Too many people leave too much money on the table when managing their IRAs. But it should not be surprising, since the rules and strategies about individual retirement accounts (IRAs) can be more complicated, once the early contribution and accumulation years are behind us.
There are various tricks and traps in the IRA rules, and there are strategies for maximizing IRA values that aren’t intuitive. This article is the first of two parts that offer tips to sidestep the onerous obstacles.
IRAs are among the most valuable assets many people own, especially after 401(k) balances are rolled over to IRAs. However, one major slip or even two smaller oversights can put a lot of extra money in the IRS’s hands.
Though many IRA owners aren’t aware of the pitfalls, the IRS knows them. A few years ago, the IRS did a study that found many people don’t follow the rules properly and the government was missing a lot of extra taxes and penalties by not closely auditing IRAs. The IRS since then has modified its procedures and is taking a closer look at IRAs.
Here are some very common, and expensive, IRA mistakes to avoid.
Contributions. The IRS found a lot of people either don’t know or pay attention to the contribution limits. When you (or your spouse) are covered by a pension plan, you can’t make deductible contributions to an IRA once your income exceeds certain levels. You still can make contributions to IRAs above those limits, but the contributions aren’t deductible.
Roth IRAs also have income limits. In 2016, when your adjusted gross income (AGI) exceeds $184,000 for married couples filing jointly ($117,000 for singles), Roth IRA contributions are phased out over the next $10,000 of AGI. The amounts are indexed for inflation each year.
You still might be able to make a backdoor contribution to a Roth IRA. First, make a nondeductible contribution to a traditional IRA. Then, convert the traditional IRA to a Roth IRA. There should be little or no tax cost to the conversion, because there won’t be income or appreciation in the IRA.
But the backdoor Roth IRA doesn’t work as well if you already have traditional IRAs with deductible contributions. Then, all of your traditional IRAs are aggregated to determine how much of the conversion is tax free. The percentage of total nondeductible contributions to the total balance across all your IRAs is the tax-free amount on the conversion.
Fixing rollover mistakes. The rollover might be the most common IRA transaction. You can roll over money from one IRA to another. You also can roll over money from a 401(k) or other retirement plan to an IRA (or in the other direction). Do these transactions correctly and they are tax deferred. But when there’s a mistake the amount you meant to roll over can be treated as a distribution and included in gross income.
When you roll over money from one IRA to another, you can handle the money yourself. Take a check from the first IRA and you have up to 60 days to deposit the same amount of money in another IRA or other qualified retirement plan. But if you miss the deadline, you have a taxable distribution instead of a rollover.
There are a few exceptions, such as when you have a serious illness or a mistake is made by the new IRA custodian. But you have to apply to the IRS for an extension of the 60-day period, and the IRS is tough about granting extensions.
Also, the IRS changed its rules last year so that each IRA owner is allowed only one 60-day rollover per 12-month period. Given the potential pitfalls, it is best not to try to use the 60-day rollover option.
Instead, use trustee-to-trustee rollovers. You complete the paperwork and have the IRA custodians arrange the rollover between them. There’s no time limit.
But even trustee-to-trustee rollovers require care. At times, a financial firm mistakenly deposits a rollover into a taxable account instead of an IRA. Or the custodian might mistakenly issue a check to you instead of making a rollover to the other custodian. There’s no penalty if these errors are the custodian’s fault and are fixed within 60 days. Otherwise, you have to appeal to the IRS for a waiver and show why the mistake wasn’t your fault.
The key is to open promptly and study account statements and transaction notices. Don’t look simply at the changes in your investments and balances. Look at the transactions and the account title. If the custodian made a mistake, have them reverse it quickly.
Taking required distributions. Many people struggle with the rules for required minimum distributions (RMD) after age 70½. The IRS knows this and is on the lookout for errors that trigger additional taxes and penalties.
You don’t have to take the first RMD until April 1 of the year after you turn 70½. But often it’s better to take the first RMD in the year you turn 70½. If you wait you’ll take two distributions the following year, perhaps pushing you into a higher tax bracket.
RMDs don’t have to be in cash. If you like an investment, have it transferred from your IRA to a taxable account. That will be treated as a distribution. The market value on the date of the transfer is your RMD and will be the tax basis for determining gain or loss going forward.
Also, RMDs are minimum distributions. You always can take more. Taking more in the early years can be a good idea, because the RMDs will increase over time. That can increase your taxable income, forcing you to take distributions that exceed your spending needs.
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Until next time,
Robert Carlson is editor of the monthly newsletter, Retirement Watch. In it, he provides independent, objective research covering all the financial issues of retirement and retirement planning. Carlson also is Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System and the founder of Carlson Wealth Advisors, L.L.C.