Costly IRA Rollover Mistake – Easily Made; Impossible to Fix.

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The rules governing IRA accounts are maddeningly complex, especially the rules for inherited IRAs. I was working with a client on an issue involving the control of an inherited IRA account when I was reminded of a case that shows just how easy it is to make a mistake that cannot be fixed.

Mrs. Beech was the adult beneficiary of her deceased mother’s traditional IRA. The account was managed by a professional money management firm, Citi Smith Barney. Citi made two distributions to Mrs. Beech from the IRA – one for $2,828, and the second for $35,358. The larger distribution was made on May 23, 2008, and the check was made out to Mrs. Beech.

Mrs. Beech deposited the $35,358 into the inherited IRA with American Funds in June 2008. Mrs. Beech reported both distributions on her 2008 income tax return, and reported the smaller $2,828 amount as the taxable amount of the distribution. Thereafter, the IRS issued Mrs. Beech a notice of deficiency for income taxes due in the amount of $9,212 for the $35,358 distribution, plus penalties in the amount of $1,842. The deficiency and penalties were sustained by the United States Tax Court.

Wait a second! Mrs. Beech deposited the distribution check for $35,358 into a new inherited IRA account well within 60 days from the date the check was issued by Citi. What did she do wrong?

Amounts paid or distributed from a traditional IRA are generally includible in gross income by the recipient payee. The Internal Revenue Code (the “Code”) provides that a distribution is not includible in gross income if the entire amount of the distribution received by an individual is redeposited into a qualified IRA for the benefit of that individual within 60 days of the distribution. This redeposit is known as a “rollover contribution.”

However, rollover treatment is not available to a non-spouse beneficiary in the case of an inherited IRA. Any distribution from an inherited IRA is taxable if the distribution is paid to a non-spouse beneficiary. Under the Code, an IRA is treated as inherited if the individual for whose benefit the account or annuity is maintained acquired that account by reason of the death of another individual who was not his or her spouse.

In Mrs. Beech’s case, the $35,358 was paid from her mother’s IRA to Mrs. Beech as the named beneficiary. She then redeposited the funds into an inherited IRA account. Since the IRA account belonged to Mrs. Beech’s mother, it was deemed to be an inherited IRA for the benefit of Mrs. Beech and, therefore, rollover treatment was not available for the distribution.  The entire $35,358 distribution was taxable income to Mrs. Beech!

Mrs. Beech would not have been treated as having received a taxable distribution from an IRA, however, if the funds in the IRA were transferred directly from Citi to American Funds without her ever gaining control or use of the funds. This is commonly known as a “trustee-to-trustee transfer.”
A trustee-to-trustee transfer is the only way for the beneficiary of an inherited IRA to make a nontaxable transfer of funds in the IRA account.

What makes a case like Mrs. Beech’s so difficult is that there is no way in the Code for the mistake to be corrected. Once Citi issued the check, it became taxable income. Neither the tax court nor the Internal Revenue Service could grant Mrs. Beech any relief from the income taxes and penalties incurred for her mistake.

The lesson from Mrs. Beech’s mistake is that in every case where a non-spouse is the beneficiary of an IRA, a transfer should only be made via the trustee-to-trustee method to avoid income taxation of the transferred amount.

The case of Beech v. Commissioner of Internal Revenue can be read here.

IRA rules and regulations are extremely complex and costly mistakes can be easily made.  If you need help navigating the IRA rules and regulations, call me, I can help.

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Year-End IRA Housekeeping

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The end of the year is fast approaching, and with it several important deadlines for IRA account owners and beneficiaries. In my experience helping clients address year-end IRA matters, the following are the most problematic areas:

Required Minimum Distribution (RMD) Deadline:

December 31 is the deadline for taking RMDs from an IRA for an account owner who reached age 70½ before 2018. The RMD has to be withdrawn from the account before January 1. The account owner cannot merely request a distribution before year end. RMDs not withdrawn from the account are assessed a 50% penalty, in addition to regular income taxes. If you haven’t taken all of your RMDs yet for 2018, make sure you take them in time to avoid the 50% penalty.

RMDs for a Deceased IRA Owner:

If an IRA owner died in 2018 before all of his RMDs were taken for the year, the remaining RMDs must be paid to the account beneficiary before the end of 2018. This is not a pro-rated amount. The RMDs are calculated for the full year. This can often times be overlooked especially if the IRA owner died late in the calendar year. Undistributed RMDs from a decedent’s IRA are subject to the 50% penalty on missed distributions.

RMDs for Inherited Traditional IRAs or Roth IRAs:

A non-spouse beneficiary of an inherited IRA can elect to take annual RMDs over their remaining life expectancy. If they do, the first RMD distribution must be taken before December 31 of the year following the year of the IRA owner’s death, and then each year thereafter over their remaining life expectancy. If you are the beneficiary of an inherited IRA, you too must take an RMD before the end of 2018 if the account owner died in 2017 or earlier. Undistributed RMDs from an inherited IRA are also subject to the 50% penalty on missed distributions. This applies to the beneficiaries of Roth IRA accounts too. While a Roth IRA owner does not have to take distributions from a Roth IRA at any time, beneficiaries are subject to the same RMD rules as beneficiaries of traditional IRAs. So don’t get caught thinking you don’t have to take distributions from an inherited Roth IRA. You do!

Splitting Inherited Traditional IRAs or Roth IRAs:

If there are multiple beneficiaries of a traditional or Roth IRA account whose owner died in 2017, the account must be split into separate accounts for each beneficiary before December 31 of 2018. This is to ensure that each beneficiary gets to use his own life expectancy in determining annual RMDs for his share of the account. If the account is not split and the RMD taken before the end of 2018, the life expectancy of the oldest beneficiary will be used to calculate the annual RMDs for all of the beneficiaries. This results in younger beneficiaries paying more income taxes each year on their distribution from the account.

No “Still Working” Exception for Older and Still Working IRA Owners:

There is no “still working” exception to the RMD rules for traditional IRA owners who are still employed beyond age 70½. While an owner of a 401(k) account may work beyond age 70½ and delay RMDs from his 401(k) account while his employment continues, that same employee must take RMDs from his traditional IRA if he reached age 70½ before 2018. This includes owners of SEP-IRAs and SIMPLE IRAs.

While not exhaustive, these are the most common areas where mistakes are made.  Even if you’ve taken your RMDs for 2018, it won’t hurt to go back and review your situation and your math to avoid any negative consequences from unrealized errors.

The rules governing required distributions from IRAs are extremely complex.  The penalties for making a mistake can be severe.  If you need help navigating the year-end complexities of managing IRA distributions, please contact me.  I can help.

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You Reached Age 70½ This Year, So When Must You Take Your First IRA Distribution?

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We are approaching the end of the year and for many of you, 2017 is the first year you must begin taking a required minimum distribution from your traditional IRAs. As you may already know, the Internal Revenue Service rules require you to take a minimum distribution (known as “RMD”) from a traditional IRA each year once you reach age 70½. An RMD must be taken for the year in which you reach age 70½. The IRS rules allow you to delay that first RMD from your IRA to no later than April 1 following the year in which you reach age 70½. Thereafter, your annual RMD must be taken from the IRA no later than December 31. Let’s take a look at how these rules work in practice:

A client contacted me today with questions about taking the first RMD from his IRA. In my client’s case, he turned 70 in January of this year (2017). So he also reached age 70½ in 2017 (July). Under the applicable IRS rules, he must take an RMD for 2017 because that is the year he attained the age of 70½. While the ordinary deadline for taking the RMD from his IRA is December 31, he has the option of waiting to take the 2017 RMD until no later than April 1, 2018. There is a catch to waiting: He’ll also have to take an RMD for 2018 (before December 31, 2018), so he’ll have to take two distributions in 2018, one for his 2017 RMD and the second for the 2018 RMD. Doing so will increase his taxable income for 2018 resulting in a higher tax bill. To avoid this, he’ll have to take his 2017 RMD no later than December 31, 2017.  Fortunately, he still has time to decide whether to wait until 2018 to take the distribution.

To calculate his RMD, my client, like most IRA owners, will refer to the IRS uniform life expectancy table. To calculate his first RMD, he must also use the balance in the IRA as of December 31, 2016. He’ll use that balance even if he elects to defer taking his 2017 RMD until 2018 (remember, the distribution is for 2017). He’ll use the balance in the IRA as of December 31, 2017, to calculate his RMD for 2018.

If he fails to take his first RMD from the IRA before April 1, 2018 (or any subsequent RMD by the applicable December 31 deadline), the IRS will impose a penalty equal to 50% of the amount of the RMD that he should have taken out from his IRA for the year. Note, the RMD is the minimum that must be withdrawn from the IRA for the year, you can withdraw more than the RMD if you so choose.

The rules governing distributions from an IRA other other retirement account are extremely complex. Always work with a competent advisor.  If you are struggling with questions regarding retirement account distributions, give me a call, I can help.

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Want to Dip Into Your IRA to Pay College Education Expenses? Read This First!

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It’s time to get back to school for you or a family member. You may be looking for a way to pay a tuition bill and other school expenses and considering taking money out of your IRA to do so. Ordinarily you have to be over age 59½ to take a penalty free, but taxable, withdrawal from an IRA. There are exceptions to this rule, and one of those exceptions allows for penalty free withdrawals to pay for certain higher education expenses, but you have to follow the rules!

1. You can take a penalty free – but taxable – withdrawal to pay for “qualified higher education expenses.” These expenses include tuition, room and board, required books, supplies, and fees. (Computer and other technology purchases qualify, even if not required by the school.) There is no dollar limit that can be taken out of the IRA account, as long as the money is used for qualified higher education expenses. (You should maintain a record of all paid expenses, including receipts.)

2. The qualified higher education expenses must be incurred at an “eligible educational institution.” An eligible educational institution is any college, university, vocational school or other post-secondary educational institution eligible to participate in the federal student aid program. This includes all accredited public, private, nonprofit and proprietary post-secondary institutions. Expenses related to elementary or high school, public or private, are not eligible.

3. The IRA distribution may be used for qualified education expenses of the IRA owner, the owner’s spouse, or any child or grandchild of the owner or the owner’s spouse.

4. The education expenses must be incurred in the year you take the IRA distribution. So, you can’t take a distribution from your IRA in 2018 to cover an expense incurred in 2017. This is an important rule that trips up a lot of people.

5. The exception to the early distribution penalty for higher education expenses only applies to distributions from your IRA account. The exception does not apply to distributions from an employer plan. [401(k), 403(b), etc.]

6. You can take a distribution from your IRA to pay eligible higher education expenses, but should you? That is the bigger issue here. Your IRA is not a piggy bank. That money is for your retirement. I generally do not recommend taking any preretirement distributions from any retirement account to pay expenses or a debt for a couple of reasons.  First, even though the distribution escapes the 10% early withdrawal penalty, income taxes must be paid on the entire distribution. Second,  you lose the advantage of the tax deferred growth on the funds withdrawn from the IRA.  You simply won’t make that up even if you are able to replace the funds withdrawn later on. If you have other options available to pay college expenses, you should explore them first, even loans, before taking a distribution from an IRA.

There are other exceptions to the 10% penalty on pre-age 59½ IRA distributions.  We’ll explore those in a future post.

Transferring Company Stock From a 401(k) to an IRA? Don’t Forget The NUA!

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So, you are newly retired and thinking about what to do with your employer sponsored 401(k) account.  The stock market has gone up quite a bit recently and you’re pleased with the value of your 401(k) (or other employer sponsored account) – especially the value of the company stock in your account. You may be thinking about transferring your 401(k) to an IRA for greater investment flexibility. Before you do, you may want to consider a nifty strategy to potentially save a bundle on income taxes.

The strategy involves the net unrealized appreciation (NUA) on the company stock in your 401(k). In a nutshell, NUA is the difference between the current market value of the company stock and the price originally paid for the stock (cost basis). This NUA may be eligible for favorable capital gains tax treatment when the company stock is sold.

If you roll over your 401(k) account, including the company stock, to an IRA, and then later take distributions from the IRA, the entire distribution (including any company stock) will be subject to income tax at your ordinary income tax rate. That rate could be as high as 39.6% just for federal income taxes depending upon your tax situation.

If, instead of transferring your account balance (including the company stock) to an IRA, you take a lump-sum distribution of the entire account balance, including the company stock (sometimes called an “in-kind” distribution), the distribution of the stock will be subject to income taxes, but you will only pay long term capital gains taxes (from 0% to 20%) on the NUA when the stock is sold (you’ll pay taxes at ordinary tax rates on the cost basis portion). If you are able to complete a tax-free rollover of the remainder of the distribution (less the company stock) to an IRA, the amount rolled over escapes income taxation. The NUA strategy will not work if the stock is liquidated inside the 401(k), or rolled over to an IRA.

In order to make the strategy work, you must take an in-kind distribution of the company stock from your company retirement account as part of a lump-sum distribution of the entire account balance.  The lump sum distribution must follow a “triggering event,” such as retirement or other separation from service, attainment of age 59½, death [yes, the beneficiary of an inherited 401(k) or other employer plan account can take advantage of NUA], or disability.  The entire balance of the account must be distributed – you can’t just take an in-kind distribution of the company stock.

For those with appreciated company stock in their 401(k) or other employer-sponsored account, taking advantage of the NUA rules can help save on income taxes when the stock is sold. But like any other income tax saving strategy, especially involving retirement plan distributions, it’s complicated, and it may not work in every situation. So, before you go ahead and transfer your 401(k) account with the company stock to an IRA, sit down and consult with a qualified professional who can help you determine whether the NUA strategy is right for you.

Think the NUA strategy may work for you? Give me a call, I can help.

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5 Ways to Put Your Tax Refund to Good Use This Year.

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Expecting a big, fat refund from the government this year? Rather than spending it on something frivolous, put it to a good long term use. Here are 5 effective ways to use your tax refund to improve your financial health:

1. Pay off a credit card. A tax refund can jump-start a debt repayment plan. If you carry a balance on a high interest (or any) credit card, use the refund to pay it off! And then use the money freed up every month to pay off another card balance. If you have no other credit card debt, then start paying yourself by banking the monthly savings.

2. Start an emergency fund. Many people live paycheck-to-paycheck with no financial cushion in case of an emergency. If you are one of them, it’s time to create an emergency fund – your own stash – for “just in case.” Who knows when the transmission on your car will need repair, or if you’ll have a medical emergency. These things happen when we least expect, or can afford them. An emergency fund will give you peace of mind and protect you should the unexpected occur.

3. Save for retirement. It’s never too late to start saving for your retirement. Use your refund to open an IRA (traditional or Roth), or consider upping your contribution to your 401(k) or other employer provided plan. Your refund can help make up the difference in your take home pay.

4. Start a college fund. If you have a child, consider starting a college savings account through a state-sponsored 529 college education savings plan. The money grows tax free, and when your child starts college, withdrawals used for qualifying education expenses are tax free. (Bonus – Michigan allows its residents a tax deduction for contributions to accounts under its program.)

5. Make a long neglected home repair. Roof worn out, furnace on its last leg, windows leaking or drafty?   Use the refund to make necessary home repairs.  Repairs can save you money in the long run in lower energy costs, improve your home’s livability, and even boost its market value.

December 31 Deadline Approaches For Mandatory Distributions From IRAs.

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The December 31 deadline for taking required minimum distributions (RMDs) from individual retirement accounts is approaching.  One either takes the mandatory RMD from their IRA by year end or suffers the 50% excess accumulations penalty (plus interest!) on any required withdrawals that aren’t taken.

Generally, an IRA owner who is at least age 70½ must take an RMD from an IRA by December 31, 2014, with one exception. If the IRA owner happened to reach age 70½ in 2014, he can delay taking the 2014 RMD until April 1, 2015. But remember, if the distribution is delayed to next year, the IRA owner will have to take two distributions in 2015. (For those with substantial taxable income, delaying the 2014 distribution may have a significant impact on their income taxes for 2015, so proper planning is a must.)

So, who has to take an RMD from an IRA before year end? Let’s take a look at some of the more common situations:

If the owner of a traditional IRA is at least age 70½ by December 31, he must take a distribution. (But, if he did reach age 70½ this year, he can delay taking this year’s RMD until April 1, 2015.) (Roth IRA owners do not have to take RMDs – a prime benefit of a Roth IRA.)

For a non-spouse beneficiary of a traditional IRA, an RMD must be taken by year end – regardless of her age – if the account owner died before 2014.

For the surviving spouse who is the sole beneficiary of a traditional IRA, an RMD must be taken in 2014 if the deceased account owner would have reached age 70½ this year. If the account owner died in 2014 and he was age 70½ or older, the spouse beneficiary will have to take an RMD in 2015, the year after the account owner’s death.

If a taxpayer is under age 59½ and has set up a §72(t) distribution plan (“Series of Substantially Equal Periodic Payments”) from her IRA, she must take her full distribution by year end.

If an IRA owner died after April 1, 2014, and he was at least age 70½ at the time of death, he will have an RMD for 2014. The RMD must be taken by the account beneficiary if a beneficiary was designated. If no beneficiary was designated, the RMD is payable to the IRA owner’s estate.

We have focused only on traditional IRA accounts in this post. Special rules apply with regard to RMDs from multiple IRA accounts, and RMDs from other types of retirement accounts such as 401(k) and 403(b) accounts, which simply cannot be addressed here in a single post.

The rules governing required minimum distributions from IRAs and other retirement accounts are many, complex, and tricky.  If you are not sure whether you must take an RMD from an IRA or other type of retirement account this year, or how much to take out if you do, please consult with your tax advisor, or give me a call. I can help.

2015 Retirement Plan Contribution Limits Released.

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The US Treasury Department recently announced its inflation adjusted amounts for retirement account contributions for 2015. Among the details:

IRAs: The limit on annual contributions remains $5,500 (no change for the third year in a row).

401(k)s: For employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan, the annual contribution limit is bumped up to $18,000 for 2015. The catch-up contribution limit for employees aged 50 and over who participate in such plans is increased from $5,500 to $6,000.

SIMPLE IRAs: The contribution limit on SIMPLE retirement accounts for 2015 is raised to $12,500, a $500 increase from 2014.

Defined Benefit (Pension) Plans: The limitation on the annual benefit remains unchanged at $210,000 for 2015.

Roth IRA Phase Outs: The 2015 adjusted gross income (AGI) phase-out range for those contributing to a Roth IRA is $183,000 to $193,000 for married couples filing jointly, a modest increase from 2014. And for singles and heads of households, the income phase-out range is raised to $116,000 to $131,000.

For more information, please read: Ashlea Ebeling, IRS Announces 2015 Retirement Plan Contribution Limits for 401(k)s and More, Forbes, Oct. 23, 2014.

Michigan Land Owners Will Get Property Tax Relief in 2015

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Michigan House Bill 5552, signed into law by Governor Rick Snyder, will add much needed exemptions to Michigan’s property tax uncapping law effective for transfers occurring after December 31, 2014.

If you are a Michigan land owner, you know that the annual increase of a property’s taxable value is “capped,” which means that although the fair market value of a parcel of land may increase substantially from year-to-year, its taxable value will increase much less so. However, a property’s value is “uncapped” when the land is sold or transferred. When a “transfer of ownership” of land occurs, the local assessor may reassess the property’s taxable value to equal the property’s then fair market value. In hot markets, or when real estate values increase over many years of ownership, this can result in a substantial increase in the property taxes a new owner would have to pay following the transfer.

In many cases, the increased property taxes are substantial, especially if the property was held by the same owner for many years. If an owner of real estate died and the property was inherited by the owner’s children, they oftentimes did not have the ability to pay the newly increased property taxes and, therefore, would be forced to sell. Whether it was the family home, hunting property, or a family cottage on Lake Michigan, family members who stood to inherit real estate from a deceased relative got no relief under the law.

Under the newly enacted amendment, the uncapping exemptions are extended to situations where the property is inherited by close relatives after the owner dies, whether by will, trust, or intestate succession (where the owner did not have a will).  After December 31, property taxes won’t necessarily increase merely because a land owner dies.  This amendment will improve estate planning flexibility for property owners and will ease the property tax burdens of surviving family members. This is a big win for Michigan land owners.

The new law goes into effect on October 22, 2014.  You can read the enrolled bill here.