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Early Distribution

Options For a Spousal Inherited IRA

Dec 6th, 2009
by jblankenship.
2 comments

wedding 1946 by dlisbonaIn these articles we’ve discussed inherited IRAs and how to handle them – but we have not covered all of the options for a Spousal Inherited IRA separately.  There are some differences, specifically more options available, so this is an important topic.  It should be noted that the majority of this article applies to inheriting IRAs or Qualified Retirement Plans (QRPs, such as a 401(k) or 403(b)), although the term IRA is used throughout.  The receiving account must always be an IRA, though.

As a person who has inherited an IRA from your spouse, you have the following options if you are the sole beneficiary of the IRA:

  • Leave the IRA where it is, and begin taking distributions based upon your own life (see Table I for the factors).  This is the default position.
  • Rollover the IRA to an inherited IRA (see this post for more information).  In this case, you’re treating the situation as if you’re a non-spouse beneficiary.
  • Rollover the IRA into an existing or new IRA in your own name.  This is the special provision that spouses can use that a non-spouse beneficiary can not.  (Note:  you could also leave the IRA where it is and just begin treating the account as if it was your own – more on this below.)

Rollover Into Your Own IRA

There’s nothing terribly complex about the mechanics of a spousal rollover of an inherited IRA – you simply put in motion the paperwork for a rollover, making sure that both the original custodian and the new custodian are aware of the fact that you’re taking advantage of this special provision for spouses.  It is also possible to leave the IRA in place where it is and treat the IRA as your own – this will become the default if you 1) make a contribution into the account; or 2) fail to take the RMDs as if the account were inherited.

Now you have the IRA funds in your own account – which you can contribute to, convert to a Roth IRA, or whatever you’d like.  Plus, if you’re under age 70½, you don’t have to start Required Minimum Distributions (RMDs) from the account. This brings up the one possible downside that you should be aware of as well, prompting a word of caution…

A word of caution

IF you go ahead and rollover the IRA from your deceased spouse’s account into an account in your own name, if you’re less than age 59½, you do not have free access to the funds in the account – one of the 72(t) exceptions must apply, or you’d be charged the extra 10% penalty in addition to taxes on the withdrawal.  It is for this reason that many inheriting spouses do not take the IRA on as their own account – especially when there is a need to access the funds for income.

One more provision

As mentioned earlier, the provision for the spousal beneficiary to treat the IRA as her own is generally for a spouse that is the sole beneficiary.  There are two ways to resolve this situation if the spouse would like to rollover the account to her own IRA and there are more than one beneficiary.

  1. Other beneficiaries could disclaim the inheritance, leaving only the spouse (see this article for more information).  Many times, a well-intentioned IRA owner will designate her spouse and a child or grandchild (or a trust for the whole mob of children and/or grandchildren) as split beneficiaries of an IRA account.  This can bring about unintended results, such as very young children having to take RMDs that they do not need.  By disclaiming the inheritance and leaving only the spouse, the spouse can set up a new IRA in her own name, with the same original, now disclaimed, beneficiary or class of beneficiaries as the beneficiary(s) of the new account. This will fulfill the original owner’s intent, while opening up the account to the extra privileges available to an owner of an IRA versus an inheritant.
  2. A somewhat less messy method is available – as a spousal beneficiary, but not the sole beneficiary, you can take a distribution of your entire share from the account, and then roll it over to an IRA in your own name, as long as it’s within the 60-day period following the distribution.  You may need to make up the difference of the withholding – in general a distribution from an IRA will be subject to 20% withholding.  If you don’t roll over the full amount into your own IRA, you will be taxed and perhaps assessed a 10% penalty on the amount that you did not roll into the new account.  Using this method eliminates the disclaimer requirement which might be necessary if there are many other beneficiaries or if the other beneficiaries do not wish to disclaim.  (Note:  This method is STRICTLY for a spousal beneficiary.  A non-spouse beneficiary will bust the stretch IRA by taking a distribution of this type, even if they rollover the amount into a properly-titled account within the time allotted.  Those rollovers should ONLY be done via trustee-to-trustee transfer.)
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Sam, You Made The Pants Too Short!

Oct 23rd, 2009
by jblankenship.
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high water pants by TimWilson With apologies to the writer and performers of the original “Sam, You Made The Pants Too Long!”… This article is about what happens when your IRA declines substantially in value and you’ve put a 72t Series Of Substantially Equal Periodic Payments plan (SOSEPP) into play – and the decline in value has brought your IRA to a point where the balance will no longer support your Equal Payments.

What Happens When Your IRA Will No Longer Support Your SOSEPP?

Here’s an example:  You’ve set up a SOSEPP in your IRA, beginning at age 50.  As we all know (see this post for details) you have to keep the payments going until you reach age 59½.  During that time, many things can happen, both positive and negative.  In this case, the IRA began with a balance of $100,000, and your annual payments are $3,000.  Things go fine for the first few years, although your account doesn’t seem to be growing.  So, you decide to take a leap and invest it all in a wild-eyed fund – some Madoff fellow’s running it.  Then, lo and behold, one morning you wake up and find that your IRA balance has become – $12 total.  You’re age 56, so you have three and a half more years that you are supposed to be taking this regular payment of $3,000 from your account!  What do you do?  You’ve read about the crazy penalties for busting a 72t payout plan – yikes!

Options

Calm down.  Take a breath, it’s really not so bad.  There are several options:  You could rollover funds from another account into the IRA, either from another IRA account or a 401(k).  You could also choose to make your one-time change to your SOSEPP plan.  Or, you could choose to let it die, and go on with your life.  The best option is the last one – it allows you to be as flexible as you can be.

If you chose the first option, it certainly would work – and your SOSEPP would just continue on as originally planned.  But what if you have decided at this stage that you really don’t need that series of payments anyway?  And it’s just a pain in the rear keeping up with the paperwork and remembering to take the payment each year…?

The same holds true for the one-time change to the RMD method.  If you did that, now you’d have to re-calculate your payment each year on a very small balance.  Once again, a pain in the rear – so why not just take the third option?

Let it die

If you go ahead and take the last payment out of your account (the remaining $12) and close the account – your SOSEPP is no longer in effect.  You now have the option of starting a new SOSEPP from another IRA account, or just discontinuing the idea of the 72t payout.  If you chose to start a new plan, you’d have to start over with a new five-year or (since in the example, you’re age 56) for three and a half more years until you reach age 59½.

What’s key to understand in this is that, for SOSEPP’s, the IRS considers each IRA account separately – yeah, I know, for everything else, all IRAs are considered as one.  What can I say?  They don’t want you to get too comfortable and start predicting how they’ll move – just when you think they’re gonna zig?  they zag.  So with that in mind, if one account (the one with the SOSEPP attached) runs dry, there’s no penalty if you just drop it and move on with your life.

That’s literally all there is to it.  No penalty, no muss, no fuss.

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IRA Trick – Eliminate Quarterly Estimated Tax Payments

Oct 13th, 2009
by jblankenship.
3 comments

the old cat trick by wstryder Retirees:  don’t you get tired of making those quarterly tax payments?  January, April, June and September, like clockwork, you have to hand over tax money, just because you’re receiving a pension, retirement funds, and/or Social Security benefits.  What if there was a way to send this money off one time, and then you wouldn’t have to remember it every few months?

There is.

IRA Trick – Eliminating Quarterly Estimated Tax Payments

A little-known fact about IRA distributions is that when you have taxes withheld from the distribution (which are then sent directly to the IRS), the withheld money is considered to have been received throughout the year – even if it is received late in December.  Using this fact to your advantage, you could figure out how much your total estimated tax payments should be for the year sometime in early December, and then take a distribution from your IRA in that amount.  Here’s the trick:  Instead of taking the distribution yourself, fill out a form W-4P to direct the funds to be withheld and sent to the IRS.  Voila!  You’ve now made even payments to the IRS for each of the four quarters, on time with no penalties!

The downside to this plan is that, in the event of the taxpayer’s untimely death before the annual distribution is made, the estimated payments will be considered as unpaid up to the date of death, and therefore the estate will be responsible for paying the underpayment penalty.  Other than that shortcoming, this trick could provide you with several months’ additional interest/return on your money, plus remove the hassle of the quarterly filings.

But, Jim, what if I’m retired and under age 59½?  Won’t there be a penalty?

There doesn’t have to be, although I’d place this particular move into the “higher degree of difficulty” category of tricks – not to be taken lightly.

Pre-59½ Retiree: How to Avoid Penalty?

Same situation as before, but now you must take another step:  once you’ve taken the distribution and properly filed the W-4P to have the distribution withheld as tax – execute a 60-day rollover, placing the same amount of money either into the same IRA or another IRA… effectively, you’ve pulled the old switcheroo with the IRS on this:  What has happened is you’ve paid tax with a distribution that didn’t happen!

How can this be?  Well, the IRS allows you to replace (or rollover) money from any source back into your IRA, so it doesn’t matter that your original distribution was used for withholding.  So you have made up for missing all those quarterly estimated payments (no underpayment penalty now) plus by rolling over the funds you’ve avoided the 10% early withdrawal penalty as well.

Caveat

I mentioned that this last trick fits into the “higher degree of difficulty” category of tricks.  The reason I say this is because using your account in this fashion (essentially a 60-day loan) can be hazardous – the primary reason is that 60 days is all you have, and 60 days can be a relatively short period of time.  Plus, the IRS HAS NO SENSE OF HUMOR ABOUT THIS.  If you miss the rollover period by one day, you’re outta luck.

In addition to the 60-day period, there is also the limitation of only one 60-day rollover per 12-month period.  Again, remember: no sense of humor at the Service.  This is especially true if it’s clear that you’ve been pulling a fast one on them with a scheme like suggested above.  It is for these reasons that this rollover trick should only be used in the most dire of circumstances – such as if you completely forgot to make quarterly payments and are facing a stiff underpayment penalty, for example.  Otherwise, I’d suggest leaving this one alone.  By all means, you should not try this trick year after year.

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IRA Inheritance – Not Taking Timely Distributions

Jul 18th, 2009
by jblankenship.
1 comment

inheritance by Marco BellucciA commenter from my post on splitting an inherited IRA sparked this particular post – his question was “What are the consequences for not re-titling an inherited IRA as F/B/O?”  You can see my response to that specific question at the original article…

But that question sparked the idea of discussing what happens when a beneficiary doesn’t act in a timely fashion with regard to taking Required Minimum Distributions from the inherited IRA?  That’s our topic for today.

The Inheritance

So, let’s say you inherited an IRA from your mother – this was her own IRA that she had contributed to or rolled over funds from a qualified plan at some point, and had designated you as the sole primary beneficiary.  Things get really hectic and confusing after the death of a parent, and sometimes we don’t cover all of the bases properly… and in this example, you didn’t realize that you needed to begin taking Required Minimum Distributions (RMD) from your inherited IRA as of December 31 of the year following the year of your mother’s death.  As of now, for example’s sake, let’s say we’re in the fourth year after your mother’s passing. (see Notes below)

At this point you have two choices:  take the entire balance of the IRA as a distribution before the end of the fifth year; or “unwind” the mistake by taking your RMDs for the first four years, paying the 50% excess accumulations penalty on each distribution, and then continuing on with your lifetime RMDs.  In each case, of course, you would be required to pay ordinary income tax on the distributions.

Five Year Distribution

This one is the “default” distribution option – and the rules are that you must take the complete distribution (either a series of payments or a lump sum) within the five years following the year of the original owner’s death.  In the example we’ve started, this means that you have roughly a year to complete this distribution. 

Since ordinary income tax is owed on distributions from your inherited IRA, if the balance is significant this could represent a sizeable tax bill for you.  It might even put you into a higher (or much higher) tax bracket, causing lots of unnecessary additional tax – if you took the other route.

Unwinding the Mistake

In order to avoid the excess taxes described above in the Five Year Distribution, you would need to go back and take distributions for the three prior years that you missed, based upon your Table I factor.  For example, let’s say your inherited IRA was worth $100,000 at the end of the year in which your mother passed away, and your age in the following year was 28.  According to Table I, your life expectancy is 55.3 years.  Dividing the IRA balance by 55.3 gives us a RMD of $1,808.32.  That’s your first distribution.

Continuing the example, you’d use Table I again along with the balance of the IRA at the end of the first year (minus $1,808.32) to come up with the RMD for the second year.  For the sake of the example we’ll assume that the IRA is growing at a fixed rate of 5% per year, and so the balance at the end of the second year is $105,000, which you subtract $1,808.32 from to come up with your balance of $103,191.68.  Your Table I factor for this year (age 29) is 54.3, yielding an RMD of $1,900.40.

For the third year, your IRA has grown to $110,250.  Subtracting your two years’ worth of RMD leaves you with $106,541.28, and your Table I factor is 53.3, giving you an RMD for the year of $1,998.90.

Adding these three years’ worth of RMDs together equals $5,707.62, which you’d take out in a distribution for the prior years.  This amount is subject to ordinary income tax (just like your W2 wages), but is also subject to a special tax on “excess accumulation”.  This tax is for failure to take RMDs in a timely fashion, and amounts to 50% of the distribution that was required, or $2,853.81.  While you could take this amount out as an additional distribution, keep in mind that you’d have to pay ordinary income tax on that amount - but at least you wouldn’t have to pay the 50% penalty on it.  You’d probably be better off just paying in half of what you take out in the RMDs, since you hadn’t had that money in your hands anyhow…

For this year, you would also need to take a RMD – and continuing our example your IRA balance at the end of last year was $115,762.50 – from which you would subtract the RMDs of $5,707.62, leaving $110,054.88.  Your Table I factor is 52.4, which provides you with an RMD of $2,100.28, which you need to take as a distribution by the end of the year.  (For this particular year, 2009, you do not have to take an RMD at all since RMDs have been waived for this year, but you’ll need to continue this RMD calculation process for each year hereafter unless other waivers are put into place.)

Don’t Try This At Home, Kids

I know I’ve cautioned you about this before, and perhaps you see it as a little self-serving (tax guy recommends a tax guy, duh!) but you can really cause yourself some extra grief if you foul this one up.  It would be worth it to have a tax professional review your calculations at the very least – and to tell the truth, you’re probably just as well to have the tax guy do the calculations for you because the cost is likely about the same for him to review your work as to do it himself.  The tax pro can help you with the required filing of Form 5329 (to account for the excess accumulation tax) as well.  In addition to the tax, interest may be owed as well on the accumulation tax due in prior years.

Notes:

It should be noted that the fact that the decedent is your parent is not critical to the facts of this example – only that you are inheriting the IRA from someone other than your spouse.  A spousal inheritance is a different animal altogether.

A factor of this example that IS important is that the IRA belongs specifically to the decendent and is not an inherited IRA.  If you’ve inherited an IRA that was already an inheritance, if it was specifically directed to you as the designated beneficiary then the rules are the same – but if you received the IRA via the estate, you’ll have to follow the five-year distribution rule exclusively.

Lastly, it is also important to note that the example only identifies a single primary beneficiary – if there is more than one beneficiary, the process described would be complicated by the fact that the oldest of all the beneficiaries (with the smallest Table I factor) would be the one whose distribution period is used for all beneficiaries, since the IRA was not split by the end of the year following the year of the death of the original owner.

Photo by Marco Bellucci
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Splitting Inherited IRAs

Jul 16th, 2009
by jblankenship.
6 comments

These things can give you a splitting headache…

splits by cheetah100In the case of an IRA, often it is desirable to split an account into two (or more) accounts in order to better accommodate a distribution plan upon the death of the primary owner of the account.  This can be done prior to the death of the IRA owner, or it could be done after the death of the IRA owner, as long as it’s accomplished before the end of the year following the year of death.

Why is this important?

When an IRA is inherited by a non-spouse individual, that individual is required to begin taking distribution of that IRA, based either upon their own age or the age of the decedent.  In most cases when the beneficiary is younger than the decedent, it is advantageous to stretch those payments out over the longer period of time.

If there is more than one beneficiary, unless the IRA is split, the Required Minimum Distributions will be based upon the attained age of the “designated beneficiary” – who is the oldest beneficiary as of September 30 of the year following the year of death.

If you’ve split the IRA into separate IRAs for each beneficiary, each titled as “John Jones, deceased, FBO Jane Brown” (probably not exactly like that because the names will be different in almost all cases), then the individual IRAs can be distributed according to the age of each individual beneficiary.  The IRA must be split by December 31 of the year following the year of death.

Note: bear in mind that you don’t have to have the IRA split into separate IRAs for each beneficiary by September 30 of the year following the year of death – this is just the administrative date for determination of the designated beneficiary.  In the event that the IRA is split into separate inherited IRAs by December 31 of the year following the year of death, then administratively the designated beneficiary of each separate IRA as of September 30 would be the individual “FBO” owner of the account.

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TWO 5-year Rules for Roth IRAs

Jul 8th, 2009
by jblankenship.
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In case the rules surrounding Roth IRAs weren’t confusing enough so far, there are actually TWO different 5-year rules that can apply to your Roth IRA account.

first ride on the bus by busymommy

5-Year Rule #1: The Account’s Age

In general, the first 5-year period begins on January 1 of the tax year when you established and first funded the account.  This 5-year rule is important in determining if any distributions you receive from the account are qualified.  In order to be qualified, a withdrawal must occur at least 5 years after that account establishment date (January 1 of the year you first funded the account).   In addition to the 5-year rule, one of the following conditions must also apply in order for your distribution to be considered qualified:

  • You are over age 59½
  • You are disabled
  • You (the account owner) are deceased
  • The distribution is for a qualified first home

See the IRS’ flowchart at this link in order to determine if your distribution is qualified.

5-Year Rule #2: Age of a Conversion

This 5-year period generally begins on January 1 of the year of a conversion to a Roth IRA from a traditional IRA or from a qualified retirement plan such as a 401(k).  Any amount that is attributable to such a conversion that was subject to taxation upon the conversion that is distributed before the 5-year period is complete would be subject to an additional 10% penalty tax applied to the distribution.  This would also include post-conversion earnings on those amounts that had been converted within the previous 5 years.  Possible exceptions to this rule are as follows:

  • You have reached age 59½.
  • You are disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.
  • The distributions are part of a series of substantially equal payments.
  • You have significant unreimbursed medical expenses.
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified disaster recovery assistance distribution.
  • The distribution is a qualified recovery assistance distribution.

Why These Rules Are Important: Distribution Ordering Rules

These two rules come into play when considering the order in which distributions are attributed.  The IRS has specific rules determining just which money is coming out of your account and how it is to be treated, depending on if it’s qualified or not.  The order of distribution is as follows:

  1. Regular contributions
  2. Conversion and rollover contributions, on a first-in, first-out basis, meaning that the total of conversions and rollovers from the earliest year come out first.  These conversions and rollovers are further sorted as follows:
    1. Taxable portion (that portion that was taxed during the conversion or rollover)
    2. Non-taxable portion
  3. Earnings on all contributions

It should be noted that, in determining the amounts for #2 (conversion and rollover contributions) that certain aggregation rules apply:

  • Add all distributions from all your Roth IRAs during the year together.
  • Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
  • Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution is made in 2008 and the conversion or rollover contribution is made in 2009, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2009.

Of course, the regular contributions can always be taken out of the account tax free (no 5-year rule applies).  After that, your two 5-year rules kick in on the rest of the types of funds in your account.

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Designated Roth Account (Roth 401(k)) Distributions

Jun 25th, 2009
by jblankenship.
2 comments

Sen._William_V._Roth_(R-DE)In a previous post we discussed the general information surrounding Designated Roth Accounts – eligibility, tax treatment, and contributions.  In this post we’ll go over the nuances involved in distributions from a Designated Roth Account under a 401(k).  Distributions are a little different from most other retirement plans, as you might guess…

Required Minimum Distributions

One of the first things that is different about a Roth 401(k)’s distributions is that the Required Minimum Distribution (RMD) rules apply to these accounts.  This is different from the Roth IRA, as RMD is not required under present law.  RMD for a Designated Roth Account is the same as the RMD rules for all other accounts to which the RMD rules apply.

The way to get around the RMD rule is to roll over your Designated Roth 401(k) account balance to a Roth IRA.  Obviously this is a tax-free event, since both accounts are non-taxable in both contributions and earnings.  As long as this is done before the first year of RMD, these rolled over funds will never (under current law) be subject to RMD rules.

Qualified Distributions

Another difference for the Designated Roth 401(k) account is in the definition of qualified distributions.  As with other retirement accounts, qualified distributions can occur when one of the following events occurs:

  • account owner reaches age 59½; or
  • account owner dies; or
  • account owner becomes disabled (per IRS definition).

In addition to one of those events, in order for the distribution to be qualified (and therefore tax-free), the account must have been in existence for at least 5 years.

Non-Qualified Distributions

A non-qualified distribution is, as you might guess, when the rules for a qualified distribution (above) have not been met.  Of course, there are complicated rules associated with any non-qualified distribution from a Designated Roth account.

Pro Rata Rule for Non-Qualified Distributions

A pro rata rule applies (instead of the ordering rules that apply to Roth IRA accounts) for non-qualified distributions.  For example, if the account had received contributions of $5,000 and had grown to $10,000, when a distribution occurs before the account has been in existence for 5 or more years, 50¢ of every dollar will be taxable.  This is different from the rule associated with a rollover, as you’ll see.

Ordering Rule

Just to confuse matters, when rolling over a portion of a Designated Roth 401(k) account to a Roth IRA in a non-qualified distribution, ordering rules apply, so that the first portion rolled over is the taxable amount (the earnings).  If the rollover was a qualified distribution, all amounts are considered basis in the new account.

Rollovers

Now, let’s see how the IRS has really muddied the waters:  when rolling funds over from an existing employer to another employer’s Roth 401(k) – it’s a straightforward activity if you do a trustee-to-trustee transfer – same as for a transfer to a Roth IRA.  However (and there’s always a however in life, right?) if you do a non-qualified 60-day rollover things really get complicated.

Complications With a 60-Day Rollover

Here’s what happens with the 60-day rollover to a new employer’s Roth 401(k) plan:  first of all, only the growth (or earnings) from your old employer’s plan can be rolled over to your new employer’s Roth 401(k) plan.  In addition, the earnings portion of the account will be subject to mandatory 20% withholding, even if you roll the entire amount into the new employer’s plan, which would be a tax-free event.

Here’s an example:  your Roth 401(k) account has $20,000 in it, of which $5,000 is earnings.  You decide to roll over this account to your new employer’s Roth 401(k) plan.  If you don’t do a trustee-to-trustee transfer, you will only be allowed to put $5,000 (the earnings) into the new account.  When you take the distribution, you’d receive a check for $19,000, which is your $15,000 basis plus the $5,000 earnings minus 20% ($1,000) mandatory withholding tax.  You are allowed to put up to $5,000 into the new plan, and up to $15,000 into your Roth IRA, all tax free, even though you were forced to have $1,000 withheld.

Of course, that amount that was withheld will be available to you as a credit against your tax obligation at the end of the year, or as a refund if it caused an overpayment.

If you did a trustee-to-trustee transfer, none of this withholding or pre-tax limitation would have applied, so it makes good sense to do the trustee-to-trustee transfer whenever possible, to avoid such a situation.

5-Year Rule

Rollover To Another Roth 401(k) or Roth 403(b)

The last nuance about Designated Roth 401(k) accounts that we’ll talk about is the 5-year provision and how rollovers affect it.  If you do a trustee-to-trustee (either qualified or non-qualified) rollover of funds to a new employer’s Roth 401(k) account, the “5-year” starting date will follow your account – or rather, whichever account was established earlier will apply to those funds going forward.

If you do a 60-day (again, either qualified or non-qualified) rollover to a new Roth 401(k), the age of the new account will apply, even if the funds had been in the old Roth 401(k) for a significant period of time.  Only the taxable or earnings component will be allowed to rollover in a 60-day rollover, so the age of the account is a moot point.

Rollover to a Roth IRA

For the same situations as in the paragraphs above, but the transfers are to a Roth IRA, no matter what kind of rollover is done, direct (trustee-to-trustee) or 60-day, qualified or non-qualified, the results are the same – the 5-year holding period will be that of the receiving Roth IRA account, no matter how long the funds were held in the Roth 401(k) account.  However, each individual conversion or rollover to a Roth IRA has its own 5-year period.  This is a good reason to establish a Roth IRA immediately, to have a vehicle to receive such transfers if the situation arises.

The one wrinkle with rollovers into Roth IRA accounts has to do with taxability of the rolled over funds:  If the distribution is qualified, then all of the funds rolled over are considered basis, and when distributed for any reason the basis is tax-free (no matter the holding period).  If the distribution is non-qualified, the funds retain their original characterization from before the rollover – part is contributions (basis) and part is earnings (taxable until qualified).

So you can see some of the great benefits of doing a trustee-to-trustee transfer over the 60-day transfer – especially if the rollover is to be non-qualified.  As always, consult your financial advisor before doing any of these, just to make sure you don’t make a mistake!

* 1000 extra points to the first person who can correctly name the 3 Rothsketeers famous Roths that I’ve depicted as “hosts” for my Roth IRA articles.

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Converting Directly From a 401(k) to a Roth IRA

Jun 14th, 2009
by jblankenship.
3 comments

conversion by OnTaskBack in the olden days prior to 2008, it was against the rules to convert funds directly from a 401(k) plan (or other CODA plan, like a 403(b)) to a Roth IRA.  At that time, you were required to do the “conversion two-step” wherein you would first rollover or direct-transfer your funds from the 401(k) plan to a traditional IRA, then do a conversion from the trad IRA into your Roth IRA.  This was an unnecessarily complicated process, and the IRS logically waited until it got ridiculous and then relented listened to taxpayers, allowing a direct conversion from these qualified retirement accounts into a Roth IRA.

The process is identical to the process for converting from a traditional IRA to a Roth IRA.  You can make this conversion from your or your spouse’s:

  • Employer’s qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
  • Annuity plan,
  • Tax-sheltered annuity plan (section 403(b) plan), or
  • Governmental deferred compensation plan (section 457 plan).

You are allowed to convert all or part of the account, subject to the MAGI limitation of $100,000 that we’ve covered before, which is eliminated for 2010.  Any pre-tax amount converted must be reported as income in the year of the conversion.

The conversion can be done either via a direct trustee-to-trustee transfer or a rollover.  In general, the trustee-to-trustee transfer is the preferred method since a rollover involves making a check payable to you, which requires the payor to withhold 20% of the rollover.  Any amount that is not successfully converted within 60 days would be taxable AND subject to the 10% penalty unless other conditions applied.

So in other words, when you convert these funds over to your Roth account, in order to pay the tax on the withdrawal you’ll need to either hold out a portion and pay the 10% penalty on those funds, or pay the tax from another source.

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The “Default” Default Distribution Period

Jun 8th, 2009
by jblankenship.
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We’ve talked about all kinds of issues surrounding distribution periods, but there’s at least one more facet of distribution periods that we have not addressed just yet.  What happens when there is no designated beneficiary for the IRA account?  More specifically, what is the longest distribution period that heirs are allowed to stretch an IRA when there is no designated beneficiary?

d-wave-deep-freeze-by-jurvetsonAs with most questions put forth to the IRS, there’s more than one answer.  So, here are the answers:  5 or 15.3.  If you’re the bottom-line type, you can quit reading now.

Oh, right:  the answer is 5 years if the IRA owner died prior to his Required Beginning Date (RBD), which is April 1 of the year following the year in which he becomes age 70½, regardless of whether or not a distribution has already been taken.  The answer is 15.3 years if the IRA owner died on or after his RBD.  Okay, now you bottom-liners can go do something else.

The Messy Details

If you’ve stuck around you must be really short on things to do or terribly interested in the nuances of tax law.  In either case, I’m sure we can get together sometime and swap stories of band camp… :-)  Following are the details of these two answers, in reverse order (yeah, that’ll rock your world!).

After RBD

So, first lets review RBD:  an IRA owner’s Required Beginning Date is defined as April 1 of the year following the year in which the IRA owner reaches age 70½.  So, if you turn age 70 on or before June 30 of any particular year, your RBD will be April 1 of the following year.  If you are first able to refer to yourself as a septuagenarian on or after July 1 of any particular year, your RBD will not occur until April 1 of the second calendar year in the future.  For example, if your 70th birthday arrived on July 3, 2009, then you would have an RBD of April 1, 2011.

So, if the owner of an IRA dies after his or her RBD and there is no designated beneficiary for the account, the rules state that the IRA can be paid out to the heirs or estate over the remaining life expectency of the original owner.  At age 71 (which is the youngest age an IRA owner can be during the year of RBD) the life expectency table indicates a life expectency of 16.3 years.  Since the distributions must begin the year after the IRA owner’s passing, the life expectency would be reduced by 1, resulting in a payout period of 15.3 years.  The beneficiary(s) would be determined by an external will, trust, or the courts.

Before RBD

If the IRA owner passed away prior to RBD and there is no designated beneficiary for the account, then the default distribution period is always 5 years.

Photo by jurvetson
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