For many people, IRAs hold a large part of their retirement nest egg. Even if they save using a company or government savings plans such as 401k, 403b or 457, eventually many roll this over to an IRA.
On the surface, IRAs appear simple to set up, contribute to and take withdrawals. However, there are a number of potential pitfalls to watch for to avoid triggering an unexpected tax hit.
There are three types of IRAs, traditional, rollover and Roth. Traditional and rollover IRAs are treated the same as far as taxes on withdrawals. You are taxed on withdrawals from any "pre tax" contributions and gains. The difference is the source of the money and some legal protection. Rollover IRAs are created when money from a 401k, 403b or other plan is "rolled out" into an IRA that you manage. All other IRAs are funded by direct contributions. Rollover IRAs retain the bankruptcy protection afforded to 401ks and 403bs.
Roth IRAs are created using "post tax" contributions and withdrawals are not taxed.
The three most common events that trip up people involve moving money into or out of an IRA. The first is taking early withdrawals. In general, you cannot take money out of an IRA before you are 59 1/2 without paying a 10 percent penalty. This penalty is on top of any tax due on the withdrawal. There are exceptions; most commonly buying your first home, educational expenses, medical or hardship. You are allowed to take "equal" withdrawals over a period of time, usually several years. This is called a 72t exception named for the tax code section. Although this greatly impacts your long term retirement as
sets, it can be used to support expenses before 59 1/2 and avoid penalties. The rules for taking withdrawals prior to 59 1/2 are complex and you should consult someone well versed in the laws before making the withdrawals.
The second event is rolling over money into an IRA. Many times the reason given for doing a rollover is to have more flexibility in investing. Sponsored plans have fewer investment choices than most IRA accounts however, you should also consider the ongoing costs, legal protection and early withdrawal capability available in a 401k. Legislation making fees more transparent and penalties assessed to the sponsor have reduced the high cost problem. This has resulted in some sponsored plans having better, lower cost investments than may be available in an IRA. 401ks, 403bs and other sponsored plans have strong legal protection against creditors. Depending on state law, your IRA may not have the same creditor protection.
If you have a 401k, you may be able to take a loan or take withdrawals without paying a penalty if you leave the company after age 55. This can be important if you take early retirement or have a short term financial need. These options are not available with IRAs.
If you have made post tax contributions to a sponsored plan or your IRA, take care to treat the pre-tax and post-tax amounts separately. For record keeping it is often easier to create separate IRAs for each. Post tax amounts can be rolled over into a Roth IRA, without having a taxable event, since you already paid tax on the contributions.
If you have a significant amount of company stock in your 401k that has appreciated in value, you may be able to save on taxes by utilizing a little used provision, Net Unrealized Appreciation. This treatment can allow you to pay some of the tax at the lower capital gains rates instead or the normal income rate. There are restrictions and the rules are complex so talk to your tax specialist before taking this on.
When making a rollover to an IRA, use a trustee to trustee transfer. This avoids having to handle a check and keeps you off the IRS radar. In 2015, tighter rules limiting non-trustee rollovers from sponsored plans or other IRAs will take effect. If you do a non-trustee rollover incorrectly, you could risk losing the tax shelter on your entire IRA.
The last event, is converting a traditional or rollover IRA to a Roth IRA. This is a taxable event so you may want to do a portion of the conversion over several tax years to avoid a large spike in your tax rate in one year. Once your money is in a Roth and you are 59 1/2, you can withdraw your contributions at any time without paying tax or penalties -- except if your Roth account has been open for less than five years. If the account has been open less than five years, taxes may be due on the earnings portion of the Roth IRA. You can still take out your contribution amounts without tax but keep good records to avoid problems with the IRS.
Your IRAs are a valuable asset for your retirement plan. Take the time to consult with a tax expert to make sure you don't get hit with a surprise bill down the road.
Tom Roberts, a financial planner and the owner of A New Approach Financial Planning in Lakewood Ranch and Sarasota, can be reached at (941) 927-9590 or via email at Tom@ANewApproachFP.com.