Common IRA Mistakes

 

You can make excess contributions in one of several ways: [1] writing a check that is in excess of the annual limit, [2] transferring accounts that are past the 60-day rule, and [3] making contributions and not being eligible to do so. If an excess contribution is made, the IRS can impose a 6% annual penalty on excess amounts.

 

If excess contributions are made year after year, the total penalty can be substantial (i.e., the cost of amending several years of tax returns + IRS penalty + IRS interest charge). The excess amounts must also be taken out from the IRA or Roth IRA accounts.

 

Traditional IRA owners must start taking their required withdrawals by April 1 of the year after they turn 70½ (e.g., Ed has his 70th birthday in March 2012; he will be 70½ in 2012 and therefore must make a withdrawal sometime in 2013).

 

The required traditional IRA withdrawal amount is based on the cumulative value of the taxpayer’s traditional IRA accounts. The taxpayer fulfills the requirement if enough money is taken out of just one account—even if custodians of the other accounts report that a withdrawal is needed.

 

If you have a client with a 401(k) who is still working for the company and owns < 5% of the company, there are no required withdrawals until the worker stops working at the company. However, if this same worker rolls over 401(k) money into a traditional IRA, the worker is subject to RMDs for the IRA account.

 

If your client realizes an excess contribution has been made, for whatever reason, the mistake can be corrected penalty free if the excess is taken out before October 15 of the following year (the year after the excess contribution). The client should withdraw the excess plus any interest or gain from the excess amount.

 

Inherited IRAs have different withdrawal rules. If someone over 70½ dies and did not make a withdrawal that year, the beneficiary must make a withdrawal and claim it as ordinary income for the year. If an IRA is inherited from a nonspouse, the beneficiary must make annual withdrawals based on his life expectancy (starting the year after death). With a nonspouse-inherited IRA, it makes no difference as to the age of the decedent or the age of the beneficiary.

 

If an IRA is inherited from a spouse, it can be rolled over into the beneficiary’s own IRA or set up as an inherited IRA. By setting up an “inherited” IRA account, withdrawals can be postponed until the deceased spouse would have turned 70½. 

 

Remember: If a client inherits an account from someone that is not their spouse, the account should be titled as an inherited IRA; annual withdrawals are still required but are based on the beneficiary’s remaining life expectancy. If someone inherits an IRA from a nonspouse and puts it into an IRA that does not indicate it was inherited, the costs can be extreme. For example, think of the accumulated penalty and interest charges for someone who inherited an IRA from a nonspouse 10–20 years ago.