Take-Away: The rules that govern distributions from retirement accounts are bewildering. Mistakes are often made when funds in a retirement account are moved that result in a taxable distribution, along with a penalty and interest. Fortunately, if the ‘fumble’ is caught soon enough, it can be ‘fixed’ without too much of a hassle.

Distribution Fumbles and Fixes:

Inherited IRA Fumble that Cannot be Fixed: One common mistake that cannot be fixed is when a non-spouse beneficiary who inherits an IRA then attempts a 60-day rollover of the inherited IRA to a new IRA. Inherited IRAs can only be moved in a custodian-to-custodian transfer. Restated, an inherited IRA cannot be transferred in a 60-day rollover. If the non-spouse beneficiary pursues a 60-day rollover then it is treated as a taxable distribution to the beneficiary of the entire inherited IRA balance.

Excess Contributions Fumble: Some contributions are not permitted to an IRA. If more than the permitted amount is contributed to the IRA, it is treated as an excess contribution. A 6% penalty applies to an excess contribution. The penalty applies each year until the excess amount is removed from the IRA. The penalty is paid by the IRA owner each year until the excess is fixed.

  • Fix: The deadline to avoid the assessed 6% penalty is the following October 15. When an excess contribution is made to the IRA, two options exist in order to avoid the 6% penalty. Either the excess amount can be withdrawn from the IRA, or the contribution can be re-characterized as a Roth IRA contribution. Note, however, that the net income that is attributable to the excess contribution must also either be withdrawn or re-characterized along with the excess The IRS has published a formula to be used to calculate that net income attributable to the excess contribution. [See IRS Publication at 590-A.]
  • Fix: If the October 15 deadline is missed, the 6% penalty will be imposed. The penalty is paid by filing IRS Form 5329 (either filed along with the IRA owner’s Form 1040 in the following calendar year or filed as a stand-alone tax return.) If the deadline is missed, and the excess contribution is withdrawn, the rules, surprisingly, do not require the removal from the IRA of any net income that is attributable to the excess contribution, as they do if the excess contribution is withdrawn before the October 15 deadline.
  • Fix: The other option to correct an excess contribution after the deadline is to carry it forward. The IRA owner would report the excess contribution on his/her Form 1040 as a contribution for the ‘next’ calendar year.

Qualified Plan Rollover Fumble: Moving funds out of a qualified plan and rolling them into an IRA is a common practice. The fumble occurs when the mandatory 20% withholding by the qualified plan is inadvertently triggered. Assume a plan participant terminates her employment. The former participant plans to roll her qualified plan account balance into an IRA within 60 days of its receipt. When the funds are distributed to the former plan participant that amount will be 20% less, as the plan sponsor is required by law to withhold 20% of the balance of the transferred account balance. If the former participant wants to complete a 100% rollover to her IRA, she will have to use her own out-of-pocket funds to add to the 80% received from the qualified plan sponsor, in order to complete the rollover.

  • Fix: If the former plan participant had elected a direct rollover option to move the balance of her qualified plan account to a designated IRA custodian, as opposed to using a 60-day rollover, there would be no mandatory tax withholding by the plan sponsor. Even if the plan sponsor delivered a check to the former participant, if that check is made payable to the IRA custodian (and not the former participant) there would be no tax withholding.
  • Fix: If the 60-day rollover is used, and the former participant uses her own funds to assure the full 100% amount is rolled into her IRA, she can file for a tax refund of the withheld amount. Note: Recall that there can only be one 60-day rollover every 365 days, so that if the IRA owner now wants to move her account balance to another IRA provider, she will have to wait until 365 days passes from her first rollover before another rollover can take place.

Net Unrealized Appreciation Fumble: Some qualified plans permit employer-sponsor stock to be held in the qualified plan account. That stock is taxed differently than other qualified plan assets.  The net unrealized appreciation (NUA) of the sponsor’s stock held in the plan account is the increase in value of the sponsor’s stock from the time that it was acquired in the plan to the date of its distribution to the plan participant. The unique tax treatment is that if the sponsor’s stock is withdrawn from the qualified plan account, the participant pays ordinary income tax on only the original cost of the stock. Not its fair market value on the date of distribution. In short, the NUA is not taxed on distribution. Rather, the tax is deferred until the stock is sold by the participant. Only then will the amount received will be taxed as long-term capital gain. However, to qualify for this tax deferral, the company stock must be distributed in a lump sum, which means that all the assets in all accounts must be distributed to the participant in one calendar year, resulting in a zero balance of the participant’s account at the end of the year. In addition, the lump sum distribution can only occur after one of four trigger events: (i) the participant attains age 59 ½; (ii) the participant separates from service, e.g. quits or retires; (iii) the participant becomes disabled; and (iv) the participant dies. The fumble takes place when there is a distribution of company stock but one of the four trigger events is not available, e.g. the distribution of the company stock at age 59 ½ does not result in a zero balance of the participant’s account by the end of that calendar year.

  • Fix: The NUA opportunity will be lost if there is not a complete lump sum distribution in the year, the company stock is distributed to the participant. That distribution cannot be fixed. However, the participant can wait until the next trigger event. Back to the example- the participant at age 59 ½ took the company stock, but he did not completely empty his account balance by the end of that calendar year. The participant could wait until he separated from service with his employer, and then then at that time perform another NUA withdrawal. Each trigger event gives the plan participant a new opportunity and all prior partial distributions will no longer counted.

Wrong Trust Beneficiaries Fumble: We have periodically covered see-through trusts that are named as beneficiaries of an individual’s IRA or qualified plan. The problem is that an estate or charity is not an ‘individual’ (with no life expectancy) and if a non-individual is named as a beneficiary, normally the IRA must be emptied within 5 years of the IRA owner’s death. That rule applies if a non-individual is named as a beneficiary of a trust, which is the designated beneficiary of the IRA, which means that the IRA cannot be stretched by the trustee in taking required minimum distributions (RMDs) over the oldest trust beneficiary’s life expectancy. So naming a non-individual as trust beneficiary can be a fumble.

  • Fix- Charities: If an IRA payable to a trust has a ‘bad’ named beneficiary, a gap period in the Tax Code can be used to fix the problem. The gap period starts on the IRA owner’s death and end on September 30 of the calendar year that follows the calendar year of the owner’s death. For example an IRA beneficiary can take his/her share of the IRA before the September 30 deadline and cash out; if that occurs, the beneficiary will be ignored when the oldest beneficiary is identified (whose life expectancy controls the stretch ) For example, if a charity is named as trust beneficiary, it should be cashed out by the September 30 deadline date.
  • Fix- Estate:  The decedent’s estate can also be considered a beneficiary, thus jeopardizing a stretch The decedent’s estate will be considered ‘cashed out’ when estate debts and expenses are paid by the September deadline date. Alternatively a reasonable amount required to pay the decedent’s debts and expenses of estate administration can be segregated for that purpose by the September 30 date is also an alternative to effectively remove the decedent’s estate as an indirect beneficiary of the trust.
  • Fix- Old Beneficiaries: If the trust names an older individual as beneficiary, that beneficiary’s interest in the trust can be removed by a qualified disclaimer of their interest in the trust. However, a qualified disclaimer must occur within 9 months of the IRA owner’s death, not the September 30 deadline of the year that follows the IRA owner’s death. If the beneficiary signs a qualified disclaimer, he/she will not be treated as a trust beneficiary and therefore their age will be ignored for purposes of determining the RMD that controls the distributions from the IRA taken by the trustee.

Distribution Check Delivered to Owner Fumble: Often custodians will tell the IRA owner that their financial institution will only issue a check as a distribution from the IRA, i.e. it will not make a direct custodian-to-custodian distribution. This position creates a problem since the check will be treated as a taxable distribution that is subject to the 60-day rollover deadline, and it will trigger the one-60-day-rollover in a 365-day period. If the check is issued by the sponsor of a qualified plan to the participant, it will be subject to the 20% mandatory income-withholding rule.

  • Fix: If the custodian or plan sponsor insists on issuing a check, the problems caused by the receipt of the check can be fixed by asking that the check be made out in the name of the owner/participant’s IRA and not in their individual name. Then the check can be delivered to the new IRA custodian for deposit. This eliminates all of the hassles associated with a 60-day rollover. This also works with a qualified charitable distribution (QCD) when the IRA custodian delivers a check to the IRA owner. If that check is made, payable to the designated charity, the IRA owner can simply receive and deliver the check to the charity and the QCD rules will be satisfied.


Confusion: While not a fumble per se, often there is a lot of confusion about the tax reporting of a distribution from an IRA or qualified plan. Form 1099-R is a source of confusion because it does not tell the full story with regard to the distribution. The instructions with regard to Form 1099-R require the custodian to report most traditional IRA distributions as taxable income. However, there is no special code on the form that reflects a rollover, a qualified charitable distribution, or the income tax basis that is associated with the IRA distribution. Thus, the Form 1099-R will report a large amount as taxable income that, in turn, freaks out the IRA owner who is not expecting to report the amount as taxable income for the year.

  • Fix: Rather than ask the IRA custodian to re-issue a new Form 1099-R, the fix appears on the face of the IRA owner’s Form 1040 income tax return filed for the year. A rollover or Qualified Charitable Distribution are reported on line 4b of the 1040 return, with the owner writing in either ‘rollover’ or ‘qualified charitable distribution’ next to that line. If the entire amount was rolled over or a QCD, then ‘0’ is entered on line 4b. Note that if some of the distribution reflects an after-tax contribution to the IRA, then a Form 8606 will have to be filed in order to claim a tax-free return of basis in the distribution.