Take-Away: IRA rules are unduly complex. While some rules tend to be straightforward, other  rules defy imagination. A few of the overlooked IRA rules follow.

Military Personnel Survivors: The death benefits that result from a military person’s death can be contributed to a Roth IRA or Coverdell Education Savings Account (CESA). This rule governs all military personnel, not just those members of the a military service who were on active duty. This Roth IRA contribution opportunity is without regard to the customary annual contribution or income limitations that are normally associated with contributions to a Roth IRA. These ‘death benefit’ contributions must be made by the end of the calendar year that follows the survivor’s receipt of the death benefit paid. If the death benefit is contributed to a Roth IRA, and distributions are later taken by the owner of the Roth IRA, the withdrawals will be tax-free even if the Roth distribution is not an otherwise qualified Roth distribution, e.g. Roth IRA was not open for at least 5 years before distributions are taken. The maximum amount that can be contributed to either the Roth IRA or the CESA is the amount of the death benefit received. Funds are consider to be contributed to the CESA first, before other funds are contributed to the Roth IRA, if contributions using the death benefit are made to both types of accounts.

Inherited Qualified Plan Account: An inherited traditional IRA cannot be converted to a Roth IRA. But an inherited qualified plan account balance, e.g. a 401(k) account,  can be converted to an inherited Roth IRA. Excluded from this opportunity, however,  are Simplified Employee Plans (SEPs) and SIMPLE IRAs. To take advantage of this rule, there must be designated beneficiary of the qualified plan account, that is  a named individual. If there is no named individual beneficiary, and the account balance passes to the participant’s estate, where there is a sole beneficiary of the estate, then the estate beneficiary is not a designated beneficiary and this opportunity will not exist- hence the need to name a person as the direct beneficiary of the qualified plan account. The qualified plan account must be transferred directly into the Roth IRA. The first distribution from the ‘inherited’ Roth IRA must be taken by the end of the calendar year following the participant’s death.

One-Per-Year Rollover: Traditional IRAs and Roth IRAs are aggregated for the one-per-year rollover (every 365 days- this is not a calendar year analysis.) This refers to the 60-day rollover, where the IRA owner can take the funds directly and transfer the funds into a new IRA within 60 days of the funds receipt. The trap is that a surviving spouse who takes the deceased spouse’s IRA and rolls the balance into his/her own IRA is still treated as using a rollover for the one-per-year rollover If the one-per-year rollover rule is violated, the ‘second’ distribution to the surviving spouse cannot be rolled over, and thus all the distributed funds could become taxable income to the survivor. Consider a situation where the deceased spouse had two IRAs, one a traditional IRA and the second a Roth IRA. Only one rollover of these two ‘inherited’ IRAs will be permitted by the surviving spouse within 365 days; if both IRAs are rolled over by the surviving spouse, the second distribution will be invalid, and thus could be taxed to the survivor if it was the traditional IRA. The IRS does not possess any authority to rectify this situation often faced by surviving spouses. As reported in the past, the easiest way to avoid the 60-day rollover rule or the one-per-year rule is to avoid all rollovers, by simply directing the IRA custodian to transfer the account balance to a new IRA the owner establishes with another custodian. A custodian-to-custodian transfer is not treated as a rollover. Thus, a surviving spouse should make direct transfers of the inherited IRAs to new IRAs that he/she opens and completely avoid the one-per-year rollover rule.

2017 Tax Act: The Tax Act created some relief for some taxpayers, but in doing so simply created more disparate distribution rules to confuse taxpayers. The Tax Act extends the rollover period for plan loan offsets. A plan loan offset results from a termination of service by the participant or a plan termination. Instead of the normal 60-day rollover period, the new law extends the period until the individual’s tax return due date for the year in which the offset took place. A plan loan offset occurs when the balance of a loan is accelerated on an event that is stated in the plan. The usual situation is where the participant terminates employment with an outstanding loan from his/her account. Their plan account is automatically offset by the outstanding loan balance, with the former employee then receiving a Form 1099-R. Thus, the offset is reported as a distribution. That reported distribution can be rolled over, even though the former participant did not actually receive any funds from the plan, i.e. they can use other funds to satisfy the Note, however, that rollover treatment will not apply to a deemed distribution, i.e. a plan loan default with no payment. A deemed distribution can never be rolled over and is taxable for the calendar year in which it occurs.

Two Exceptions to 10% Early Distribution Penalty: The 2017 Tax Act also created two exceptions from the 10% early distribution penalty which is usually imposed when a distribution is taken by a participant from a qualified plan or IRA prior to attaining age 59 ½. The first exception is for federal employees who participate in a phased-retirement program- they work a reduced schedule while receiving a portion of their salary along with annuity payments from their federal retirement plan. The second exception covers distributions to public safety employees who separate from service at age 50 years or older, i.e. governmental employees at federal, state, and local levels. The employee only has to attain age 50 years in the year that they separate from their employment. Public safety employees is pretty broadly defined: (i) law enforcement officers; (ii) firefighters; (iii) EMS employees; (iv) air traffic controllers; (v) border protection officers; (vi) custom officials; (vii) US Capital and Supreme Court police; and (viii) US Department of state diplomatic special agents. These individuals can take a distribution from their qualified plans after attaining  age 50. Thus, they can then transfer the funds to an IRA without triggering the 10% early withdrawal penalty. Note, however, that if the funds are placed in an IRA and a distribution is later taken from that IRA prior to attaining age 59 ½, a 10% penalty will be imposed.

Ten Percent Excise Tax: We are all aware  of the 10% penalty that is imposed on distributions from an IRA prior to the IRA owner attaining age 59 ½. A surprise to some is that the 10% penalty for the early IRA withdrawal applies even if the IRA owner has no income for the year in which the distribution is received. In Nasuti v. Commissioner, Tax Court, No. 2560-11 (July 18, 2012) the Tax Court held: “The 10% penalty applies to the amount of the early distribution that is required to be added to gross income and is completely independent of any other income tax that is due or not due.” This 10% penalty applies and it is an additional tax, even if the taxpayer had negative or no other taxable income in the year for which the distribution was taken. For those individuals who are unemployed and who think they can take funds from their IRA without any income tax consequence, this will come as a big surprise to them. We call it an excise tax, but in actuality it is really just a penalty for taking a withdrawal prior to age 59 ½.

IRS Liens: Most states, like Michigan, have statutes that protect IRAs from the claims of judgment creditors. But the IRS can impose a lien against a taxpayer’s IRA to recover funds to satisfy back tax liabilities, interest and penalties. Assume that occurs, and the IRS asserts its lien and it takes funds from an IRA when the IRA owner is under age 59 ½. One would normally think that the ‘forced’ distribution from the delinquent taxpayer’s IRA would also cause the 10% penalty to be imposed. But that is not the case. The 10% penalty for an early withdrawal from an IRA does not apply if the funds are taken pursuant to an IRS lien. Accordingly, if a taxpayer owes back taxes and the IRS  looks to take funds from the taxpayer’s IRA, it is better for the taxpayer to let the IRS take the IRA funds via its lien as no 10% early withdrawal penalty will be imposed. If the taxpayer withdrew the funds from his/her IRA and then used those same funds to pay the IRS to satisfy the back tax liability, the taxpayer would also trigger the 10% early withdrawal penalty from the IRA. Pritchard et. ux v. Commissioner, Tax Court Memo 2017-136 (July 10, 2017.) In short, being an honorable taxpayer who withdraws IRA  funds to pay back taxes punishes the taxpayer, while the taxpayer who sits back and does nothing to address their back tax liability, thus forcing the IRS to impose its lien, escapes the 10% penalty. Go figure!

Dead IRA Owner: Assume an IRA owner has earned income in 2018 and thus he plans to make a contribution to his/her IRA. That contribution must be made by the IRA owner by April 15, 2019. Assume the IRA owner dies on February 15, 2019, before he makes the IRA contribution for 2018. The IRS takes the position that an IRA contribution cannot be made after the IRA owner’s death. It’s reasoning is that there is no longer any need to fund an IRA to provide retirement income, since (ah ha!) the retiree- IRA owner is now dead. Private Letter Ruling 8439066. While the IRS position sounds somewhat logical, why is it then that post-death contributions can still be made to SEP IRAs or SIMPLE IRAs?  If you can explain the difference to me, please give me a call!

RMDs for Married Owners: A mistake many older IRA owners make is that they assume their required minimum distribution (RMD) can be taken from one spouse’s IRA, and reported on their joint Form 1040 income tax return as ‘their’ taxable income. If each spouse is over the age of 70 ½, each must take his/her RMD from their own IRA account. Then cannot take the combined RMD amounts from only one spouse’s IRA, even though the taxable income is reported for both of them on the joint tax return. If one spouse fails to take his/her RMD for the calendar year from his/her own IRA, the amount not taken will be subject to the 50% penalty for failing to take an RMD, even if the amount taken from the other spouse’s IRA, amounts to their two RMDs in the aggregate.

Roth IRA RMDs: Assume that a beneficiary inherits a Roth IRA. The distributions from the Roth IRA to the designated beneficiary are not taxable. But the beneficiary is still subject to rule that requires the beneficiary of the Roth IRA to take required minimum distributions, even when the distribution is not subject to the tax. Again, there is a 50% excise tax (aka penalty or fine) if the beneficiary of an inherited Roth IRA fails to take their required RMD from the Roth IRA for the year. It is a mistake for beneficiaries who inherit Roth IRAs to assume that if the original owner of the Roth IRA did not have to take required minimum distributions from the Roth IRA they do not either.

Conclusion: There is often little logic or consistency in IRA contribution and distribution rules. As a result, relying upon common sense can be dangerous.