Why This Matters:
– Christie Whitney
Four Big IRA Mistakes That You Can’t Undo
By Leonard Sloane
Investors often make mistakes with their individual retirement accounts. Fortunately, the tax code allows many of these missteps to be corrected.
Contribute too much to your IRA, for example, and you can withdraw the excess and related earnings without paying a 6% annual penalty if you do so before Oct. 15 of the following year. Or if you forget to take one of the annual withdrawals from your traditional IRA, known as required minimum distributions, you can take the distribution when you realize you’ve missed an RMD and use Internal Revenue Service form 5329 to request a waiver of the penalty.
But there are some IRA missteps that can’t be fixed. Make the wrong kind of rollover or violate certain distribution rules, and there may be no way to correct the situation. The consequences could include significant taxes, penalties and the loss of opportunity for growth.
“These are fatal errors,” says Bradley D. Tiche, a financial planner in Wexford, Pa. “They’re made because people are unsure about what actions to take.”
Here are four mistakes that generally can’t be undone and how to avoid them:
1. Taking a nonspouse beneficiary rollover
A surviving spouse who is the beneficiary of an inherited IRA can withdraw the funds and deposit them into his or her own IRA tax-free within a 60-day window. This isn’t an option for nonspouse beneficiaries.
For nonspouse beneficiaries to move inherited IRA assets while preserving their tax treatment, they must move the money directly from one custodian to another in a direct transfer. If the money is paid to the beneficiary instead, the taxable portion of the distribution becomes income.
Some custodians may be reluctant to do a direct transfer, but this should be a priority. It is especially important for nonspouse beneficiaries who want to spread out the distributions—and the resulting tax bill—over 10 years. Your options if your custodian refuses a direct transfer are keeping the funds with that custodian or withdrawing them and paying the tax.
How to avoid it: When moving an inherited IRA as a nonspouse beneficiary, make clear to both financial institutions that you want a direct transfer. This can even be in the form of a check from the sending custodian made out to the receiving custodian and sent to you—as long as the check isn’t payable to you.
2. Exceeding the one-rollover-a-year rule
IRA owners are limited to one indirect IRA-to-IRA rollover during any 12-month period.
The key phrase is “12-month period.” It isn’t based on the calendar year, and the limit generally applies across all of an individual’s traditional and Roth IRAs rather than separately to each account.
Any excess contribution has to be removed from the receiving IRA and pretax funds in the ineligible rollover are taxable. Those younger than 59½ also could face a 10% tax on early distributions unless an exception applies.
How to avoid it: Move IRA money directly between financial institutions rather than taking possession of it yourself. Direct custodian-to-custodian transfers aren’t subject to the once-per-year rollover limit.
3. Altering a 72(t) plan
So-called 72(t) plans allow individuals to tap their IRAs before age 59½ without paying a 10% early-withdrawal penalty. But IRA owners who want to take advantage of this rule must set up a distribution plan for “substantially equal periodic payments” that must be in effect for at least five years or until age 59½, whichever is longer.
Once the plan begins, flexibility is limited. Any change—such as contributing more to the IRA or changing the distribution amount—can trigger a 10% penalty that is retroactive to all distributions taken before age 59½.
How to avoid it: Divide your IRA, with one part used for the 72(t) plan and the other maintained normally for more flexibility.
4. Violating the “same property” rollover rule
When making a withdrawal from an IRA for an indirect rollover, the “same property” must be moved to another IRA within 60 days to be eligible for tax-free treatment.
So, if you remove a particular stock, only those shares can be used for the rollover. If you make a mistake and roll over different property—say, cash or shares of another company—it is considered an excess contribution and must be removed. In addition, the distribution may be subject to tax and a penalty.
How to avoid it: If you’re rolling over securities rather than cash, don’t sell or swap the property. Or, if possible, use a direct transfer.
