Essential IRA Tips for Helping Clients Save Taxes and Avoid Penalties

Denise Appleby, APA, CISP, CRPS, CRC®, CRSP – IRA Strategies for Mistakes Prevention Expert

Denise Appleby, APA, CISP, CRPS, CRC®, CRSP – IRA Strategies for Mistakes Prevention Expert

Editor’s note: This article is an adaptation of the live webinar delivered by Denise Appleby in 2017. Her comments have been edited for clarity and length.
You can read the summary article here as part of the 4th Qtr 2017 Retirement InSight and Trends Newsletter, worth 1.0 CE when read in its entirety (after passing the online quiz.)
You may also choose to take the full length course 10 Essential IRA Tips for Helping Clients Save Taxes and Avoid Penalties for 1.0 hours continuing education (CE) credit.

By Denise Appleby, CISP, CRC®, CRPS, CRSP, APA, President of Appleby Retirement Consulting, Inc.

There is so much that we need to be paying attention to today to protect our clients. By the end of this article, I hope you learn how to prevent rollover and RMD mistakes that can cost your clients their IRAs, and help ensure that the right person inherits IRAs. The cost of making errors includes loss of tax-deferred status, premature taxation, early distribution penalty, excess accumulation, excise taxes … I could go on and on.

Abide by the One-per-year Rollover Rule

This rule applies to rollovers that occur between IRAs. I get asked this question a lot: “I am rolling over from my 401(k). Am I subject to the one-per-year rollover rule?” The answer is no. However, if someone breaks this rule, there is loss of tax-deferred status, excess IRA contributions from ineligible rollovers, and 6 percent excise tax if the ineligible rollover is not corrected properly and corrected by the deadline. So, what is this rule?

There are two ways you can move money between IRAs:

1. Transfers are nonreportable, and they are nontaxable. Usually, for a transfer to occur, you go to the receiving financial institution and say, “I have an IRA at another custodian. Please send them a request to send my money to the new IRA I have with you”, and they will send it directly to the IRA. That is a trustee-to-trustee transfer. The IRS is never told about those transactions because it is never reported on the tax return.

2. There are several reasons why someone might want to do a rollover. They may be impatient; they cannot wait on the transfer process, so they want to run over to Bank A, grab a check, bring it over to you, and it is done, possibly within a day. Alternatively, someone might say, “I am hard up on cash. I am going to take some money from my IRA and put it back within 60 days.” That is referred to as a rollover transaction.

The key to remember is that your clients can do only one IRA-to-IRA rollover during a 12-month period. Now, here is what is very important: This applies on an aggregate basis. So, if someone took a distribution from a Roth IRA and rolled it over within 60 days, they are locked up for the next 12 months. They cannot do another IRA-to-IRA rollover with their traditional SEP IRA or Simple IRA.

What I am encouraging you to do here is to tell your clients to use a trustee-to-trustee transfer method when they want to move their assets between IRAs unless they have no other choice. For those who want to use the rollover method, remind them that they can only do that once during a 12-month period because if they break that rule, any rollover that exceeds the first rollover becomes ineligible and is no longer eligible to be held in their IRA.

Obey the 60-day Rollover Rule

Someone who takes a distribution and puts it back must do so within 60 days, and if the rollover is proper – if it meets a 60-day deadline and the amount is eligible to be rolled over – then it is reportable, but not taxable. You will find that many clients do intend to complete this rollover within 60 days, but you make plans and life happens, right?

There are a prevalent number of rulings that the IRS has issued about these 60-day deadlines.  People are saying to the IRS, “Please, I made a mistake; I was sick; I was in jail; my mom was sick; I could not completely roll over,” then you get an idea of how many people are missing this deadline for one or more reasons.

What happens if someone misses the deadline? The first thing is that the amount is no longer eligible to be rolled over unless they qualify for an exception. Then, you also have the loss of tax-deferred status and the 6 percent excise tax that accrues for every year that an ineligible rollover remains in the IRA until it is corrected.

The 60-day rollover rules can be used for IRA-to-IRA rollover; that is where the once-per-year rollover rule applies. You can also apply to moving assets between IRAs and employer-sponsored retirement plans. In that case, there is no one-per-year rollover rule.

Believe it or not, it also applies to Roth IRA conversion. Many people believe that the only way you do a Roth conversion is by a direct transfer, where you move the money directly from one account to another. However, you can also do a Roth conversion using the indirect Roth conversion method.  Someone takes a distribution from a traditional IRA to the Roth IRA custodian and says, “Deposit this to my Roth IRA as the Roth conversion, and in that case, the Roth conversion must be completed within 60 days of receipt.

There are some cases where the 60-day deadline can be waived. The first is the automatic waiver. The way that applies is let is say an IRA custodian has a set of procedures that someone must follow to complete a 60-day rollover and the IRA owner did everything he or she was required to do. There have been cases where an assistant got a check, and it got stuck somewhere in a drawer and never got deposited to a client is IRA, or a client might have a regular checking account and an IRA, and somehow, the rollover check got deposited to the regular checking account. In a case like that, if the rollover is completed within a year – as opposed to the 60-day – then there is an automatic waiver.

There is a self-certification method that is pretty new where if your client meets a certain requirement, they can certify to the IRA custodian that they meet those requirements, and therefore, the custodian would complete the rollover within the allowed timeframe. If your client is not eligible for the automatic waiver or the self-certification, that is when they have to go to the IRS and say, “Please help me.” This service is not free. It is going to cost them $10,000, and there is no guarantee that the IRS is going to say yes. This process is called a private-letter ruling. Typically, they get an attorney involved who is familiar with the process, so you are not just talking about the IRS is $10,000 fee, but the attorney fee as well. As you can see, this is one of those cases where the prevention is better than the cure.

Spouse Beneficiary Assets Owned versus Inherited

This tip is very important for young spouses. I have seen many cases where a spouse beneficiary inherited an IRA, took a distribution later, and was subject to a 10 percent early distribution penalty when that could have been avoided. Why?  Distributions from inherited accounts are automatically exempted from the 10 percent early distribution penalty.

A spouse beneficiary has two options: they can put it in their own IRA or keep the assets in an inherited IRA. The question for a financial advisor is, “What should I tell my client who is a spouse that just inherited an IRA from his or her deceased spouse?”

You are going to ask your client a couple of questions. One of them is, “How old are you?” If your client is a spouse beneficiary under age 59½, your follow-up question must be, “Do you plan to take the distribution from these assets before you reach age 59½?” If the answer is yes, then you want to keep those assets in an inherited IRA because distributions from the inherited IRA are exempted from the 10 percent early distribution penalty.

I am a big believer in checklists. I recommend you create a checklist especially for inherited accounts.  Be sure to include if your client is a surviving spouse of the IRA owner, whether the client is under age 59½, and if so, whether or not you need to have that client keep those assets in an inherited IRA to avoid the 10 percent early distribution penalty.

Check Exceptions Before a Rollover

Money is always moving to and from retirement accounts. That includes moving between an IRA and an employer-sponsored retirement plan. You know that distributions taken before the retirement account owner reaches age 59½ are subject to a 10 percent early distribution penalty, but you also know that there are some exceptions to that 10 percent early distribution penalty.

Here is a tip: When your client comes to you to say, “I want to move money from my 401(k) to an IRA with you,” ask the age question again, and if your client is under age 59½.  Check to see if your client is losing an exception by rolling over those assets to you. Some of the exceptions to the 10 percent early distribution penalty apply to IRAs, some apply to employer-sponsored retirement plans, and some apply to both.

For example, a man qualified for what is referred to as the “age 55 exception.” With the age 55 exception, if you separate from service with the employer that sponsors the retirement plan in the year you reach age 55 or later, any distribution that you take after you separate from services is exempted from the 10 percent early distribution penalty.

He knew that much, but what he did not know is that if he rolled over the amount to his IRA, then he would lose that exception, and that is exactly what he did. He took the distribution, rolled it over to his IRA, then took the distribution from his IRA. The custodian reported the distribution with a Code 1 in Box 7 of Form 1099-R to the IRS that the amount was subject to the penalty. The IRS came asking for the $20,000, he said, “I do not owe you,” he took the IRS to court, and he lost. The tax court rightly said, “The minute you rolled over those assets to your IRA, then you lost that exception.”

It works the other way, too. There are some exceptions that apply to IRAs that do not apply to employer-sponsored retirement plans, which is the first-time homebuyer exception. So, check with your clients who are doing rollovers to see whether or not they are going to lose an exception as a result of the rollover, and if that is the case, then any amount that they need to distribute immediately should be paid to them and not rolled over to the receiving account.

Meet the RMD Deadline

Individuals who are at least age 70½ need to take a required minimum distribution. Those who reach age 70½ this year and it is their first RMD can defer taking their RMD as late as April 1 of next year. What is the big deal? What if someone does not take their RMD? Well, the big deal is that they are going to owe the IRS a 50 percent excess accumulation penalty.

I recommend creating a list of clients who are supposed to take RMDs for the year. Some custodians will even go as far to send their advisors a report that says, “These are the clients that are supposed to take an RMD this year, and this is the amount the clients have taken in RMDs so far,” so that you will know to which clients to reach out.

RMDs do not apply to Roth IRA owners, but they do apply to Roth IRA beneficiaries, and they apply to traditional SEP and Simple IRAs and employer-sponsored retirement plan accounts, including Roth 401(k)s, Roth 403(b)s, and Roth 457(b) accounts. We want to check to make sure that they do take RMDs from the accounts they are required.

Here is the one that people often forget: RMDs for inherited accounts.  Custodians are required to monitor RMDs for IRAs or send out an offer to calculate the RMD upon request. They are not required to do any RMD reporting for inherited IRAs. So many inherited IRA owners forget or are unaware of the fact that they need to take RMDs from inherited accounts. When you are doing your RMD process for clients, just remember to include your clients with inherited accounts because they too are supposed to take RMDs. If they are supposed to take an RMD this year will depend on several factors, including whether or not the retirement account owner died before the required beginning date and the beneficiary options that are available to those beneficiaries.

What happens if you find out that your client missed the RMD deadline? Do not be too alarmed because the IRS says if the failure is due to reasonable cause, then they will waive the penalty. There has been only one instance in my experience where the IRS denied the waiver request, and that is because the CPA filled out the form incorrectly, and once we fixed that, then everything was fine.

If your client comes to you in January and says, “I did not take my RMD last year. I understand that I owe the IRS a 50 percent accumulation penalty. What should I do?” The first step is to find out whether or not the deadline was missed due to reasonable cause.  In that case, you or the CPA can file IRS Form 5329 to ask for the waiver. You take the RMD; you include proof that the RMD has been taken or that steps have been taken to remedy the RMD shortfall, and you include an explanation to the IRS. It is very likely that they will honor the request to waive the penalty. The penalty is not paid unless the IRS comes back and says, “I am denying your waiver request,” so it gives your clients some time to get their house in order.

Aggregation Rules

A few months ago, I got a call from a financial advisor, and he was working with someone who had a 403(b) account and an IRA.  He was not working with a school district anymore, so he was supposed to take RMDs. He liked how the 403(b) was performing, so he decided that he was going to leave the 403(b) as is and take the RMDs for the 403(b) and the IRA from his traditional IRA, and he had been doing that for ten years.

What is wrong with that picture? He knew that there was such a thing as an RMD aggregation rule. To honor the RMD aggregation rule, you can calculate your RMD for multiple accounts separately, but you can total the amount and take it from one or more of those retirement accounts.

The RMD aggregation rule does not apply to all types of retirement accounts, and if someone applies the RMD aggregation rule when it should not be applied, then technically, he is missing their RMD deadline. In his case, because he did not take any RMD from the 403(b), he missed the RMD deadline from the 403(b) for ten years, so he owed the IRS for ten years of the 50 percent excess accumulation penalty.

What does the RMD aggregation rule allow? If someone has multiple traditional IRAs – which for this purpose, are traditional SEPs and Simple IRAs – then the RMD for those retirement accounts must be calculated separately, but they can be totaled and taken from one or more of those IRAs. If someone has multiple 403(b) accounts, he or she can be calculated separately, but they can be totaled and taken from one or more of those accounts.

If someone has assets in multiple 401(k) plans – because that does happen, where clients may leave 401(k) assets at old employers – then the RMD for those accounts must be taken from the individual accounts. You cannot aggregate employer-sponsored qualified plans for RMD purposes.

The RMD aggregation rule is permitted only for multiple 403(b)s and for multiple traditional IRAs, and you cannot cross account-types. You cannot take the RMD for a 403(b) from an IRA and vice versa because if someone does that, then they are going to have an RMD shortfall for the account for which no RMD was taken.

Move Inherited IRAs Using the Transfer Method

If an IRA owner dies and leaves the IRA to a child, it is possible that that child might want to change financial institutions because they have a financial advisor that they like or prefer. They may not like their mother is financial advisor, so they want to move it to you because they like you.

The question becomes how should they move it to you, and if they use the wrong method to move that to you, then what happens? We are going to have the consequence of loss of tax-deferred status, excess IRA contributions from ineligible rollovers, and the 6 percent excise tax if not corrected.

Non-spouse beneficiaries that take distributions from retirement accounts cannot roll over those distributions. The only way to move inherited assets for non-spouse beneficiaries is to use the trustee-to-trustee transfer method. If the assets are coming from an employer-sponsored retirement plan such as a 401(k) and you are moving it to an IRA, it must be done as a direct rollover. If the assets are paid to the non-spouse beneficiary, then those assets cannot be rolled over.

If that happens, what you are going to have is a client who is a beneficiary with a check in hand for, say, $1 million, and they are sitting in your office saying, “This is my $1 million check. I took it from the IRA that I inherited from my rich uncle, and I want to put it in my IRA with you,” and you are going to have to deliver that bad news to say, “Well, because you took that check as a distribution, it is all over. You are no longer eligible to keep it in an IRA.”

As you know, in some cases, beneficiaries can take distributions over their life expectancy, which allows them to continue the tax-deferred benefit that was available to the IRA owner, and that can be very powerful – especially for Roth IRAs – because the earnings will eventually become tax-free for qualified distributions.

When you are talking to a beneficiary that inherited an IRA or employer-sponsored retirement plan, and they want to move those assets to you, I strongly recommend that you hold their hand throughout that transaction.  Even if you tell your client, “Go tell the bank that you want a transfer,” I cannot tell you how many experienced people I have conversations with where, throughout the conversation, I have to stop them and say, “You mean a transfer, not a rollover, right?”

When you walk into a bank and tell them that you want to rollover your account when you mean you want to transfer, the bank is going to facilitate a rollover, so you want to make sure you are using the right terminology. For your client, hold their hand through the process, look at every piece of paperwork that they complete, and make sure that no paperwork is submitted to the financial institution without looking at it first and giving your client the thumbs up to say, “This is okay to be submitted.”

Stick by the 72(t) Rules

I do not see many people doing 72(t) distributions any more, and I guess it is because the job market is picking up. Distributions from retirement accounts are subject to a 10 percent early distribution penalty if they are taken before age 59½ unless an exception applies, and one of the exceptions is a 72(t) distribution or substantially equal period payment – SEPP for short.

72(t) is a section of a tax code which governs the rules, which is why we refer to it as 72(t). 72(t) distributions are subject to a strict set of rules.  If a client is taking a 72(t) distribution and breaks any of the rules, then you have what is referred to as a “modification,” and if there is a modification, then the 10 percent penalty that was waived under the program is now owed to the IRS, plus interest.

You are probably saying, “Well, that does not sound too bad, does it?” Someone who starts a 72(t) distribution at age 40 would be required to continue that 72(t) distribution for 19 years. Now, imagine someone coming to you in Year 10 telling you that he or she has a modification. That means for all the 10 percent penalty that was waived ten years ago; they now owe the IRS all those 10 percent penalties that were waived plus interest, so you can see how serious that is.

The lesson here is if you have a client who is taking 72(t) distributions, I strongly recommend giving them a checklist of the things that they can and can it do with a 72(t) program.  If they break any one of those rules, then, of course, we are going to have to have that conversation about the recapture of the 10 percent early distribution penalty.

Other things that you cannot do with a 72(t) are once you start the program with the IRA, you cannot make a rollover contribution to that IRA.  You cannot do partial transfers, you cannot commingle with other accounts, and you cannot take less or more than the 72(t) amount.

Do Beneficiary Audits

I would be willing to take a bet that if we survey IRA owners (retirement account owners and beneficiaries), it will show that one of the Top 5 mistakes made with retirement accounts is that the wrong beneficiary inherits the retirement account. In many cases, this could be prevented.

A beneficiary audit is not complicated. You are going to check to see who the beneficiary is on a retirement account and whether the beneficiary form has been completed properly.   Believe it or not, something as simple as naming three primary beneficiaries of a retirement account and giving each 25 percent could invalidate a beneficiary form (25% times 3 is 75 percent, right)? The custodian gets that form, sees that there are three beneficiaries, to whom each is allocated 25 percent. That does not add up to 100, and they kick it back and send the client a letter saying, “Your beneficiary form is invalid. You need to revise it and send one in.”

Your client gets the letter and never looks at it.   When the client dies, the kids come forward to claim the IRA, only to find out that there is no beneficiary, so they are not the beneficiaries and depending on the terms of the IRA agreement, the estate might be the beneficiary. The consequence is not only can the wrong person inherit the retirement account, but the distribution options to the beneficiaries could then be very limited.

There are also cases where if there is no beneficiary named, or if the beneficiary dies before the retirement account owner, then we have to look to the IRA agreement or plan document to determine who is the default beneficiary of the retirement account.

When naming a beneficiary, there are several things that should be taken into consideration, like whether the beneficiary is a designated or a non-designated beneficiary. You can name anyone as a beneficiary, but you can also name non-persons as a beneficiary – for instance, a charity or an estate. Usually, when it is a charity or an estate that is named as a beneficiary, then the distribution options that are available to the beneficiaries are more limited, and that remains the case even if there are multiple beneficiaries and one of those beneficiaries is a non-person.

Assume a retirement account owner dies before the required beginning date, or before they are supposed to start taking RMDs.  There are two beneficiaries, one charity, and one child, so both are required to take full distribution within five years unless the charity distributes its share by accepting it by September 30th of the year following the year of death. If the distribution by the charity is done by September 30th of the year following the year of death, then the remaining individual who is a beneficiary would be able to take distributions over his or her life expectancy.

I have seen many cases where people have spent thousands of dollars updating their will.  In the will, they will state, “I want John Brown to be the beneficiary of my IRA.” This approach does not work for the IRA because the only way to name a beneficiary for an IRA is to complete the beneficiary form or if the beneficiary is determined under the default provisions of the IRA agreement.

Key Takeaways for Advisors

  1. Ensure that clients understand the rules and limitations that apply to the different methods for moving their retirement accounts. For instance, if someone is rolling over assets from a 401(k) to an IRA, it should be done as a direct rollover to avoid the mandatory 20 percent withholding on any pretax amount.
  2. Determine if there are solutions for errors that have been made with transactions. Most of my clients came to me because of mistakes that had been made, and I have developed a reputation for putting in preventative measures and fixing mistakes. Advisors will come to me very worried, saying, “My client made this mistake, and I am so worried because I do not want to have this conversation with them.” You will want to check first to see if there is any solution before you give a client the bad news.
  3. Add a beneficiary checkup to your annual review for your client and perform this checkup not just for the accounts that you have under management, but for accounts that they have elsewhere as well. You may find out that your client has an old 401(k) with a $10 million balance that they did not even know they could move.
  4. Determine if the client will lose any exceptions to the 10 percent early distribution penalty before you recommend that they move those assets, and
  5. Ensure that RMDs are taken by the deadline.

It is okay to show your clients why they need to come to you – not just for investment advice, but for information about how to help protect the tax-deferred status of their retirement account. Show them some of the cases as examples. These are people who thought they knew the rules, but they did not, and because they decided to do it on their own, they ended up losing their retirement accounts.

10 Essential IRA Tips for Helping Clients Save Taxes and Avoid Penalties – Denise Appleby

10 Essential IRA Tips for Helping Clients Save Taxes and Avoid Penalties – Denise Appleby

About Denise Appleby:

Denise Appleby, APA, CISP, CRPS, CRC®, CRSP, Founder and Owner of Appleby Retirement Consulting, Inc, a firm that provides IRA tools and resources for financial and tax professionals.

Denise has over 15 years of experience in the retirement plans field, and has co-authored several books and written over 400 articles on IRA rules and regulations.

Denise held several senior retirement plans related positions with Pershing LLC, which includes Vice President of Retirement Plans Products and Services, Retirement Plans Manager, Trainer, Training Manager, Compliance Consultant, Technical Help Desk Manager and Writer. Denise has extensive experience with training the staff and financial advisors of many broker-dealers on retirement plans related topics. Denise has also provided training to hundreds of financial advisors, as well as tax and legal professionals on the rules and regulations that govern IRAs, SEP IRAs, SIMPLE IRAs and qualified plans.

Denise’s wealth of knowledge in retirement plans led to her making appearances on CNBC’s Business News, Fox Business Network and numerous radio shows, as wells as being quoted in the Wall Street Journal, Investor’s Business Daily, CBS Marketwatch’s Retirement Weekly and other financial publications, where she gave insights on retirement planning. Her expertise and knack of explaining complex retirement plans rules and regulation, so that they are easily understood, created a demand for her to speak at various conferences and seminars around the country.

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©2018, Denise Appleby, APA, CISP, CRPS, CRC®, CRSP, Founder and Owner of Appleby Retirement Consulting, Inc. All rights reserved. Used with permission.

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