5 quirky IRA rules you never heard of
From: www.financial-planning.com
When it comes to IRAs, the tax rules get pretty complicated to say the least.
Here are five unusual quirks that all financial planners should know. Understanding these anomalies could come in handy, helping you save clients some serious money.
1. Military death benefits can be contributed to a Roth IRA: Help families of veterans with this one because it can make a big difference in their taxes.
The tax code allows a beneficiary of military death gratuities and Service Members Group Life Insurance (SGLI) to contribute those funds to a Roth IRA or a Coverdell Education Savings Account (ESA). This provision applies to beneficiaries of all military personnel — not just active military. Importantly, the Roth contribution can be made without regard to the annual contribution or income limits that apply to those accounts. The contribution must be done by the end of the year following the receipt of the death benefit. For instance, if the beneficiary’s spouse passed away this year, they would have until the end of 2019 to make the contribution.
If your client later decides to withdraw any part of the military death benefits or SGLI payments that he or she contributed to a Roth IRA, those distributions will be tax free, even if the distribution from the Roth IRA is otherwise not a qualified distribution.
Your clients may also want to consider allocating their military death benefits to a few different uses. Some of the funds can go to a Roth, some to the ESA and some can be held out for immediate needs. That said, the total amount contributed to a Roth and an ESA cannot exceed the total amount of the benefits received. Funds are considered contributed to the ESA first and the Roth IRA second. Any excess amounts contributed would have to be withdrawn from the Roth IRA first.
Example: A client receives an SGLI beneficiary distribution of $250,000. She immediately contributes $50,000 to an ESA account for her son. The most the client could now contribute to a Roth IRA is the remaining balance of $200,000. If the beneficiary receives more than one benefit, he or she has one year from the date of receipt of each benefit to make a contribution to the Roth IRA or the ESA.
2. Inherited IRAs cannot be converted, but inherited plan funds can: An inherited IRA cannot be converted to an inherited Roth IRA. That said, an inherited company plan (excluding a SEP or SIMPLE IRA) can be converted to an inherited Roth IRA as long as the beneficiary is a designated beneficiary — meaning that the beneficiary is an individual or qualifying trust that is named on the company retirement plan beneficiary form.
If no beneficiary is named on the 401(k) beneficiary form, and, say, the deceased employee’s son inherits the 401(k) through the estate, then there is no designated beneficiary. In that case, the 401(k) cannot be converted to an inherited Roth IRA, nor can it be transferred to an inherited traditional IRA.
In addition, for the inherited plan funds to qualify to be converted to an inherited Roth IRA, or be transferred to an inherited traditional IRA, the account must be properly titled and directly rolled over to an inherited traditional or Roth IRA. The designated beneficiary should also take the first RMD by the end of the year after death to ensure the ability to stretch distributions.
If the beneficiary chooses to convert the plan funds to an inherited Roth IRA, the amount converted will be taxable the same as any Roth conversion. In addition, the inherited Roth is subject to ongoing RMDs, although they will likely be tax free.
Planning tip: If your client inherits a 401(k) and is considering converting those 401(k)s funds to an inherited Roth, first see if the client has his own IRA or plan funds that can be converted. Either conversion (the inherited plan funds or his own retirement accounts) will be taxable, but if there are limited funds to pay the conversion tax, first have the beneficiary convert his own IRA to a Roth, rather than the inherited plan funds. Why? If he converts his own IRA to a Roth IRA, then this is his own Roth IRA and will not be subject to lifetime RMDs.
In addition, after death he can leave that Roth IRA to a spouse who can roll it over to her own Roth and continue avoiding lifetime RMDs, or he can leave it to some other designated beneficiary who can stretch the inherited Roth over a longer period. If he converts his inherited plan funds to an inherited Roth IRA, then that inherited Roth IRA is subject to RMDs beginning in the year after death. This would erode the inherited Roth more quickly. Even though he can convert the inherited funds, he should use the money available to convert any of his own IRAs to a Roth first, and keep that Roth free of RMDs for life.
