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Six Costly IRA Myths and Blunders

Last update on: Aug 13 2019
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Individual Retirement Accounts are a long-standing and well-known part of the tax code. Yet, distributions from IRAs are one of the most misunderstood sections of the code. The situation is further complicated because the rules changed in recent years. There still are people – even financial professionals – who follow the old rules.

Mistakes about the tax rules on IRA Distributions can be very expensive. Be sure you don’t make any of these classic blunders.

Fixing rollover mistakes. Most people know the basic rules about rollovers. An account balance can be rolled over tax free from a qualified retirement plan (such as a 401(k) plan) to an IRA or from one IRA to another. There is no deadline if the balance is rolled over directly from one trustee to another. If the account owner takes the balance from one account, he or she has up to 60 days to get the same amount of money deposited in the same or another retirement account to avoid taxes.

Mistakes often happen with rollovers. For example, a plan trustee might transfer an IRA to a taxable account instead of to another IRA. Or the trustee might issue a check to the owner instead of transferring the account to another trustee.

In the past, the account owner had no remedy. If the rollover was not executed properly, it was treated as a taxable distribution. The reason for the improper rollover didn’t matter. The owner was stuck with the tax bill and perhaps a 10% early distribution penalty.

The 2001 tax law changed that. The IRS has the discretion to grant waivers of the 60-day rule, allowing additional time for the owner to deposit the funds in a qualified retirement account. The IRS explained the process for obtaining a waiver in Revenue Procedure 2003-16. The procedure also states that a taxpayer gets an automatic extension without having to apply to the IRS when the financial institution was the sole cause of the problem.

When an IRA rollover was not executed properly, do not assume that additional taxes and penalties are due. Consult a tax advisor and the IRS procedure. You might avoid an expensive tax bill.

Required distribution computations. IRA owners over age 70½ are required to begin taking required minimum distributions (RMDs). That rule is longstanding. But key changes were made in 2002.

Among the changes was a new life expectancy table that is used by most taxpayers to compute the RMDs. Too often, taxpayers or their advisors are using the old tables, often because they are using a book or other reference dated before the changes. The result is the RMDs for those taxpayers are higher than they need to be. The taxpayers lose deferral on more of the IRA than is required.

Whether computing the RMDs yourself or having it done by an advisor, be sure the 2002 changes are reflected in the computations. The 2002 tax tables are posted on our members’ web site at www.RetirementWatch.com.

No more conduit IRAs. Suppose you are leaving a job and having your 401(k) balance rolled over to an IRA. In the past, the best advice was to set up a new IRA to receive this rollover. If you did, the IRA was eligible to be rolled over again into the 401(k) or other retirement plan of a future employer whose plan accepts such rollovers. This could be a benefit if the new employer’s plan was attractive or because it simplified your finances by consolidating more money in one account.

This was changed in the 2001 tax law. Now, an employer plan no longer is restricted to accepting transfers only from such rollover IRAs. There now is only one reason to establish a conduit IRA for your rollover. If you were born before 1936 and are eligible for the 10-year averaging option on a lump sum distribution from an employer plan and want to preserve that option, you need to use a conduit IRA. Otherwise, the extra IRA no longer is necessary.

The five-year rule. Before the 2002 changes by the IRS, IRA owners had to take very specific actions to avoid their beneficiaries’ being required to distribute an IRA within five years of inheriting it. Unfortunately, many IRA sponsors and advisors still believe that in most cases an IRA must be distributed and taxed within five years after being inherited.

Under the 2002 regulations, however, the five-year rule applies to few inherited IRAs. A designated beneficiary is allowed to stretch the distributions over his or her life expectancy. A designated beneficiary is any person named as a beneficiary or contingent beneficiary on the beneficiary designation form, then appointed designated beneficiary by the estate executor.

Estates, charities, and many trusts are not eligible to be designated beneficiaries. So, in most cases the five-year rule does apply to them.

The five-year rule might apply if there is no designated beneficiary. (Under the old rules, having no named beneficiary meant the IRA had to be distributed within a year; that no longer is the rule.) If the deceased owner had not yet begun RMDs, the IRA must be distributed within five years. The distribution can be on any schedule as long as the entire account is distributed by the end of the fifth year.
If the deceased owner already had begun RMDs and there is no designated beneficiary, then distributions can continue over the remaining life expectancy of the deceased owner. The estate or its beneficiary continues making distributions on the schedule established by the deceased owner.

Converting to Roth IRAs. A new rule this year makes more older Americans eligible to convert regular IRAs to Roth IRAs.

A conversion is allowed when the owner’s adjusted gross income is less than $100,000. If the owner is married, the joint income of the spouses must be under $100,000. Until this year, if the owner was required to take RMDs, then the RMD for the year of conversion had to be taken no matter when during the year the conversion was made, and the RMD was included in adjusted gross income for the year. That could push the owner’s income above the $100,000 limit.

Now, the RMD still must be made, but the $100,000 limit does not include the RMD. This should make more people eligible to convert to Roth IRAs.

The 401(k) Roth IRA. Not many people know that in 2006, 401(k) plans can be expanded. Employers can add a Roth IRA feature to the plans. Employees can defer money to either a regular 401(k) account or the Roth account, or any combination of the two. The total contribution amount is not increased.

Unlike contributions to a regular 401(k) account, the employee includes in income the amount deferred into the Roth account. But withdrawals from the Roth account are tax free under the same conditions as Roth IRAs. Unlike Roth IRAs, the owner of a 401(k) Roth account must begin RMDs after age 70 ½.

High income individuals will benefit from this option. Only individuals with incomes below certain levels are eligible for Roth IRAs. But there is no income limit on the 401(k) Roth accounts. Any employee can contribute to a Roth 401(K).

In addition, under the 2001 tax law single employee businesses are eligible to open 401(k) plans, and they will be able to add the Roth account option in 2006.

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