When it comes to IRAs, the tax rules get pretty complicated to say the least.
Here are five unusual quirks that all financial planners should know. Understanding these anomalies could come in handy, helping you save clients some serious money.
1. Military death benefits can be contributed to a Roth IRA: Help families of veterans with this one because it can make a big difference in their taxes.
The tax code allows a beneficiary of military death gratuities and Servicemembers' Group Life Insurance to contribute those funds to a Roth IRA or a Coverdell Education Savings Account. This provision applies to beneficiaries of all military personnel — not just active reservists. Importantly, the Roth contribution can be made without regard to the annual contribution or income limits that apply to those accounts. The contribution must be made by one year from the date of receipt of the death benefit. For instance, if the beneficiary received the death benefit on December 14, 2018, they would have until December 13, 2019, to make the contribution.
If your client later decides to withdraw any part of the military death benefits or SGLI payments that he or she contributed to a Roth IRA, those distributions will be tax free, even if the distribution from the Roth IRA is otherwise not a qualified distribution.
Your clients may also want to consider allocating their military death benefits to a few different uses. Some of the funds can go to a Roth, some to the ESA and some can be held out for immediate needs. That said, the total amount contributed to a Roth and an ESA cannot exceed the total amount of the benefits received. Funds are considered contributed to the ESA first and the Roth IRA second. Any excess amounts contributed would have to be withdrawn from the Roth IRA first.
Example: A client receives an SGLI beneficiary distribution of $250,000. She immediately contributes $50,000 to an ESA account for her son. The most the client could now contribute to a Roth IRA is the remaining balance of $200,000. If the beneficiary receives more than one benefit, he or she has one year from the date of receipt of each benefit to make a contribution to the Roth IRA or the ESA.
2. Inherited IRAs cannot be converted, but inherited plan funds can: An inherited IRA cannot be converted to an inherited Roth IRA. That said, an inherited company plan (excluding a SEP or SIMPLE IRA) can be converted to an inherited Roth IRA as long as the beneficiary is a designated beneficiary — meaning that the beneficiary is an individual or qualifying trust that is named on the company retirement plan beneficiary form.
If no beneficiary is named on the 401(k) beneficiary form, and, say, the deceased employee’s son inherits the 401(k) through the estate, then there is no designated beneficiary. In that case, the 401(k) cannot be converted to an inherited Roth IRA, nor can it be transferred to an inherited traditional IRA.
In addition, for the inherited plan funds to qualify to be converted to an inherited Roth IRA, or be transferred to an inherited traditional IRA, the account must be properly titled and directly rolled over to an inherited traditional or Roth IRA. The designated beneficiary should also take the first RMD by the end of the year after death to ensure the ability to stretch distributions.
If the beneficiary chooses to convert the plan funds to an inherited Roth IRA, the amount converted will be taxable the same as any Roth conversion. In addition, the inherited Roth is subject to ongoing RMDs, although they will likely be tax free.
Planning tip: If your client inherits a 401(k) and is considering converting those 401(k)s funds to an inherited Roth, first see if the client has his own IRA or plan funds that can be converted. Either conversion (the inherited plan funds or his own retirement accounts) will be taxable, but if there are limited funds to pay the conversion tax, first have the beneficiary convert his own IRA to a Roth, rather than the inherited plan funds. Why? If he converts his own IRA to a Roth IRA, then this is his own Roth IRA and will not be subject to lifetime RMDs.
In addition, after death he can leave that Roth IRA to a spouse who can roll it over to her own Roth and continue avoiding lifetime RMDs, or he can leave it to some other designated beneficiary who can stretch the inherited Roth over a longer period. If he converts his inherited plan funds to an inherited Roth IRA, then that inherited Roth IRA is subject to RMDs beginning in the year after death. This would erode the inherited Roth more quickly. Even though he can convert the inherited funds, he should use the money available to convert any of his own IRAs to a Roth first, and keep that Roth free of RMDs for life.
3. Once-per-year IRA rollover rule applies to spousal rollovers: This one can easily catch surviving spouses off guard and end up negating a spousal rollover.
Under the once-per-year rule, an IRA owner can only do one IRA-to-IRA or Roth IRA-to-Roth-IRA rollover within 365 days (not a calendar year). IRAs and Roth IRAs are aggregated for this rule. For example, if you do a rollover from one IRA to another IRA, then you cannot do another IRA rollover from any other IRA or Roth IRA for one year. These are the so-called “60-day rollovers” where the funds are received by the IRA owner as opposed to a direct transfer (which is not subject to either the once-per-year rule or the 60-day rule).
Of course, the direct transfer (a trustee-to-trustee transfer) is the recommended way to move IRA funds to avoid these problems, but many clients still do the 60-day rollovers, and especially spouses who inherit, because that is what they are usually advised to do.
If the once-per-year rule is violated, the distribution cannot be rolled over and all of the pre-tax IRA funds become taxable. There is no way to correct this because the IRS does not have the authority to do so.
This can have serious consequences after death when a spouse inherits more than one IRA and wants to do spousal rollovers for each inherited IRA. The IRS ruled, in
The inheriting spouse can only do one IRA-to-IRA 60-day rollover within a year. If that surviving spouse inherits, say, a Roth IRA and a traditional IRA and does spousal rollovers for both within a year, only the first of those rollovers will be valid. The other one will result in a distribution with no chance of being rolled over in the future. The funds will no longer be IRA funds. This is an easy trap to fall into when a client dies with several IRAs and the spouse is the beneficiary of each of them. Avoid this problem by only doing spousal rollovers as direct transfers for each IRA inherited by the spouse.
4. Early withdrawal penalties apply even when there is no income: Early IRA or plan withdrawals can be subject to a 10% penalty if no exceptions apply. Some clients who need the funds have low or even no income and think that the 10% penalty won’t apply. But as Matthew Nasuti found out in tax court, that is not the case, (Matthew James Nasuti v. Commissioner, U.S. Tax Court, No. 2560-11, July 18, 2012).
Matthew Nasuti was terminated from his job in 2008. While he was unemployed, he took a $19,030 early distribution from his IRA and used the money to help pay his living expenses. He did not, however, report the 10% early distribution penalty. Among other reasons, he argued that because his adjusted gross income was negative for 2008, the IRS was prevented from assessing the 10% penalty. That is not so.
The Tax Court decided against Nasuti and stated that the 10% penalty applies to the amount of the early distribution that is required to be added to his gross income and is completely independent of any other income tax that is due or not due.
The 10% penalty is an additional tax. It is related only to the amount of the early distribution. It is calculated separately and added to any income tax due, even if no other income tax is due or if a client had negative income.
Another quirk to the 10% penalty: One of the lesser-known exceptions to the 10% penalty is for an IRS levy. If the IRS levies a client’s IRA or plan funds, there is no 10% penalty — but only if the IRS takes the funds. The exception does not apply if the client voluntarily withdraws retirement funds and uses those funds to pay the IRS.
Years ago, we had a client who owed a large amount to the IRS and had no other funds to pay the tax other than his IRA. We advised him not to withdraw from his IRA but instead to let the IRS levy his IRA and take the funds from there. That move saved the client more than $50,000 using the levy exception to the 10% penalty. If he had withdrawn the funds himself, he would have owed the penalty.
In a recent tax court case (
5. IRA contributions for deceased IRA owners: This scenario is a common one that comes up each year at tax time. A client has earned income this year, so he qualifies to make an IRA or Roth IRA contribution, which can be made up to April 15 of next year. But then he dies before making the contribution.
He had the qualifying income, so can the IRA contribution still be made on his behalf, after death? The IRS says no.
The IRS ruled years ago that you cannot contribute to an IRA for a person who has passed away (private letter ruling 8439066). The reasoning behind that position, in case you are wondering, is the IRS felt that deceased people don’t need to fund accounts for their retirement. You can’t argue with that logic! However, the same is not true for SEP and SIMPLE IRAs. These can still be funded after the client has died, assuming they are otherwise eligible.
It’s just something to know, in case a client (or their accountant) asks about this issue at tax time.
