Switched Keys

This tax season has been one for IRA traps. IRAs are great, but meeting the rules can be a challenge. With hefty penalties on large sums, any mistake can be disastrous. Here's a few issues I've encountered this year.

Don't Forget to Take RMDs.

With most companies taking care of making distributions, most people don't have to worry about required minimum distributions (RMDs). But, that does not always happen. If the company doesn't, you have to remember to. The rules make it difficult to calculate and remember the date the RMDs start. The first one begins in the year you turn 70 1/2 (not 70 or 71). That one, and only that one, can be taken as late as April 1. After that, they have to be taken by December 31. Yes, there is forgiveness, but you have to catch up and if two RMDs are taken in the same year, you can end up in a higher tax bracket. Incidentally the penalty is 50% of what should have been taken.

Bad Bank Advice

Even if you don't have an IRA of your own, you may need to know the tax consequences of receiving a IRA due to someone's death. The bank could just send it to you without any further explanation. Then another bank may give you bad advice about what to do with it. That happened to one client. The bank told her to put it into a CD (What is the interest on CD's now?), and the person ended up with a hefty tax bill. If the person would have known, she would have rolled in over into another IRA.

Lump-sum Distributions

Lump-sum distributions come with quite a large tax liability, but there is an apparently a grandfathered rule that allows recipients of an IRA paid due to death to calculate the tax on a 10-year basis. There are specific rules, including that the person must have been born before Jan 2, 1936. That date doesn't change each year. Both times I've encountered this, the tax savings were near $5,000. Who's going to know this rule? You should.

This issue also has another component if you are using a certain software package. Although this program calculated the taxable amount correctly based on Form 4972, instead of using that as the tax, it added it to the normal tax amount. No other software that I have used does that. That's another bit of advice. Know what your software is doing; it might not always be right.

Tax is More Than Withholding

Speaking of lump-sum distributions, carefully consider the tax that will be owed on the distribution. Just because a company is required to take 20% withholding on the distribution doesn't mean that is all the tax they will have to pay on it. It may just be a down-payment on their total tax liability. If it's an early distribution and there's not a good reason for it, there may also be an additional 10% penalty.

Roth IRAs (Or Are They?)

Unlike Traditional IRAs, Roth IRAs are not taxable. Usually, the company reports distributions on a 1099-R with a code indicating the type. It usually doesn't say Roth on it anywhere. In one case, a taxpayer came in with a form indicating a normal distribution, with a Code 7. He said it was a Roth IRA, in which case it should have had a different code. He insisted it was a Roth, and had a good argument to back that up. Keep good records, read them, and if it's a rollover know what type of rollover you are making. If it doesn't get tagged as a Roth, it becomes taxable all over again. Not good.

The side note here is to know your forms. They are not always right and if the wrong information is put in the software, you get a wrong result.

IRA Opportunities

While there are traps, there are also opportunities with an IRA. There are exceptions for early withdrawals for certain dire needs, such as education, housing, and medical needs. You can also start retirement before 59 1/2 (SEPP) under certain circumstances. The one most overlooked is the Roth rollover. It always worth considering, especially in those years with limited income. If it doesn't work, it may be possible to undo it. The IRS has publications that cover IRAs. If you don't want to download them or read them on-line the IRS will mail them to you free if you request them.

The importance of knowing your finances is becoming more crucial with all the options that are available. It's not enough to know you have a good employer package or bank product. You need to know how to use it .. and how not to.