My thanks for Natalie Choate for analyzing and pointing out the following information.  Ms. Choate is truly a rock star in the world of IRA law, and much gratitude is owed to her by those of us in the financial community for her thorough analysis and commentary that she provides on such matters as this.

If you live long enough, you’re liable to see just about anything… the following is an example of the most extreme example I’ve ever heard of for using the tax law to your own advantage, deliberately flaunting the law for purposes of evading tax.

The Facts

If you intentionally over-fund your Roth IRA, above the amount that you’re allowed to contribute for the tax year.  The tax law allows you to remove the excess contribution by October 15 of the year following the year of contribution.  If you do not remove the excess contribution (and the gains associated with it) by that point, you will be subject to a 6% excise tax on the excess contribution until the situation is rectified.

The situation can be rectified by either crediting the excess contribution to a future years’ contribution, or by withdrawing the excess amount prior to the deadline for the following year.  Each year that you do not rectify the over-contribution you will be subject to the excise tax.

The Anomaly

If you do not remove the excess contribution and the growth associated with it by October 15 of the year following the year of contribution, once you’ve been assessed the excise tax, your rectification is only required to the extent of the excess contribution – not the growth associated with it.  The growth is no longer considered (under present tax law).  In other words, you can rectify the excess contribution at that point by simply removing the excess, but the growth doesn’t have to be removed.

If you’re following the way this is working, you’ve probably figured out the gist of the “idea” we’re talking about here.

The Terrible, Terrible Idea

Here’s an example of the bad idea in play:

Let’s say you have no Roth IRA at all, but you have $20,000 that you’d like to invest.  Furthermore, you don’t have compensation that would make you eligible to contribute anything to a Roth in the first place.  Ignoring all convention, you open an IRA and contribute the $20,000, investing it in the latest hot stock.  October 15 the following year rolls around, and your hot stock has doubled in value.  (It should be noted that if your hot stock didn’t do so well, such as losing money, you could pull it out now and walk away with no consequence.)

Under the normal conventions, you could withdraw the entire $40,000 (your contribution plus your gain), but you’d have to pay ordinary income tax on the gain of $20,000.  Doing this, you’d avoid the excess contribution 6% excise tax, $1,200.

However, in this terrible, terrible idea, you decide to wait until after October 15, and pay the excise tax on the over-contribution.  Now you have three choices:

• If you’re otherwise eligible for contributions to the Roth in the current year, part of the excess contribution can be used (credited) as a regular contribution.  You would then be subject to the excess contribution tax on the remainder of the over-contribution until it’s been used up by future credits (this is one of the right things you could do).
• If you’re not eligible for the contributions, you could withdraw the excess contribution at this point, along with the growth in the account, paying ordinary income tax on the growth.  This is the other right thing you could do.
• If you’re up for a challenge (and possibly jail time), you could withdraw only the excess contribution and leave the growth in the account to grow tax free for the rest of your life.  It probably won’t do you a lot of good in Alcatraz, though.

The Reason This is a Terrible Idea

The IRS is never in favor of kooky tricks like this that don’t work as the law intended.  So what might happen?  Well, the IRS could review your IRA account and disqualify it completely, on the basis that the custodian should never have allowed the excess contributions in the first place.  In this manner, you’d be subject to tax on the growth in the account and the whole account would be null and void.  Your IRA custodian is likely to be in hot water as well, as this would be a violation of the basic rules of IRAs.

Since the entire concept of the ability to withdraw the excess contribution is designed to help taxpayers resolve an honest mistake, abusing this provision is likely to be soundly disallowed.  If the facts were known, (which they would be discovered eventually), the IRA is likely to be disallowed completely, and the abuse is likely to carry with it severe penalties.

The IRS doesn’t presently have remedy for the situation – and in the case where you honestly make a mistake and elect to leave the funds in the account (crediting against the current year, as in the first bullet point above) – it wouldn’t be too much of a leap for the IRS to disqualify distributions from the gains.  This would become especially so if the activity I’ve described becomes a rampant abuse.

It’s best to follow the rules as intended and leave well enough alone.

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As you know (if you’re read the article about Penalties for Changing SOSEPP) it can be costly to you if you make a change to your SOSEPP once you’ve set it up.  The good news is that a Roth Conversion is NOT considered a “distribution for purposes of determining whether a modification”, and therefore in itself will not trigger a loss of the penalty-exempt status of the SOSEPP.

What does happen then, in such a circumstance?  Well, that’s when things go into the “it depends” category, followed closely by a whole lotta “no guidance from the IRS”.

If you have converted the entire balance of your IRA that is subject to the SOSEPP to a Roth IRA, you will be required to continue taking your series of payments from the new Roth IRA just the same as if they were still coming from the traditional IRA.  If you don’t, you will most likely be subjected to recapture of the penalties on the earlier SOSEPP distributions, unless you’ve reached the end of the distribution requirement period – five years or age 59½, whichever is later.

On the other hand, if you’ve only converted a portion of the traditional IRA to a Roth IRA, this is where it gets murky.  The IRS has not provided definitive guidelines on exactly how you handle the SOSEPP from here… it is abundantly clear that you must continue your series of periodic payments until the end of the distribution period.  What’s not clear is if you must continue taking the payments from the remainder of the traditional IRA, or from the Roth IRA, or proportionately from both accounts, or in any amounts you choose from either account, as long as the amount is proper to fit the bounds of your SOSEPP.

The best way to deal with this situation would be to convert the entire account if that’s feasible.  If it’s just not feasible, then you should ask for a Private Letter Ruling from the IRS – especially if we’re talking about sizeable amounts (you be the judge).  If the possible tax and penalty is relatively minor, I’d suggest taking proportionate amounts from the trad and Roth IRAs until the SOSEPP distribution requirement period ends.  Make sure that you keep documentation on all of these transactions – you’ll need it if the IRS comes a-callin’.

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If you look at the article Creditor Protection for Retirement Plan Assets, you’ll see that IRAs in general have protection from creditors in the case of bankruptcy, up to $1 million.  On the other hand, separated rollover assets from a 401(k) or other ERISA-protected account enjoy indefinite protection from creditors.

Rolling over the ERISA-protected funds into an account that contains contributory IRA funds (that is, an IRA that you have made deductible or non-deductible contributions to) automatically removes the ERISA protection and therefore the indefinite protection from creditors.

So it may make sense for folks who could be impacted by this protection (or rather the removal of the protection) to maintain separate accounts for rolled-over ERISA funds.  This would be anyone whose total IRA account is (or may become) over $1 million – and regardless of whether or not you think bankruptcy is a possibility.  In today’s sue-happy world, unusual circumstances could creep up on you at any moment and put you in the position where you might need this protection.

It’s very important to note that this protection only applies to actual bankruptcy – if you’re merely being sued by a creditor and you haven’t declared bankruptcy, your protection depends on federal non-bankruptcy law and state law.  The article mentioned at the outset includes links to state law information with regard to these kinds of situations.

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Rolling IRA Money into a 401(k) to Avoid RMD

This is a somewhat narrow slice of folks, but as the population and workforce ages, there are bound to be people that this will be available to.  Here’s how it works:

If you are age 70½ or older and you have an IRA, you will be required to take a distribution from your IRA each year.  However, if you are still working and have a 401(k) plan available to you, you can avoid having to take these RMDs until the year that you retire.  If your 401(k) plan allows it (and today most plans do), you can rollover your IRA account into your 401(k) plan.

This is possible because 401(k) plans (and other Qualified Retirement Plans such as a 403(b) or a 457) don’t require you to start RMDs while you are still working.

So, if you don’t need the RMDs to live off of, you can eliminate the requirement by rolling over those funds into your 401(k) plan – and then begin taking RMDs upon your retirement.  At that point you can also roll the funds back into an IRA as you see fit.

Of course, this shouldn’t be the only factor that you consider – you should also look at the inherent costs in your 401(k) plan, along with your investment choices and any plan-specific issues that may cause a problem for you with the rollover.  In general though, this is a pretty good move for folks who happen to fit the criteria.

One last thing – if you happen to own the company that you work for (or own 5% or more of it), you can’t roll your IRA money into that company’s 401(k) plan.  It’s just one of those IRS things…

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However, in some cases your old 401(k) plan may have access to desirable investments that you couldn’t otherwise access, or possibly you have access to other benefits from participation, such as availability of a financial advisor.  As long as the overall costs remain low in the plan, you might want to leave the funds there.  Plus there are also some additional benefits inherent within 401(k) accounts that are not available to IRAs – you can read up on the reasons to leave your money in the 401(k) in the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k).

On the flip side, there are certain things that you can’t do in a 401(k) (or other Qualified Retirement Plan) that you can ONLY do with an IRA while you’re under age 59½.

IRA-Only Options

With an IRA, there is no penalty for withdrawal for (click the link following each for more detail):

• Health Insurance Premiums while unemployed – §72(t)(2)(D)
• Qualified Higher Education Expenses – §72(t)(2)(E)
• Qualified First-Time Homebuyer Expenses – §72(t)(2)(F)
• Qualified Reservist Distributions – §72(t)(2)(G)

And none of those are available without penalty from your 401(k).  Of course you would have to pay tax on the distribution, but otherwise you can take the money for those purposes.

In addition, setting up a Series of Substantially Equal Periodic Payments (SOSEPP) is generally easier to qualify for and to set up from an IRA than from a 401(k), so this may be an additional reason to consider rolling over.

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In a case like this, although the intent of the original owner could still be met by distributing the account as the original beneficiary designation directs, but there may also be cases where the intended heirs think otherwise and would prefer to direct the assets to the surviving spouse.  It could be important from a tax standpoint since the surviving spouse has the unique option to transfer the account to his or her own name as owner, potentially allowing for deferral of taxes for many years. There could be many reasons for this to happen, but the point is that the situation could and often does arise.  How can this be accomplished to the best interest of the surviving spouse?

After Life Actions

If the account is directed to the estate or a trust and the surviving spouse is entitled to an elective share of the estate or the trust, the IRA could be chosen as the surviving spouse’s share – and thereby available to the surviving spouse.

Another option for the account that is now owned by an estate or trust with spousal and non-spouse beneficiaries is that the non-spouse beneficiaries could disclaim their portion(s) of the estate or trust, leaving the spouse as the only beneficiary.

While there are ways around the issue, this definitely doesn’t take the place of proper estate planning, by any means.  You’re always better off if you make the proper moves before death, so that there is no question about your intent and who your beneficiary should be.

Important Notes

It is important to note that the IRS doesn’t have an official position on these matters with regard to how and when the surviving spouse who wasn’t specifically named as the beneficiary may be able to utilize the inherited IRA as an owned IRA (in his or her own name).

There are many Private Letter Rulings (PLRs) that address these situations – and the consensus from those PLRs seems to be this:  if the circumstance is that the surviving spouse has sole ownership and rights to assign the account and/or distributions to himself or herself, then usually the IRS allows transfer to an owned IRA (rather than an inherited IRA).  If the anyone other than the surviving spouse has rights or control ownership, then the IRA is considered to have been transferred from the entity (the trust or the estate) and is not available to him or her as an owned IRA, only as an inherited IRA.

As with all PLRs, these cannot be used to support your own position with regard to an action you might take, only as guidance in determining a course to consider.  You will need to get your own PLR if your situation is unusual and not covered by the IRS in any other way.

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The trick to all of this is to know how much to have in each kind of account… of course there are no hard and fast rules to determine what’s the best percentage to have in each kind of plan, but below is a discussion of some of the factors that you should consider as you balance out your tax treatment.

Early in life…

Early in your investing career it probably makes the most sense to load as much of your savings into your 401(k) or other tax-deferred savings vehicle as possible, in order to maximize the benefit from tax savings up front.  The biggest reason for this (beyond the tax savings) is so that you take advantage of your employer’s matching benefit, along with deferring taxes on your income as it increases over time.

Later in your career when your income is higher, maximizing contributions to tax-deferred accounts will have a greater benefit to you from a tax savings standpoint – and this is assuming that you expect for the taxes you’ll pay later (during retirement) will be lower due to your diversification of tax treatment.

Also early in your investing career, as your income supports it you should begin making contributions to your Roth IRA as soon as possible.  This is partly due to the restrictions on income around investing in Roth IRAs – but mostly because you are paying tax at lower rates (in your lower-earning days) than you might later on in your career when your income increases.

And then on top of it all, when your income has grown to a point that you can maximize the other options (401(k) and Roth), you should begin investing in an account that is treated by capital gains tax (primarily).  This will give you the third leg of the tax-diversification stool.  Since capital gains are (presently) taxed at a much lower rate than ordinary income – which is what your IRA or 401(k) distributions are taxed at – it makes a great deal of sense to have some of your money invested in these accounts as well.

Later in life…

Later on in your life, as you reach that point where you will have to begin taking Required Minimum Distributions (RMDs) from your IRA and 401(k) accounts, it might make sense to take significant portions of those accounts and either convert them to Roth accounts or capital gains taxed accounts.  The preference would be to place the funds distributed into a Roth IRA, especially if you are in a position where you will not need access to the funds for some time and therefore can benefit from the tax-free growth of the account.  But you may also want to balance those conversions to Roth with some non-tax-deferred investments as well – because you never know what may happen with the tax code.

It’s (very!) possible, given the government’s need to increase tax revenues to pay for things like the health care initiative, that there could be changes in the works for how tax-deferred plans are taxed.  Just a few options that have been put forth in recent memory include:

• extra taxes on IRA assets (this was in place back in the mid-80’s)
• changes to the minimum distribution rules to require faster distribution or to eliminate “stretch” capabilities
• adding investment restrictions, such as requiring a portion of IRAs to be invested in “socially responsible” investments
• nationalization of retirement accounts – e.g., governmental takeover of all IRA and 401(k) plans in exchange for a superannuization plan like some socialized countries use

Yet another option, especially if you have very few assets outside your IRAs and 401(k) plans, you can reduce your taxable estate (when we have an estate tax again, that is) by taking extra distributions from your IRA or 401(k) and making gifts to your children and grandchildren.  You could place the assets in a trust that represents a completed gift, or give the money directly to your future heirs – this way you are able to see your children and grandchildren enjoying the fruits of your labors while you’re still living.

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Actions for Dealing With an Over-Contribution

You have three options for dealing with the over-contribution situation:  you can pull the over-contribution out; you could also re-characterize the contribution; or you could do nothing.

Pull the over-contribution out. This is known as a corrective distribution.  Essentially this is exactly as it sounds:  you pull out the money that represents the over-contribution, plus (here’s the wrinkle) any growth or income attributed to the over-contribution.  You need to do this by the due date (including extensions) of the tax return for the year of the contribution… In this case “due date” has a special meaning:  if you filed your return on time (including extensions) this means October 15 of the year following the year of the contribution, even if you did not use an extension; however, if you did not file your return on time, the deadline is (was) April 15 of the year following the contribution year.

So if you contributed a total of $1,000 more than you were eligible for to your IRA, and there was growth and income of $200 attributable to the over-contribution, you need to withdraw $1,200 before October 15 of the year after your contribution year.  And, you’ll need to pay ordinary income tax on the $200 of earnings – plus 10% in early distributions penalty.  Of course if you didn’t file your tax return on time, (actually if you plan to not file your tax return on time) you need to pull out your over-contribution by April 15.

Recharacterize. This method resolves an over-contribution to a Roth IRA, by changing the character of the contribution to a traditional IRA instead of a Roth IRA.  This can only be done if you’re eligible to make a contribution (either deductible or non-deductible) to a traditional IRA (you meet the income, other plan coverage, and age limits).  To do this you submit Form 8606 to the IRS indicating a change to the over-contribution amount, plus or minus any earnings or losses that have occurred attributed to the over-contribution, from Roth to traditional.  This has the same deadlines mentioned above for the corrective distribution.

Do nothing. In essence you’re not exactly doing nothing – you’re accepting the fact that the over-contribution occurred, and you’ve chosen to accept the consequences.  The consequences are that for any amount you’ve over-contributed, you are subject to a 6% penalty for excess contribution.  This may be the best course of action if the over-contribution can be absorbed as a contribution in the following year.

As an example, maybe you made a contribution to your Roth IRA of $5,000 for the year, and it turns out that your income level only allows a contribution of $4,800 – something you didn’t discover until it was too late.  The consequence is that you’ll owe a penalty of 6% – $12 total – on the over-contribution of $200.  As long as you are eligible to contribute at least $200 to your Roth IRA in the following year (and you don’t over-contribute again), you can pay the penalty and leave the money where it is.

Unfortunately, if the over-contribution amount in question is large, this method doesn’t really help much.  This can be the case if you’ve mistakenly rolled over an inherited IRA into your own IRA instead of an inherited IRA – and you’re a nonspouse beneficiary.  If you don’t catch it in time, you will be subject to the 6% penalty for the year of the rollover and every subsequent year thereafter until you distribute the IRA.  When you finally catch the mistake (or rather, the IRS catches your mistake, more than likely), you’ll be subject to ordinary income tax (and retroactive penalties and interest) on the entire distribution as well, since you effectively treated the IRA as your own money from the very start.

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In reviewing whether or not a Roth IRA conversion in 2010 makes sense and furthermore whether you should spread the tax over the next two years, you need to consider what the tax cost is for a conversion in 2010, weighed against the costs you’ll experience if you spread the tax over 2011 and 2012.

Unfortunately we often shortcut the analysis by only taking the marginal rate on the income including the conversion and calculate the tax – this would give you an erroneous result, since our tax system includes graduated tables.  I’ll illustrate this below.

How to Properly Calculate the Tax

The only way to ensure that you are working the tax numbers out correctly is to work through the operation as if it were on your tax return.  The table below shows a simple example of an individual with a fixed income contemplating a Roth Conversion of $75,000 paying the tax in 2010, and the second and third columns analyzing paying the tax in 2011 and 2012.

Since the marginal rate for the example is 25% for all three years, you might mistakenly believe that 25% is the rate that you should apply to the entire conversion, which would give you an erroneous result.  Since the Actual Rate on the conversion is just a bit lower for the spread years versus 2010, there is an advantage to spreading the tax instead of paying it in 2010.  It’s not a huge difference, $760 in this example, but it’s a difference nonetheless.

Keep in mind that this is only an example, and that the 2011 and 2012 tax tables and other provisions are guesses at best.  But the point is that you shouldn’t make assumptions about tax costs for conversions and the spread option – it’s best to make sure that you work your way through the returns to see the results in the “real world”.

In addition, this particular analysis is only reviewing the tax cost to help decide whether spreading the tax over 2011 and 2012 is beneficial – there are a great many other factors to consider when doing analysis of a Roth Conversion beyond this.  Make sure your analysis is thoroughly considering all of the factors before proceeding.  And get professional help if you need it.

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Hold on there, cowboy!  There’s a problem with your kooky little scheme – the IRS has planned for just such an eventuality.  Effectively, any amount that you withdraw from your Roth IRA that is not previous contributions or conversions, will be subject to tax in the year that you withdraw it, until you’ve paid the tax on the conversion.  This is in addition to the amounts that you owe tax on during that year due to your election to spread the tax.  Gobbledygook, right?  Right – howza bout an example?

An Example

You have an IRA worth $100,000, and in 2010 you decide you’d like to convert it to a Roth IRA.  You have an existing, five-year-old Roth IRA, with $20,000 in it.  In 2011, you withdraw $30,000 from the Roth IRA.  At the end of the year, instead of owing tax on $50,000 (half of the conversion amount of $100,000), you actually owe tax on $60,000.

This is calculated as:  your withdrawal was $20,000 from earlier contributions, and $10,000 from the conversion.  That $10,000 must be added to the previously-agreed-upon $50,000 amount that you knew you’d owe tax on for 2011.  And then in 2012, you will owe tax on the remaining $40,000 from the conversion.

So, in other words, the IRS has determined that this two-year tax deferral is not going to be used as a tax-free method for achieving tax-free withdrawals from your IRA – once the amounts have remained in the account until 2012, any amount can be withdrawn without tax.  But of course, you’ve already paid the tax on the conversion by that point (or rather, you will by tax day in 2013).

So what happens if you withdraw the funds in 2010 after converting earlier in the year?  Effectively this is treated as a distribution from your original IRA (actually recharacterized from the Roth conversion), so you’d owe tax on that amount in 2010, and the remaining amount would be split between 2011 and 2012.

The “Hole”

I suppose that technically there is a time period where you could have access to 100% of the funds having paid zero tax:  between January 1, 2012 and April 15, 2012, when the tax bill is due for the first half of your conversion amount.  So you have three and a half months to unleash your devilish scheme on the world… not sure what you’ll do with this information, but perhaps there is some advantage that you might receive by leveraging the amount.  I doubt there’s much advantage to be had, especially given the loss of deferral if you withdraw the funds, but maybe you have a plan.  Go to town!

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