5 IRA Timing Rules That Can Derail Your Retirement

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.  

 

 

4 Questions to Ask Before Venturing Into a Self-Directed IRA

Prospective investors must understand the risks, as well as the specific rules, governing these accounts.

The stock market has posted tremendous gains during the past three years, with the S&P 500 gaining nearly 30% on an annualized basis and many more aggressive funds posting even gaudier returns than that. 

But because the financial crisis was so bruising--and because stocks have exhibited plenty of volatility since they bottomed out--many investors are still feeling lukewarm on stocks. New flows into bond funds have been robust, and investors have also been gravitating toward commodities and alternatives investments. Equity funds, by contrast, continue to see redemptions, even when you factor in relatively strong inflows into equity exchange-traded funds.

Against that backdrop, the notion of a self-directed IRA might seem promising. Such vehicles enable investors to buy into asset classes that are often outside of the purview of fund companies and brokerage firms--including non publicly traded real estate, private equity, precious metals, and partnerships and joint ventures. These investments might exhibit radically different performance patterns than stocks and bonds, a quality that bear-market-battered investors could be craving.

In some respects, all IRAs are self-directed, in that as the account owner, you're entirely in control of what you put inside of your account. And on the surface, self-directed IRAs have features that are comfortably similar to conventional IRAs that hold stocks, bonds, or mutual funds. The contribution limits are the same, rollovers from other IRAs are permitted, and you can opt for a traditional or Roth version.

Some articles about self-directed IRAs make it sound like the big brokerage firms and mutual fund companies are in an evil cabal designed to keep you out of the best-performing investments. However, investing in a self-directed IRA isn't as simple as sending a check to Fidelity or Vanguard and tuning out; instead, it's far from it. In addition to analyzing the investment merits of a prospective self-directed IRA investment, it's also important to consider how the inclusion of a single, possibly large, and undiversified investment interacts with your other holdings. You also need to be aware of the different rules governing these accounts because you could run into serious trouble if you run afoul of them.

  

Here are some of the key questions to consider before taking the plunge into the world of self-directed IRAs.

What will it cost?

If you hold stocks or mutual funds in an IRA, your costs will be pretty transparent: mutual fund management fees and any commissions you might pay to buy and sell. Self-directed IRAs charge another layer of fees because you must go through a custodian, who in turn will invest in the assets on your behalf. As a result, there's typically a setup fee for a self-directed IRA as well as ongoing administrative costs; these costs can vary widely by custodian, so you really need to do your homework. And if you choose to set up a limited liability company that your IRA invests in, thereby giving you more control over your investments, your start-up costs are apt to be even higher. Your ongoing administrative costs might be lower, however. Of course, investing in mutual funds or individual stocks isn't free, but taken together, the extra costs associated with self-directed IRAs mean that your investments will need to perform that much better than traditional stocks and funds just to pull ahead.

How does it fit with the rest of your portfolio?

 
Even if you're sold on the merits of an investment you'd like to put inside of a self-directed IRA--such as a rental property or gold bars--it's still important to consider how it fits within the context of your overall portfolio. Are you sinking a disproportionate sum of your money into a single asset? Property holdings are among the most common investments held inside self-directed brokerage accounts, and real estate guru Ilyce Glink points out that a reasonable rule of thumb is that real estate holdings--including a primary residence--should compose no more than 25% of a person's net worth.

Do you thoroughly understand the rules?

Self-directed IRAs come with a whole separate set of rules, the majority of which are designed to prohibit self-dealing, which is, essentially, obtaining use from an asset even though you're receiving a tax deferral on it. Say, for example, you buy an apartment building in a self-directed IRA, but your son is living in one of the units. You're receiving tax-deferred income on your rentals, but you're also receiving a benefit at the same time. If the Internal Revenue Service gets wind of this self-dealing, the entire sum in that IRA could be considered taxable and subject to the 10% early withdrawal penalty because you've effectively distributed your IRA holdings prematurely. Consult with a qualified legal or financial advisor to ensure that your self-directed IRA investment is on the up and up and that you're hewing to the rules on an ongoing basis.

Could an ETF accomplish the job with fewer complications?

True, self-directed IRAs allow you to invest in assets that mutual funds don't invest in, such as individual plots of farmland and residential properties on which your IRA can, in turn, earn income. However, it's worth noting that many of the asset classes that had historically been the domain of self-directed IRAs are now available in some fashion via exchange-traded funds and conventional mutual funds. Investors can now buy ETFs that invest in private equity firms, gold, and farmland, for example. Of course, such funds might not be a pure play on a given asset; for example, private equity ETFs and funds invest in publicly traded private equity firms. But the fund format provides more diversification potential than you'd be able to obtain by sinking a large sum into a single property or company as well as fewer administrative obligations and costs.  

Article by Christine Benz, posted March 12, 2012 on www.news.morningstar.com. See original article here.

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For information on how to use a self-directed IRA to purchase a franchise, visit www.theirainstitute.com.  

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success.