Individual Retirement Accounts, or IRAs, remain some of the leading retirement savings instruments used by Americans in the workforce. IRAs can be opened by anyone, and by funding these accounts with the maximum annual contribution, it is possible to set aside a substantial amount of money for future use. IRAs come in many forms, including those that have significant tax advantages. Of course, each type of IRA has its own regulatory requirements, and these requirements can sometimes create confusion. In this guide, we will present two scenarios regarding inherited IRAs and rollovers as well as the conversion of one type of IRA into another and how that can affect one’s tax implications. These scenarios are common, and by exploring them, you will be able to understand the best ways of protecting your hard-earned retirement savings.
Rollovers and Required Minimum Distributions: The Basics
Before discussing our first IRA scenario, it is important to understand the concept of rollovers. People change jobs during their careers, and often wonder what to do with the money they have saved in an employer’s retirement plan when they are ready to start a new job. In simple terms, a rollover is a process of taking the funds accrued in your previous employer’s retirement plan, typically an employer-sponsored 401(k) plan, and placing them in the new employer’s plan, or to establish an IRA with the funds.
The IRA can be a traditional or Roth IRA, giving you better control over your retirement assets. Not all employer-sponsored plans offer the possibility of a rollover, so it is important to check specifics before attempting to use this option. Rolling over funds into a new retirement plan avoids tax penalties and allows the funds to continue growing in a tax-deferred environment. Some people may inherit an IRA from a loved one. This inherited IRA may be eligible for rollovers, which is the central theme of our first scenario. We will take a closer look at this possibility in the next section.
Another concept to understand is that of the Required Minimum Distribution (RMD), which is the minimum amount or amounts one must withdraw from qualifying retirement accounts when the account holder reaches a certain age. For retirees who are in the year they reach the age of 70 ½ years, regulations require RMDs for the following types of retirement accounts:
- Simplified Employee Pension (SEP) IRAs
- Traditional IRAs
- SIMPLE IRAs
- 401(k) Retirement Plans
Failure to take RMDs according to regulations can result in steep tax penalties. This, unfortunately, is relatively common with those holding multiple retirement accounts or those who have inherited an IRA from a loved one. Our first IRA scenario touches on RMDs and rollovers; by carefully considering the regulations, one can avoid any tax penalties for failing to take a distribution from the account(s) in question.
Scenario #1: The Inherited IRA
A client aged 71 has inherited a 401(k) plan from her deceased daughter, who was aged 41 when she passed away. She visits her retirement advisor with questions about the inherited account, particularly how it might affect her own individually-held accounts and distributions. The 71-year old client has her own Traditional IRA. She wants to know if she can combine accounts, or must treat them separately.
In this scenario, the woman can directly roll over her daughter’s accumulated 401(k) assets into something called an Inherited IRA. Sometimes referred to as a “beneficiary IRA”, this account is designed to handle the assets of an IRA or employer-sponsored retirement plan after the original account holder passes away. There are certain rules governing inherited IRAs, and the rules differ between spouses and non-spouses.
In our scenario, the 71-year old woman can roll over her daughter’s 401(k) assets into an inherited IRA established for this purpose. She would then have to take RMDs from the inherited IRA as she has reached the age when RMDs are mandated. Unfortunately, she cannot combine the inherited IRA with other retirement accounts she already owns.
RMDs from both accounts are calculated differently. From the inherited IRA, the Internal Revenue Service’s Single Life Expectancy Table is used to calculate the RMDs. For her own account, the IRS Uniform Lifetime Table is used to calculate the RMDs.
Scenario #2: The Conversion
In some cases, converting one form of IRA into another can create unforeseen tax burdens. This is especially true when the account holder also receives government-sponsored subsidies or benefits, which may count as ordinary income for taxation purposes.
This second scenario touches on these aspects. In the scenario, a retiree receives $1800 in pre-tax distributions from a Traditional IRA – a figure that totals $21,600 per year in distributions. The retiree also receives about $5000 in premium subsidies from the Affordable Care Act to cover medical insurance expenses. The retiree’s financial advisor converted $20K in assets from a Traditional IRA to a Roth IRA in 2017. The retiree made the unfortunate discovery that because of the conversion, his taxable income had doubled. The situation was made more complicated in the fact that this higher taxable income made him ineligible to receive healthcare premium subsidies, and was forced to repay the subsidy he had already received. Once he revealed the complication to his advisor, the advisor recharacterized the conversion, expecting to adjust the gross income so he wouldn’t have to repay the healthcare premium subsidy. Upon preparing his 2017 tax return using off-the-shelf tax software, he discovered that the $20K could not be moved back to a regular IRA since he had no earned income, at least according to the tax software.
The truth behind conversions
The truth behind conversions is this: converting Traditional IRA assets into Roth results in a tax bill that can also affect one’s eligibility for certain government-sponsored benefits, including tax breaks and subsidies. Thankfully, a “do over” period exists for the 2017 tax year; in this period, recharacterization of Roth IRA conversions can be done until October 15, 2018. For conversions done in 2018 or subsequent years, the do-over period is no longer an option. Here is a great example of when tax software may not be adequate in preparing a return. A tax professional’s expert assistance is required to recharacterize the conversion on the tax return, as this process can be extremely complex. With the tax professional’s help, the tax bill was eliminated and the client’s eligibility to receive healthcare subsidies was restored.