IRA Mistakes Taxpayers Should Avoid

Individual retirement accounts offer valuable tax advantages, but they also come with specific rules governing rollovers, distributions, and inherited accounts. While certain IRA mistakes can be corrected, others may result in unexpected taxes and penalties with limited opportunities for relief.

Understanding some of the more consequential IRA rules can help account owners and beneficiaries avoid costly mistakes and preserve the tax benefits of their retirement savings.

Moving an Inherited IRA as a Nonspouse Beneficiary

The rules for inherited IRAs differ depending on whether the beneficiary is the original account owner’s spouse.

A surviving spouse generally has more flexibility when moving inherited IRA assets. Nonspouse beneficiaries, however, generally cannot receive an inherited IRA distribution and then complete a tax-free 60-day rollover.

Instead, a nonspouse beneficiary generally must use a trustee-to-trustee transfer to move inherited IRA assets while maintaining their tax-deferred status. The receiving IRA must remain properly established as an inherited IRA for the beneficiary. If the funds are distributed directly to the beneficiary, the taxable portion generally must be included in income.

This distinction can be particularly important for beneficiaries who plan to take distributions over the applicable distribution period rather than recognizing the account’s taxable value all at once.

Exceeding the One-Rollover-Per-Year Limit

IRA owners also need to be careful when completing indirect rollovers.

Generally, an individual can complete only one IRA-to-IRA rollover involving receipt of the funds during any 12-month period. The rule generally applies across an individual’s IRAs rather than separately to each account.

Completing an additional rollover during that 12 month period may cause the transaction to be treated as a taxable distribution and potentially an excess contribution to the receiving IRA. Depending on the account owner’s age and circumstances, additional taxes may  apply.

Trustee-to-trustee transfers between IRAs are not subject to the one-rollover-per-year limitation, making them an important option when moving retirement assets.

Making Changes to a 72(t) Distribution Plan

Section 72(t) provides a potential way for individuals to access retirement funds before age 59½ without incurring the additional 10% tax that generally applies to early distributions.

To qualify, the account owner must follow a schedule of substantially equal periodic payments for the required period. The payment schedule generally must continue for at least five years or until the account owner reaches age 59½, whichever is longer.

Improperly modifying the arrangement before the required period ends can have significant tax consequences, potentially resulting in the additional tax being applied retroactively to prior distributions.

Because flexibility is limited once the payment schedule begins, individuals considering a 72(t) arrangement should carefully evaluate their expected financial needs before establishing the plan.

Following the Same-Property Rollover Rule

Another potential issue can arise when IRA assets are distributed as part of an indirect rollover.

Generally, the same property distributed from the IRA must be contributed to the receiving retirement account for the transaction to qualify as a rollover. For example, if shares of a particular investment are distributed, those same shares generally must be rolled over.

Selling, exchanging, or substituting different property before completing the rollover could cause the transaction to lose its intended tax treatment.

Using a direct transfer between custodians can help reduce the risk of inadvertently violating this requirement.

Planning Considerations

IRA transactions can have long-term tax consequences, and seemingly minor procedural mistakes may be difficult to reverse. Before moving retirement assets or establishing an early distribution strategy, taxpayers should understand the applicable rules and deadlines.

Direct transfers between financial institutions can help avoid several common rollover issues. Beneficiaries should also pay particular attention to inherited IRA rules, which can differ significantly depending on their relationship to the original account owner.

How LMC Can Help

Retirement account rules can be complex, particularly when they involve inherited IRAs, rollovers, or early distributions. At LMC, we can help to quantify the potential tax implications of IRA transactions and evaluate available options before taking action.

Contact your LMC advisor with any questions about your specific circumstances.