So you think you don’t need/can’t afford an advisor? Have you considered the cost of making IRA mistakes? Even seemingly simple transactions are subject to rules and restrictions under the tax code. Did you contribute too much by mistake? This mistake cannot be corrected by simply withdrawing the excess amount. There are rules on how to fix the mistake. If you are not thoroughly familiar with the IRA rules, it is all too easy to make a mistake, and mistakes can be very costly.
No Required Minimum Distribution
The penalty for missing all or some of a required minimum distribution (RMD) is 50% of the amount not taken. That is not a typo. If you miss a $20,000 RMD, the penalty is $10,000. That’s the bad news. The good news is that IRS does have the authority to waive this penalty for good cause.
There are rules and limits on what can be contributed to an IRA. You must have earned income in order to contribute. There are age limits for IRA contributions and income limits for Roth IRA contributions. Excess contributions also occur when funds not eligible for rollover are deposited in the IRA. The penalty for an excess contribution is 6% of the excess amount for each year it remains in the IRA. If the excess is corrected by October 15th of the year after the year for which the contribution is made, there is no penalty. The excess amount must be returned plus/minus any gains or losses on the excess amount. The IRS has no authority waive this penalty.
IRA distributions taken prior to age 59 ½ and certain Roth IRA distributions taken prior to age 59 ½ are subject to an early distribution penalty of 10% of the taxable amount distributed. Congress realized that we might need access to our retirement funds early and has set up exceptions to the 10% penalty for certain limited situations. The IRS does not have the authority to waive the penalty for any distributions that do not meet the Congressional exceptions.
Multiple 60-Day Rollovers
An individual is only allowed to do one 60-day IRA-to-IRA or Roth IRA-to-Roth IRA rollover in a 12-month period. Once the individual has done a 60-day rollover, all other distributions of pre-tax funds are taxable. Any other amounts rolled over become excess contributions and are subject to the 6% excess contribution penalty, if not timely corrected, in addition to being taxable.
Rolled over RMD
An RMD cannot be rolled over. Employer plans should pay out the RMD before doing a rollover of the plan balance. Individuals who cash out an IRA should only rollover the amount of the distribution that is in excess of the RMD amount. An RMD should be taken before doing a Roth conversion. These are all common rollover mistakes. The amount of the RMD becomes an excess contribution in the receiving account. The excess contribution cannot be corrected by simply removing the RMD amount. To avoid the 6% penalty, it must be corrected by October 15th of the year after the rollover by removing the excess amount plus/minus any gains/losses in the account attributable to the RMD amount. If it is not timely corrected, the penalty applies for each year that the RMD remains in the account.
While IRA RMDs cannot be rolled over, they can be transferred to another IRA. The RMD would then have to be taken by the end of the year to avoid the 50% missed RMD penalty.
A prohibited transaction in an IRA generally causes a loss of the entire IRA. The IRA is treated as though the full account balance had been distributed on January 1st of the year of the prohibited transaction and it is taxable for that year. And you thought the 50% penalty was bad! This is a much worse outcome.
Mistakes Reported on Form 5329
Individuals who have missed RMDs, made excess contributions to their IRAs, have taken an early distribution should report these transactions on IRS Form 5329. The form can be filed with their tax return for the year. If the mistake is discovered in a subsequent year, the form can be filed as a stand-alone tax return. The form is used to report the transaction and to calculate the amount of penalty owed (actually it is an additional tax under the tax code).
Interest and Penalties
When any of these mistakes occur there can be additional interest and penalties assessed as well as the penalties noted above. When the transactions are not timely reported to the IRS and penalties aren’t paid, then interest begins to accrue on the penalty amount. In addition, there can be other penalties such as failure to file penalties for not filing Form 5329 and accuracy related penalties if the amount of the transaction is large enough. In some cases, such as when Form 5329 is not filed, the statute of limitations may not start to run, leaving the individual open to these taxes and penalties at any later date.
Need a Private Letter Ruling?
In cases where a mistake can be fixed, but only with IRS approval, a private letter ruling (PLR) request may have to be filed. In recent years those fees have increased dramatically. A ruling for a late 60-day rollover or Roth recharacterization now has an IRS fee of $10,000. All other PLR requests for IRA issues are now $28,300. But that fee, for individuals with income under $250,000, is reduced to $2,400 and for individuals with income of $250,000 - $1,000,000 to $7,600. Those are just the IRS fees. In addition, individuals will have to pay someone to prepare their PLR request.
A knowledgeable advisor can help you avoid these pitfalls, which in turn saves you money, which in turn gives you a better retirement. What better reason could there be for working with an advisor?