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Reviewing Little-Known IRA Traps

Last update on: Apr 21 2016

IRAs seem to be simple things when we open them and begin annual contributions. Over time, as we move from the accumulation years, trickier rules kick in. This is where many people inadvertently lose portions of their nest eggs to taxes and penalties. Others simply miss opportunities they didn’t know were available. Here’s a review of some opportunities to consider and traps to avoid.

Establish a Roth for a youngster. A child or grandchild who worked over the summer or part-time during the year could use some encouragement and a bonus. You can contribute to a Roth IRA for the child as a gift. In 2013 you can contribute up to the lower of $5,500 or what the youngster earned from working. (Investment income doesn’t count.) This amount will be a gift that qualifies for the annual gift tax exclusion of $14,000.

The Roth IRA, even if you make only one contribution, can compound over the years to provide a nice foundation for retirement. Then, money can be withdrawn tax-free. Or, the youngster can withdraw the contributions tax-free any time, such as to pay for college or use as a down payment for the first home.

Check your IRA custodial agreement. Your IRA is supposed to be protected from creditors under the bankruptcy law. But the protection doesn’t apply if you committed a prohibited transaction. Many people are inadvertently committing prohibited transactions with their IRAs that void the bankruptcy protection, according to a recent court decision.

Here’s how a technicality can cause trouble for an IRA. The IRA owner opened an IRA with a major brokerage firm. He had no other accounts at the broker and didn’t intend to use margin lending in any account, but he didn’t check the box on the application to decline margin lending that was standard with that custodian. The agreement also provided for cross-collateralization, meaning that if he took out a margin loan and couldn’t pay it from other assets, the IRA could be used to pay the loan. This, according to the court, amounted to pledging the IRA to back a loan, which is a prohibited transaction.

He eventually won on an appeal, where the court ruled there isn’t a prohibited transaction unless a loan actually takes place. But it was a long, expensive process, and there’s no guarantee other courts will rule the same way. To be safe, you should avoid any IRA agreements that provide for cross-collateralization of loans. Many IRA custodians are in the process of removing such language from their documents.

The IRS is monitoring contributions and distributions. A congressional research report found that many IRA owners are violating either the contribution limits or required minimum distribution rules. The IRS could generate a lot of money in taxes and penalties by more closely enforcing the rules. So, you have to be sure you don’t contribute too much to IRAs during the year and that you withdraw the right amounts.

Of special interest to my readers are the required minimum distributions rules after age 70½. The investigation found that a lot of people don’t take the required minimum each year. The penalty for that is 50% of the amount you should have withdrawn but didn’t. For a refresher on how to calculate your RMD and the deadlines, see back issues of Retirement Watch or IRS Publication 590.

Inherited IRAs. Be sure your heirs have good information about how to handle an inherited IRA, because the rules can become very tricky.

For example, when an heir decides to move an inherited IRA to a different custodian, the rollover must be directly from one trustee to another. With other IRAs, you can receive a check from the IRA custodian and take up to 60 days to deposit the same amount with the new custodian. But the 60-day rule doesn’t apply to inherited IRAs. If it’s not a trustee-to-trustee transfer, the entire amount is treated as a distribution even if you deposit it in a new IRA within 60 days.

Also, September 30 of the year after the original owner’s passing is an important date. By then, the IRA custodian needs to be notified who the beneficiaries are and who is the “designated beneficiary,” whose age is used to determine required distributions.  Also, if a non-individual, such as a charity, a trust, or the estate, was named as a co-beneficiary, the entire IRA must be emptied within five years. But if that beneficiary is paid its full share by the Sept. 30 deadline, it no longer will be a beneficiary. Required distributions then are scheduled over the life expectancy of the oldest beneficiary.

There are a host of other things heirs need to know about inherited IRAs. I compiled them in my report, Bob Carlson’s Guide to Inheriting IRAs. You can read more about it by going to www.RetirementWatch.com and clicking on the Bob’s Library tab.

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