Is your Traditional IRA or Roth IRA following all the rules? You may assume the answer is yes, but IRA mistakes are far more common than you may realize, and the IRS is gearing up to investigate and penalize them accordingly. The Wall Street Journal reports that in 2006 and 2007 the IRS let about $286 million in penalties go uncollected, and by October 15 it will present a report to the Treasury Department on how it plans to crack down on future mistakes. This means that the time to get your IRA in order is now!
The most common IRA mistakes come from three areas: contributions, distributions, and inherited IRAs. Keep reading to learn about some of the ways people trip up in these areas and how to avoid them!
Contribution Limits
The contribution limit for 2012 for both Traditional and Roth IRAs is $5,000 per person, or $6,000 if you are age 50 or older. If you have more than one IRA, the contribution limit applies to all of your accounts taken together. Remember that there are income limitations on contributing to a Roth IRA, so you may not qualify to contribute the full amount.
An “excess contribution” is made when you contribute to a Roth IRA despite having too high an income or when you contribute more than the annual limit to either a Roth or Traditional IRA. The penalty on excess contributions is 6 percent of the extra amount deposited; this may not seem like much, but if the account has several years of excess contributions the penalties can add up very quickly! An excess contribution can also be triggered when transfers or rollovers are not done correctly, meaning that the entire balance transferred could be hit with a 6 percent penalty.
So remember to roll over your IRA directly between institutions, or, if you decide do it manually, keep in mind that you have only 60 days to do so or you will pay regular income tax and, if you’re under 59.5, a 10 percent penalty. Excess contributions are a surprisingly big source of potential revenue for the IRS: It’s estimated that in 2006 and 2007, excess contributions to IRAs amounted to about $1.6 billion!
Required Minimum Distributions
Mistakes in distributions also often come from mismanagement of Required Minimum Distributions (RMDs), which are the mandatory drawdowns from your Traditional IRA that start when you reach 70.5 years of age. Your minimum distribution is your account balance as of December 31 in the year before you reach 70.5 divided by your life expectancy (provided by the IRS in Publication 590), which can be taken from one or several of your IRA accounts. The penalty on any portion of an RMD not taken is a whopping 50 percent, so it is critical that you take your distribution each year and keep tabs on the amount that you need to draw from your accounts.
Inherited IRAs
Keep in mind that there is no required mandatory distribution (RMD) on Roth IRAs unless you inherit one, in which case you’ll need to start taking distributions the year after inheritance (if the assets have been in the account for more than five years, RMDs will be tax-free). This brings us to another one of the major sources of confusion and potential penalties: Inherited IRA accounts.
If you inherit a Traditional IRA from your spouse, things are relatively simple. You can roll the account over into your own Traditional IRA, which allows you to treat the assets as your own and delay RMDs until you reach 70.5. Alternatively, you can move the assets into an inherited Traditional IRA account. In this case, if your spouse was over 70.5 at the time of death, your RMDs would start the year after his or her death, and if your spouse was under 70.5 the RMDs would be delayed until he or she would have reached that age. There are two situations where this strategy is advantageous. First, if you are older than your deceased spouse and your spouse was younger than 70.5, you can delay RMDs until he or she would have been 70.5 years old. Second, if you are younger than 59.5 and need the assets, you can begin taking RMDs the year after your spouse’s death without incurring a 10 percent early withdrawal penalty.
For Roth IRA accounts inherited from a spouse, you can also either transfer the assets into your own Roth IRA or move them into an Inherited Roth IRA. Keep in mind that withdrawals of income earned are tax-free only if the assets have been in the account for five or more years (contributions can be withdrawn tax-free anytime). The clock on the five years does not reset at the time of inheritance; in other words, you get credit for the years that your spouse held the account.
For any other beneficiary, you must begin making withdrawals from an inherited IRA the year after the person’s death, regardless of whether it is a Traditional or Roth IRA. The procedure is the same as it is for a regular RMD: You take the account balance at the end of the previous year and divide it by your own life expectancy. It does not matter how old you are when you inherit the account, the distributions must begin the year after you inherit it. Distributions from inherited Roth IRAs are not taxable, while those from inherited Traditional IRAs are taxable at your income tax rate. Keep in mind that the penalty for not making a mandatory distribution is 50 percent of the undistributed amount. It’s generally recommended that multiple beneficiaries split the account into individually titled inherited IRA accounts so that each can use their own life expectancy when calculating RMDs.
Finally, keep in mind that if the deceased hadn’t taken their RMD for the year yet, you must take the distribution and count it on your own tax return. This can be easily overlooked in the wake of a loved one’s death, but it is critical in preserving their legacy.
Conclusions
These rules can be very confusing, but taking time to understand them can help you avoid headaches and penalties in the future. For more reading on the subject, take a look at the Wall Street Journal’s article and their follow-up article on the subject. For more detailed information about what you need to know about your IRA in 2012, take a look at this article. For more details about how RMDs might affect your accounts, take a look at this comprehensive explanation of RMD rules.
Finally, talk to your tax or financial advisor about your IRA to ensure that your contributions, distributions, and inherited accounts are all in good order, and don’t be afraid to ask questions! The more knowledge you have, the more powerful you’ll be in building and preserving your retirement savings.
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To learn about retirement savings, download my free eBook, “10 Tips You Need to Know About Your IRA Rollover.” This short book is packed with critical information that will help you make the right decisions about your retirement savings.
Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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