Rollover Blunders and How to Prevent Them

The good news: The IRS recently relaxed the 60-day rule for rolling over IRA assets. The bad news: People can still be subject to whopping fines in the face of certain kinds of mistakes.  It is very likely that at least one investor will propose at least one of the faulty strategies below before year-end.  Even more amazing is how many professionals will suggest them to their clients.  Each of these bad ideas can cause adverse consequences. Pull your facts together to prevent an unwelcome and often nasty outcome.

Bad idea 1: Converting a Roth IRA too late

This idea was reported to be proposed to someone by their tax preparer who was preparing her 2006 tax return.  The preparer realized that due to unexpected deductible expenses and a simultaneous drop in income, their client was going to essentially be in a zero tax bracket for 2006.  The suggestion was for the client to initiate a conversion of her IRA account valued at $40,000 to a Roth IRA and report the conversion on her 2006 tax return so that the tax implications of the conversion would be minimal.  The problem is that we are now in 2007 and any IRA conversion done now will be reportable on the 2007 tax return, not last year’s.  The preparer was under the impression that since taxpayers have until April 15th of the following year to fund their prior year’s Roth IRA contributions, they should be able to do conversions up to that date and still have the conversion count for the prior year.  Unfortunately, the rules don’t work that way.  The Roth IRA conversion creates taxable income in the calendar year of the conversion.  This means that a conversion done in January cannot be attributed to the prior year.

Instead, if the professional had really been on the ball, he might have suggested that the client convert the IRA to a Roth IRA in 2006, even if they weren’t sure where the income levels would actually end up.  The IRS allows you to re-characterize (essentially undo) any Roth IRA conversion up until October 15th of the year following the year of the conversion.  In this case, the conversion could have been made in time to be included on the 2006 return.  If the actual income levels by year-end had made the conversion unattractive, it could be reversed this year by notifying the custodians and requesting a trustee-to-trustee transfer back to the IRA of the converted amount plus any earnings since the date of the original conversion.

Bad idea 2: Forgetting about other deductible IRAs

Investors have already asked about this one.  They are beginning to understand the open season for Roth IRA conversions created by the Tax Increase Prevention and Reconciliation Act of 2005.  In tax year 2010, taxpayers will not be limited by their modified adjusted gross income when deciding whether to convert up to $100,000 of IRA assets to Roth IRA assets.  In fact the government is subtly encouraging taxpayers to consider 2010 conversions by allowing them to spread the recognized income from the conversion over calendar years 2011 and 2012, rather than recognizing it in 2010.  The downside to this is that our current tax brackets are scheduled to expire in 2010, and without legislative changes, the 2011 and 2012 brackets will be higher.  Many are under the impression that they could contribute to a non-deductible IRA for 2006-2009 and then convert those non-deductible IRA funds to a Roth IRA in 2010 without recognizing any income from the conversion.   This might be true only if they do not have any other deductible IRAs. If they have any other deductible IRA accounts, even a SEP or a SIMPLE, this strategy could seriously backfire.  First, non-deductible contributions to an IRA become basis in the IRA and are not reported as income when the conversion occurs since they are treated as a return of capital.  The IRS rules require that all of the taxpayer’s IRA accounts are aggregated together for the purpose of determining the tax effects of any conversion.  Any non-deductible contribution (basis) is allocated proportionately to the total balance in all the IRA accounts.  This occurs even if the non-deductible IRA is totally separate from the other IRA accounts.  So if the non-deductible contribution represents 10% of the total balance of all the IRA accounts, then only 10% of the conversion will escape being recognized as income.  This means that the tax cost of converting might be far greater than what the taxpayer is expecting.  Clearly, this outcome is far different from being able to convert just the non-deductible portions of the IRAs with no tax consequences.  The second problem created by this strategy would be the need to forever track the remaining non-deductible basis on the annual IRS form 8606.

Bad idea 3: Rolling over too soon after divorce

Those going through divorce are understandably overwhelmed, especially by the sheer magnitude of the financial decisions required of them. When employer retirement plans are to be divided, a formalized Qualified Domestic Relations Order usually controls the division of the retirement account. It is common for the ex-spouses to be in a hurry to rollover the plan assets to their own IRA as soon as they can. In the case of an ex-spouse who has not yet reached age 59½, this could be an expensive mistake.  ERISA retirement plan assets (401k, profit sharing, money purchase, Keogh plans, etc.) distributed to an ex-spouse incident to divorce escape the 10% penalty on premature withdrawals when the ex-spouse is younger than 59½. The ex-spouse could request distributions from the retirement plan as needed and not be exposed to the penalty. The need to withdraw funds from retirement accounts post-divorce is common when non-income producing assets (such as the family home) make up the bulk of the divorce settlement.  However, once the funds are rolled over to an IRA, the 10% penalty applies to premature distributions, and there is no exception for divorced spouses. Before you agree to help your recently divorced client rollover retirement assets from an ex, be sure you have explored any potential need to use those assets for cash flow prior to age 59½.

 Bad idea 4: Rolling over too soon after retirement

This is another rollover mistake. Employees eligible for early retirement are also anxious to pull all of their assets together and so they often rollover their 401(k) accounts soon after leaving their employer. Many employers actually encourage employees to terminate their accounts in the employer’s plan. This can prove to be expensive for the same reason as for the divorced clients.  Distributions from an employer retirement plan due to retirement after age 55 are usually exempt from the 10% premature distribution penalty under [[71461IRS code section 72(t)]]. However, once those funds have been rolled into the taxpayer’s IRA, the age 59½ requirement applies and there is no exception for early retirement unless a structured distribution of a series of substantially equal periodic payments is created that meets the requirements of the IRS code section 72(t).

Many early retirees do not adequately plan for their cash flow in the first few years of retirement. If there is any chance they might need to tap those retirement accounts in the years before they reach age 59½, then at least some of the funds should be left in the employer’s plan. I realize that often advisors are always keen to gather more investment assets, but it is in you’re the retiree’s best interest to avoid the penalty if in fact they will need to use those funds.

Bad idea 5: Taking premature distributions

Employees looking for emergency funds should usually avoid tapping into their retirement plans, but many people think of these accounts as “free” money and are willing to pay the 10% premature distributions penalty if they really need the cash. The most serious premature distribution mistakes occur with Savings Incentive Match Plans for Employees (SIMPLE) plans. A SIMPLE plan is a type of IRA account that is funded with employer contributions (profit sharing and matching) and employee salary deferrals. An employer sets up a specific SIMPLE IRA account for each employee and deposits all contributions directly into this IRA.  A SIMPLE IRA is subject to the same rules and restrictions as any other deductible IRA with one major exception. Any premature distributions made within the first two years of participation are subject to a whopping 25% penalty, not the usual 10% penalty. This is true even if the employee is no longer a participant in the SIMPLE plan. Even rolling over a SIMPLE IRA account to a regular IRA within these first two years will be treated as a taxable distribution from the SIMPLE IRA subject to the 25% penalty. In this case, the rollover funds will also not qualify as a rollover contribution to the regular IRA.  Once an employee is no longer participating in the SIMPLE plan and two years have passed since the employee first participated, the employee may treat the SIMPLE IRA as any other traditional IRA and it can be rolled together with other IRA accounts or converted to a Roth IRA if the usual income limits are met.

Final thoughts

These five mistakes are easily avoided by being familiar with the rules regarding IRAs and employer retirement plans. On the other hand, most of these mistakes are difficult, expensive, and often impossible to correct.  Those who want to rollover their retirement accounts or convert their IRAs should make sure they are making the best decision.