More than 40 million Americans own an Individual Retirement Account, unfortunately many owners aren't aware of the plan's most basic rules.
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According to The Investment Company Institute (ICI), the “traditional” IRA, which is made up of tax-deductible contributions, is the most popular with one-third of all households include at least one person who has a plan. Roth IRAs, which are funded with after-tax contributions, can be found in 17% of U.S. households.
Despite IRAs widespread acceptance and the fact that they have been around for 40 years, most of us are largely unaware of the most basic rules about what you can and cannot do with an IRA...and mistakes can be surprisingly costly.
The Hunt for 1/8%
CPA and IRA expert Barry Picker in Brooklyn, N.Y., says ones of the most common errors IRA owners make involves frequently rolling over an IRA from one custodian to another. The low-interest rate environment we’re in now (and for the foreseeable future) encourages this behavior as IRA owners shop for whatever provider will pay a fraction of a percent more. Picker talks of clients who check the newspaper each morning in a search to find where they can get a (slightly) better return on their money.
“When their CD comes due, they go to their bank and say, ‘The bank down the block is paying more. Give me my money.’” They take the IRA proceeds, walk down the street and invest them in a six-month CD inside a new IRA at Bank No.2. Then, says Picker, “Six months later they take the money out and move it again. You can’t do that!”
The (Costly) 12 Month Rule
The rules that govern Individual Retirement Accounts can be found in IRS Publication 590, Page 23 states:
Generally, if you make a tax-free rollover of any part of a distribution from a traditional IRA, you cannot, within a 1-year period, make a tax-free rollover of any later distribution from that same IRA. You also cannot make a tax-free rollover of any amount distributed, within the same one-year period, from the IRA into which you make the tax-free rollover.
Note that the rollover limit is specifically 12-months and is not based on a calendar year. In addition, the IRA that the assets are coming out of as well as the IRA that the assets are going into must abide by this, i.e. no additional rollovers into or out of either one for 12 months. The only exceptions that get you off the hook involve the financial institution being insolvent or taken over by the Federal Deposit Insurance Corporation (FDIC).
“If you do a second rollover within 12 months, your IRA is toast," warns Picker. "It’s immediately taxable.”
It gets worse.
If you don’t correct your mistake by withdrawing the illegal rollover, you have made what is called an “excess contribution.” Not only will you owe income tax on the amount, it is subject to a 6% penalty for as long as it remains in the account.
The Solution? Hands Off!
There is a simple way around this entire issue: instead of cashing out your IRA account and taking possession of the assets- cash, stocks, bonds, etc.- you can move them via what’s called a “trustee-to-trustee transfer.” In this case, you never take possession of the assets. They are moved (electronically) from the original custodian to the new one.
The Rollover That Doesn’t Exist
You know the old saying that “a little bit of knowledge is a dangerous thing”? The individual who wrote this must have had IRAs in mind. Not only are some of the rules confusing, they apply differently depending upon what type of IRA you’re talking about.
“Rollover” is just one example. As previously described, this involves the IRA owner withdrawing the assets from the account and personally delivering them to the custodian of a new IRA.
Can you pick out the most important word in the previous paragraph? Hint: it’s in the second sentence.
Answer: “owner.” Only the registered owner of an IRA can legally roll the assets over to a new custodian.
Why is this a big deal? Because if you have inherited and IRA, you are never considered the “owner.” It will always be titled in the name of the dead person who left it to you. Legally, you are the beneficiary of the IRA. “There is no rollover provision for an inherited IRA!” emphasizes Picker. “The only way to move the account is with a trustee-to-trustee transfer where you never get your grubby hands on the cash.” (Or mutual funds, or stocks or whatever else the account is invested in.)
Though Picker says he has heard of “situations where people put assets from an inherited IRA into their own account and no one ever finds out,” there are many cases where the IRS has taken beneficiaries to court- and won.
As of the end of June, there was $5.1 trillion in IRA accounts. With that amount of money in motion as baby boomers increasingly move into retirement, inherit IRAs from their parents and pass IRAs to their heirs, the government is paying attention. According to Picker, “There has been talk in the past few months that the IRS is going to step up surveillance of IRAs. There is no statute of limitations. Even if an event occurred ten years ago, they can penalize you.”
When it comes to IRAs, the worst thing you can do is assume- that either: a) you know what a term means, or that b) just because a process works a certain way in some circumstances, it applies to all of them.
Get professional advice.
Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content.
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