Get familiar with IRA dates, ages — or risk your savings
Owning an IRA is one thing. Knowing the rules about IRAs is
entirely different. And not knowing those rules can cost you dearly.
“IRAs
are extremely complicated and it’s relatively easy for the average IRA account
owner, and their financial adviser for that matter, to make simple, but very
costly mistakes,” said Jeffery Levine, an IRA technical consultant with Ed
Slott and Company.
IRA
account owners need to be aware of all sorts of different dates, ages and
“clocks.” When it comes to IRAs, timing is everything.
“Unfortunately
though, the tax code isn’t exactly friendly when it comes to timing issues,”
Levine wrote in the current issue of Ed Slott’s IRA Advisor newsletter.
Here’s
a look at the five timing issues with which, according to Levine, advisers and
IRA account owners seem to have the most problems.
1. The age-55 penalty exception
In
general, unless an exception applies, IRA owners must wait until they are 59½
to withdraw IRA funds without penalty (the 10% early distribution penalty). The
age 59½ rule is based on the IRA owner’s actual age and not the year in which a
client turns 59½, Levine wrote.
One
exception is “the age-55 exception.” Participants in workplace retirement plans
who separate from service in the year in which they turn 55 or older can take a
distribution from their company retirement plan without having to pay the 10%
early withdrawal penalty. They must pay income tax on the distribution, but
they do not owe the 10% additional tax that the Internal Revenue Code imposes
on most withdrawals before age 59½.
For
the purpose of this rule, the applicable year is a calendar year in which a
person turns 55, and not 365 days.
Of
note, this age-55 exception only applies to company retirement plans and not to
IRAs, even if plan funds that would have otherwise met the age-55 exception are
rolled over to an IRA, Levine wrote. So if you want to avoid the 10% penalty,
take the money before rolling it into an IRA.
Trying
to make sense of all this? Don’t bother. In a recent court case, a judge ruled
against an IRA account owner who quit his job, rolled the money from his
company retirement plan into an IRA, and then took a distribution from the IRA
without paying the 10% penalty. The IRA account owner argued that he didn’t owe
the 10% penalty; the judge ruled otherwise.
“Why
should it matter that the money went from the [worker’s company] plan to an IRA
before being withdrawn?” the judge wrote in his decision.
“The
answer is that the Internal Revenue Code says that it matters…Many parts of the
tax code are compromises, and all parts reflect the need for lines that can’t
be deduced from first principles,” the judge said. “Why can an employee
withdraw money from an employer’s plan without the 10% addition at age 55 but
not age 54? Why does the 10% additional tax apply to withdrawals at age 59 and
181 days, but not 59 and 183 days? These questions cannot be answered by logical
analysis. The [Internal Revenue] Code’s lines are arbitrary.”
2. The five-year rule for 72(t) payments
According
to Levine, 72(t) payments — also known as SEPPs or SOSEPPs for “series of
substantially equal periodic payments” — are distributions from an IRA that
allow owners under 59½ to access money penalty free. With a 72(t), you take
equal distributions from your IRA for five or more years or until you reach
59½.
But
the 72(t) schedules can be doubly confusing since there are two separate time
frames to keep track of.
“In
order to successfully complete a 72(t) payment schedule and avoid back
penalties and interest, the schedule must continue for the longer of five years
or until the [IRA account owner] reaches 59½,” Levine wrote.
For
this rule, the age 59½ requirement is the IRA account owner’s actual 59½
birthday, he said. The five-year requirement is a full five years from the time
the first 72(t) payment is distributed.
3. The five-year rule for Roth IRA conversions
On
paper, Roth IRAs are relatively easy. In reality, not so much. Case in point:
According to Levine, many advisers and Roth IRA account owners struggle to
figure out what is taxable and what might be subject to penalties with
distributions from a Roth IRA.
“Given
the fact that there are actually two separate Roth IRA five-year rules, it’s
not too difficult to understand why,” Levine said.
For
instance, one five-year rule applies only to Roth IRA conversions. Under this
five-year rule, Levine wrote, penalty-free distributions of Roth conversions
may be made at the account owner’s actual attainment of age 59½ or after five
full years, whichever is sooner. A separate five-year period is established for
each conversion.
The
actual attainment of age 59½ is pretty straightforward. But what makes this
rule a little tricky is the five full years requirement.
For
instance, one might think that if a conversion is completed on May 10, 2012,
the five full years would be up on May 10, 2017. “But if one thought like that,
one would be wrong,” Levine said.
“The
subtle wrinkle that throws many account owners and advisers off is that while
the five years must indeed be five full years, you don’t begin counting on the
date the conversion is completed. Instead, the starting date for the five years
— when the five-year clock begins to tick — is January 1 of the year the funds
are deposited in the Roth IRA.”
As
a result, he said, “even though a separate five-year period applies to each
Roth conversion, multiple conversions made in the same calendar year have a
common clock since they share the same January 1 start date.”
4. Five-year rule for Roth IRA qualified distributions
The
beauty of Roth IRAs is this: Qualified distributions are tax- and penalty-free.
The key to whether a distribution is qualified or not is this: The distribution
must be made five full years after an account owner establishes his first Roth
IRA, and either the account owner is age 59½, or disabled, deceased (the
account is inherited by a beneficiary), or the distribution is for the
first-time purchase of a home.
Here
again, attainment of age 59½ is the account owner’s actual age 59½. “But to be
a qualified distribution that’s only half the equation,” Levine wrote. “The
account owner must also complete the five-year requirement. Remember, this
five-year rule is a different five-year rule than the five-year rule for
conversions, although they do share some similar aspects.”
There
are several key differences. “One difference is that the five-year clock for
qualified distributions can, in some cases, begin to tick on January 1 of the
year before the first dollars are actually contributed to a Roth IRA,” Levine
wrote.
How
can that be, you might ask. “A contribution to a Roth IRA will start the Roth
qualified distribution clock ticking on January 1 of the year the contribution
is made for, which is not necessarily the year the contribution is made in,” wrote
Levine. That’s because Roth contributions can be made up until April 15 of the
year after the calendar year it is being made for, he wrote.
Another
important difference between the two rules is that the five-year rule for
qualified distributions carries over to all future Roth IRA accounts. “Separate
clocks are not needed,” wrote Levine.
5. The timing of non-spouse beneficiary RMDs
In
general, a non-spouse beneficiary must begin taking required minimum
distributions or RMDs by Dec. 31 of the year following the year of the IRA
account owner’s death, said Levine.
“However,
when an IRA owner dies after reaching their required beginning date and has not
taken their RMD for the year, the beneficiary or beneficiaries must take what
would have been the IRA account owner’s RMD by Dec. 31 of the year of death,
not the year following the year of death,” said Levine.
Resources
There
are many other IRA timing issues about which you should be concerned. There’s
the age 70½ rule for RMDs for IRAs, the age 70½ rule for qualified charitable
distributions, and the once-per year IRA rollover rule to name but a few. The
key to avoiding penalties is getting a handle on these rules well before making
any decisions about your IRA.
When
it comes to learning about these IRA timing rules, your resources are, sadly,
few and far between. One website, IRAhelp.com,
is operated by Slott’s company. That website has a directory of advisers
who have received training about IRA distribution rules.
Books
include An IRA Owner's Manual by Jim Blankenship
and Life & Death Planning for Retirement Benefits
7th Ed. 2011 by Natalie B. Choate.
Of
course, there’s always the IRS’s website, which offers IRS Publication 590,
among other resources. Read
Publication 590.
After
that, our best advice is this: You’d be ill-advised to make any IRA moves
without being 100% certain that your timing is perfect.
Robert Powell is editor of Retirement Weekly,
published by MarketWatch. Robert Powell has been a journalist
covering personal finance issues for more than 20 years, writing and editing
for publications such as The Wall Street Journal, the Financial Times, and
Mutual Fund Market News. Read original article here.
For information on how to purchase a franchise using funds from a self-directed IRA, go to the website for The IRA Institute here.
