Common IRA misconceptions

Common IRA misconceptions

Clemmer, William A


Originally simple in concept, IRAs have been complicated by misconceptions

Individual Retirement Accounts (IRAs) are well-known and often used as a simple and efficient method to accumulate funds on a tax-advantaged basis for retirement and other purposes. IRAs were originally designed to be very different from “qualified plans.” In other words, an IRA was to be less burdensome, and require little paperwork and no IRS filing. Only one line on page 1 of Form 1040 refers to IRA.

IRAs are used for many purposes; today there are 13 types. Nevertheless, the IRS has maintained the basic IRA simplicity-a fact often lost in the increased ways that the techniques are being used. As a result, numerous misconceptions are heard and repeated. The following are but a few of the IRA misconceptions and the facts concerning them:

* The acronym IRA means Individual Retirement Account. In fact, IRA stands for Individual Retirement Arrangement. There are three types of “arrangements”-an individual retirement account, an individual retirement annuity, and accounts established by employers and certain associations of employees under Code Section 408(c).

* An IRA must be established by the end of the taxable year, generally December 31. In fact, an IRA may be established as late as the time when the individual’s federal income tax return for the year is due (including extensions).

* Annual contributions to an IRA must be made by the end of the taxable year. In fact, a contribution may be made to an IRA as late as the time when the individual’s federal income tax return for the year is due (including extensions).

* The contribution rule for a SEP-IRA is the same as for a traditional IRA. Partially true. In fact, a corporation’s tax return is due on March 15. Therefore, an extension is needed to delay the contribution to a later date (see later).

* A minor cannot set up an IRA. In fact, neither the traditional nor Roth IRA has a minimum age limit. All that’s needed is taxable income. Many financial organizations, however, will not establish an account for a minor without a parent’s or guardian’s signature.

* A spouse with no income is ineligible to contribute to an IRA- In fact, in the case of a married couple with compensation filing a joint income tax return, the couple may establish two separate IRAs. The total annual contribution for both IRAs may not exceed the lesser of 100% of the combined compensation for both spouses or $4,000 (for 2001), with $2,000 (for 2001) being the limit for each individual.

* A husband and wife must establish the same type of IRA. In fact, a husband and wife do not have to contribute to the same type of IRA. For example, the husband may contribute to a Roth IRA and the wife may contribute to a traditional IRA, or vice versa.

* Pre-tax and after-tax contributions must be in separate IRAs. In fact, the IRS requires that the value of all of an individual’s IRAs be combined for the purpose of calculating the taxable and nontaxable portions of any IRA distribution. Therefore, there is no need for separate IRAs, except for minimizing substantially equal payments (an exception to the pre– 59-1/2 distribution penalty rule) and for holding distributions from qualified plans that qualify for capital gains (on employer securities) or special averaging treatment.

* A taxpayer must have a valid reason for requesting an extension. In fact, an extension is automatically granted when certain forms are filed. Individuals must file Form 4868 by the regular due date of their Form 1040. The automatic extension is four months. In the case of a partnership, for SEP, SIMPLE-IRA, or qualified plan purposes, a partnership must file Form 8736 by the return due date of its Form 1065 and all partners must also file for extensions on Form 4868. The automatic extension for a partnership is three months. A corporation must file Form 7004 by the regular due date of its Form 1120 or 1120S for an automatic six-month extension.

* Individuals who participate in a corporate retirement plan and who have earned income greater than $160,000 ma3 not contribute to an IRA. In fact, such individuals can make nondeductible contributions to an IRA until age 70-1/2.

* Transfers or rollovers may not be made from a 403(b) tax-sheltered annuity or custodial account (TSA) or an eligible 457 plan to an IRA. In fact, transfers and rollovers from a TSA or an eligible governmental 457 plan can be made into an IRA.

* Individuals may roll over an IRA once a year without being taxed or penalized. In fact, this is true-but only if the rollover payment is received in the form of a check or other property. However, an individual can request as many direct transfers as he or she wishes from one IRA trustee or custodian to another. The one rollover per 12-month period restriction applies separately to each IRA.

* No withdrawals may be made from an IRA until age 59-1/2 without payment of an “early withdrawal fee.” In fact, there are eight different ways to withdraw funds penalty-free prior to age 59-1/2. In addition to the eight exceptions, amounts transferred to an IRA of a spouse or former spouse under a divorce or separation instrument under Code Section 408(d)6) are not subject to penalty (because they are not taxable, nor deemed taxable for this purpose).

* Withdrawals must commence in the year age 70-1/2 is attained. In fact, the first distribution (the one required for the year age 70-1/2 is attained) may be distributed by April 1 of the following year; however, the second year’s distribution must also be removed in that same year.

* After age 70-1/2, a required minimum distribution (RMD) must be taken annually from each traditional IRA. In fact, although all IRAs are aggregated for calculating the RMD, the RMD may be withdrawn from any one (or more) of the IRAs.

* A non-spouse who inherits an IRA must withdraw all the funds. In fact, this depends on the IRA provider and the IRA agreement. IRA assets may have to be withdrawn by the fifth year after the original owner’s death unless distributions commence over the nonspouse’s life expectancy within one year of the death of the IRA holder.

* Once calculated and begun, the RMD amount must remain fixed. In fact, the RMD is just that-a required minimum distribution. A greater amount may be taken in any year without penalty.

William A. Clemmer and Gary S. Lesser, Esq.

The authors

William A Clemmer and Gary S. Lesser, JD, head up Financial Services Agency Consulting (FSAC), a division of The Rough Notes Company. Clemmer has more than 25 years of financial services industry experience on Wall Street. Lesser writes and lectures widely on retirement planning and taxation issues. He is a member of the board of advisors for the Journal of Taxation of Employee Benefits.

Copyright Rough Notes Co., Inc. Mar 2002

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