Get familiar with IRA dates, ages or risk your savings
By Robert Powell, MarketWatch
Last Update: 12:01 AM ET May 17, 2012
BOSTON (MarketWatch) 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 its 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 isnt exactly friendly when it comes to timing issues, Levine wrote in the current issue of Ed Slotts IRA Advisor newsletter.
Heres 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 59 to withdraw IRA funds without penalty (the 10% early distribution penalty). The age 59 rule is based on the IRA owners actual age and not the year in which a client turns 59, 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 59.
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? Dont 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 didnt owe the 10% penalty; the judge ruled otherwise.
Why should it matter that the money went from the [workers 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 mattersMany parts of the tax code are compromises, and all parts reflect the need for lines that cant be deduced from first principles, the judge said. Why can an employee withdraw money from an employers 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] Codes lines are arbitrary. Read more about that case, Young Kim v. CIR, 11-3390 (7th Cir. 2012).
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 59 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 59.
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 59, Levine wrote.
For this rule, the age 59 requirement is the IRA account owners actual 59 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, its 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 owners actual attainment of age 59 or after five full years, whichever is sooner. A separate five-year period is established for each conversion.
The actual attainment of age 59 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 dont 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 59, 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 59 is the account owners actual age 59. But to be a qualified distribution thats 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. Thats 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 owners 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 owners RMD by Dec. 31 of the year of death, not the year following the year of death, said Levine.
There are many other IRA timing issues about which you should be concerned. Theres the age 70 rule for RMDs for IRAs, the age 70 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 Slotts 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, theres always the IRSs website, which offers IRS Publication 590, among other resources. Read Publication 590.
After that, our best advice is this: Youd 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. Follow his tweets at RJPIII.
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