expenses don’t avoid the penalty.

In addition, the distributions must cover medical expenses paid in the year of the distribution.

The penalty isn’t avoided when the medical expenses were paid in the year before or after the year of the distribution.

Finally, only medical expenses that exceed 10% of the taxpayer’s adjusted gross income for the year qualify for the exception to the penalty.

If the distribution is used to pay for medical expenses below that threshold, the penalty applies.

In this case, the taxpayer was considering all medical expenses, not only those that exceeded 10% of adjusted gross income.

She also tried to qualify medical expenses that were paid in the year before the distribution was taken, because that’s when her husband lost his job. So, she owed the penalty on the distributions.

In another recent case, the taxpayer was getting divorced and agreed to pay half the IRA to his wife as part of the settlement.

He distributed his entire IRA before the divorce was final and gave half to his wife.

He paid income taxes on the distribution but believed the 10% penalty was avoided because the distribution was related to the divorce.

The penalty can be avoided when a distribution was made due to a divorce, but the distribution must be made under a qualified domestic relations order.

He needed to wait until the divorce was final and he had a court order telling him to transfer the money to his wife.

Unconventional investments

Your IRA can be invested in investments other than stocks, bonds and mutual funds.

But you’ll have to follow some rules. The IRA needs a custodian or trustee authorized by the IRS who will hold unconventional investments.

Here’s an example of how not to buy unconventional investments in an IRA, though it worked out in the end.

The IRA owner wanted to purchase stock in a private company, but the custodian said it would hold only publicly traded securities.

Instead of finding a new custodian, the IRA owner directed the custodian to wire funds from the IRA directly to the company he wanted to invest in. He directed the company to issue shares in the IRA’s name and send paper stock certificates to the custodian.

The custodian received the share certificates, but the receipt was more than 60 days after the funds were wired. The custodian treated the transaction as a distribution and issued a 1099-R to the taxpayer.

The IRS said he had to include the amount in gross income because he had constructively received the IRA money.

Eventually, a federal appeals court ruled the taxpayer didn’t receive a distribution because he never had control over cash, stock, or other proceeds from the IRA. But he had to spend a lot of time and money fighting the IRS.

If you want to own unconventional assets in an IRA, the custodian has to hold the assets.

Take the time to transfer your IRA to the right custodian and plan your investments.

A good starting action is to conduct an internet search for “self-directed IRAs” and evaluate which available custodian best meets your needs.

Nondeductible IRA contributions

When you can’t deduct contributions to a traditional IRA because your income is too high or you are covered by an employer retirement plan, you still can make contributions.

They won’t be deductible, but you can make the contributions and take advantage of the tax deferral on income and gains. Yet, there might be a better use of your money.

Roth IRAs weren’t available when nondeductible contributions to traditional IRAs first were developed. But now, when your adjusted gross income doesn’t exceed the limit for making Roth IRA contributions, it’s better to contribute to a Roth IRA.

The income limits for 2017 are $196,000 for married couples filing jointly and $133,000 for single taxpayers.

A Roth IRA is better than nondeductible contributions to a traditional IRA, because the Roth IRA doesn’t have required minimum distributions after age 70½ and distributions of income and gains are tax free after five years.

Distributions of income and gains from the traditional IRA, on the other hand, are taxed as ordinary income, even if they were long-term capital gains or qualified dividends when earned.

Even owning investments through a regular taxable account can be better than making nondeductible contributions to a traditional IRA.

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