Retirement Plan Quirks

Take-Away: Much confusion in the retirement planning world stems from the fact that there are different rules for each type of retirement plan, e.g., IRA, Roth IRA, 403(b) plan, qualified plan, etc. Added to that confusion arising from a bewildering number or different rules for contributions and distributions is that fact that sometimes common sense, or logic, is used to decipher those rules, leading to some quirky results.

Background: To say that the retirement plan rules for contributions and distributions are confusing is a gross understatement. One of my big ‘pet peeves’ (actually that, too,  is an understatement,) is the fact that the rules vary from retirement account to retirement account depending on where that account was opened and that often logic and consistency are dispensed with when it comes to the IRS’s rules. A couple of examples follow:

Excess Contributions: In order to make a contribution to a retirement account like a traditional IRA, the individual account owner must have earned income, i.e., compensation. But earning too much income will preclude that individual from contributing to a Roth IRA. If this distinction between traditional and Roth is not kept in mind, it is possible that the contributing individual will have made an excess contribution to their retirement account. Fortunately, there are some corrective steps that can be taken to eliminate the problem. An excess contribution can be fixed, without any penalty assessed, if it is corrected by October 15 of the year after the year for which the contribution was originally made. If this correction is made prior to the October 15 deadline, the excess contribution and any earnings on the excess contribution (sometimes called the net income attributable, or NIA) can be withdrawn penalty-free. These earnings will be taxable, but no special tax form will need to be filed.

Quirk: If the excess contribution is corrected, but only after the October 15 deadline, the NIA does not need to be withdrawn from the account. There will be the 6% annual penalty on the excess contribution, and that excess must be removed from the individual’s retirement account, but any earnings on the excess contribution can remain in the retirement account. Huh? That is the rule, even if the IRA owner was totally ineligible to open the retirement account to begin with.

Inherited IRA vs Inherited 401(k): When an IRA owner dies his/her IRA passes to their designated beneficiary. That designated beneficiary must maintain the account as an inherited IRA. That inherited IRA cannot  be converted to an inherited Roth IRA. While that designated beneficiary can take withdrawals from the inherited Roth IRA and then use those withdrawals to make annual contributions to their own Roth IRA (assuming the eligibility rules are met) but no direct conversions to a Roth IRA are permitted.

Quirk: While the beneficiary of an inherited traditional IRA cannot directly convert that traditional IRA to a Roth IRA, the designated beneficiaries of a retirement account established under a qualified plan, i.e., a 401(k) account, can convert the inherited plan assets, like from the 401(k) account, directly to an inherited Roth IRA. No reason is given for this distinction in the Tax Code for why an inherited 401(k) account can be converted to an inherited Roth IRA while a traditional IRA cannot be directly converted to an inherited Roth IRA.

Rollover from IRA to Qualified Plan: Roth and after-tax (non-Roth) funds cannot be rolled from an IRA to a qualified plan, like a 401(k) account. Once those after-tax contributions are made to an IRA, that is where those funds will remain. Only pre-tax dollars can be moved from an IRA to a qualified plan. (This transfer to a qualified plan from a traditional IRA  is sometimes referred to as a reverse rollover.) A reverse rollover is an exception to the pro-rata rule [remember the old ‘cream in the coffee rule’ we have covered in the past) and it sometimes can be leveraged in situations when the IRA owner wants to separate their pre-tax  IRA dollars from basis (i.e., after-tax  dollars) in order to complete a clean tax-free Roth conversion.

Quirk: Roth IRA dollars cannot be rolled into a qualified plan retirement plan account, unlike traditional IRAs. As a Tax Court decisions once declared with regard to this no after-tax contribution prohibition in Young Kim v. Commissioner, “This makes no sense.” Yet there it is, and there it must be navigated to stay out of trouble with the IRS.

Conclusion: Sadly the Tax Code and the IRS’s Regulations are chock-full of quirks that have to be kept in mind. Applying logic, consistency, and common sense will more likely than not get you into trouble when it comes to retirement plan contributions, distributions, and rollovers.