Slott Report Mailbag: Can Inherited Retirement Plan Funds Be Converted to an Inherited Roth IRA?

Summer is almost here, as the unofficial start to the summer season begins with Memorial Day weekend. To celebrate, we open some IRA, tax and retirement planning mail and answer several of your most pressing questions. This week's Slott Report Mailbag looks at some intricate IRA issues along with a question about the provisions in the new tax law. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Mr. Slott:

Can non-spouse beneficiaries of an employer-sponsored 403(b) TSA plan convert inherited TSA funds to inherited Roth IRAs?

Thank You,

Send questions to mailbag@irahelp.com

Walter Orlosky

Answer:
Inherited plan funds can be converted via DIRECT rollover (i.e. not a 60-day rollover) to a properly titled inherited Roth IRA. There are certain requirements that must be met. The beneficiary must inherit the plan funds as a named beneficiary, not through the estate or a non-qualifying trust. The funds must go as a direct rollover from the plan to the inherited account; they cannot be made payable to the beneficiary. Any required distributions from the plan are not eligible for rollover and should be paid out from the plan first.

The transfer of the inherited plan funds to an inherited Roth IRA will be a taxable event to the beneficiary. The beneficiary will have required distributions from the inherited Roth account. Because of these two factors, a Roth conversion by a beneficiary might not make sense, particularly if they have their own retirement funds they could be converting instead.

2.

Congress (finally!) approved the required changes to the Internal Revenue Code in early January, but apparently the federal government has not yet published the regulations with the specifics on in-service Roth IRA conversions. My plan's recordkeeper tells me that without the regulations in hand, they cannot set up software to process conversions of funds from traditional 401(k)s, 457(b) plans, etc. for people who have not separated from their employers.

Is there some date when the regulations will be finalized? We're halfway through the year, and I would like to get started on it this year and have enough time to adjust my paycheck withholding to cover the taxes due on my first increment of conversion.

Sandra Brock

Answer:
There is no way of knowing when IRS might be releasing regulations. They have now scheduled several furlough days where all of IRS will be shut down due to the sequester. This could push the release back even further.

3.

Does the 3.8% investment tax apply to retirement funds? For example, if I take a lump-sum distribution of my 401(k) plan, which holds employer stock, will the basis be taxed at 3.8% on top of income tax and will the NUA (net unrealized appreciation) be taxed at 3.8% on top of capital gains at the time I sell the stock?

Connie Carroad


Answer:
The investment surtax of 3.8% does not apply to most retirement payments. It could apply to certain non-qualified annuity payments. However, the retirement payment will increase your income and could put you over the threshold to where the surtax will apply.

Example: The surtax will apply if MAGI (modified adjusted gross income) is over $250,000 (individuals married, filing jointly). A couple’s MAGI is $235,000. Then they take a distribution from an IRA of $25,000. This increases their MAGI to $260,000 ($235,000 + $25,000 = $260,000). They are now $10,000 over the threshold and some of their investment income would be subject to the surtax.

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5 Things To Know About Disability Exception to 10% Early IRA Distribution Penalty

Retirement funds, like the money in your IRA, should generally be preserved for use in your retirement. This is not exactly a novel concept, but one that often bears repeating. That being said, sometimes events happen beyond your control that might require you to access your retirement funds before you intended. If you happen to be younger than age 59 ½, then your distributions could not only be hit with income tax, but a 10% penalty.

There are, however, a number of excuses, more formally known as exceptions, that you can use to get out of the 10% penalty and lessen your tax burden. One such exception is for disability. Below, we discuss five important facts you need to know about this exception if you plan on trying to use it to avoid the 10% penalty.

1) This Exception Applies To Plans and IRAs
Some exceptions to the 10% penalty only apply if your distribution comes from an IRA. Others apply only to distributions from a plan, like a 401(k). The disability exception, however, is one of a handful of exceptions that you can use to get out of the 10% penalty regardless of what type of retirement account your distribution is coming from.

2) It Must Be Your Disability if it’s Your Retirement Account
Some exceptions to the 10% penalty allow you to take other family members into consideration when you take a distribution. For instance, the higher education exception to the 10% penalty can be used when you have higher education expenses, but it can also be used to help pay for a spouse’s, child’s or even grandchild’s higher education expenses. In contrast, if you plan on using the disability exception to the 10% penalty, you must be disabled and the distribution must come from your own account. You cannot use another family member’s disability to claim the exception for distributions from your own retirement account.

3) You Must Be Really Disabled
In order to claim the disability exception to the 10% penalty, the tax code says that you must be unable to do any work and the disability is going to be of indefinite duration or is likely to result in death. That’s a pretty strict definition. It is not having to change careers as a result of an injury or even “retiring on disability” if you are still able to work in another capacity. If you can still work in some “substantially gainful” way, you aren’t disabled enough, per the tax code, to claim the disability exception.

4) Your 1099-R Will Still Indicate the 10% Penalty Is Owed
When you take a distribution from a retirement account, the account’s custodian sends you (and IRS) a 1099-R to report your distribution. In addition to showing the amount of the distribution, there’s a box (box 7) on the 1099-R that discusses the type of distribution. There is a code (code 2) that indicates there’s a known exception to the 10% penalty and the distribution is not subject to this additional tax, but don’t count on seeing it on your 1099-R if you’re planning on claiming the disability exception. Custodians are not generally in the business of determining whether or not you’re disabled, and if you are, how disabled you are. So chances are, any 1099-R you receive will show a code 1 in box 7, which means that there is no known exception to your distribution. That means it’s up to you to tell IRS the 10% penalty doesn’t apply.

5) You Get Out Of The Penalty By Completing Form 5329
And how do you tell IRS the 10% penalty doesn’t apply to you because you are disabled? Simple, you file IRS Form 5329 with your tax return. Along with properly completing the form, you should submit at least one signed letter from a licensed physician attesting to the severity of your disability. That will generally satisfy any questions IRS might otherwise have. Remember, just as your custodian is not really equipped to say how disabled you are, neither is IRS. So if you can proactively provide appropriate evidence from a doctor, it’s usually enough to satisfy IRS that you are, in fact, disabled enough to claim the exception.

-By Jeffrey Levine and Jared Trexler

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Non-Deductible IRA Contributions: What You Need to Know

In order to make an IRA contribution, you must be younger than age 70 1/2 for the year and also have wages or compensation from your job. Once you make your IRA contribution, then you have to figure out whether it's tax deductible or not.

If either you or your spouse actively participates in an employer retirement plan at work, then you might not be able to take a tax deduction, depending on your income. If you, or your CPA, determine that you aren’t eligible to take a tax deduction for your IRA contribution, then your IRA contribution is nondeductible.

If you make an IRA contribution that isn’t tax deductible, you must file IRS Form 8606 to report it as nondeductible. You will now have what’s known as “basis” in your IRA (money that isn’t taxable when you later take a withdrawal). Even though you may not get a tax deduction, nondeductible IRA contributions will give you tax-deferred interest just like all of your other IRA money; plus, you are saving more money for your retirement.

When you have basis, you’ll also have to file Form 8606 in any year you take a distribution from any traditional IRA, including SEP and SIMPLE IRAs, to calculate the nontaxable portion of your withdrawal.

If you don’t file Form 8606 to report nondeductible contributions, then there’s a $50 IRS penalty. But worse than that, if you can’t prove you have basis, all of your future IRA distributions will be treated as fully taxable.

Roth IRA contributions are also not tax deductible, but you don’t file Form 8606 to report Roth contributions. If you discover that your IRA contribution isn’t tax deductible, you are better off making a Roth IRA contribution instead. Assuming your income isn’t too high, the Roth IRA funds grow tax-free, not just tax-deferred. The income limits for making a Roth IRA contribution for 2013 are $178,000- $188,000 if you’re married filing jointly or $112,000 - $127,000 if you’re single.

For example, if you’re married filing joint and you and your spouses’ total income is below $178,000, you can make a full Roth IRA contribution of $5,500 (or $6,500 if you’re age 50 or older).

-By Joe Cicchinelli and Jared Trexler

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Sequester Hits IRS

The sequester is coming! The sequester is coming! That is all you heard in February and March.

The sequester is automatic federal budget cuts that took effect on March 1, 2013. The intent was to reduce the federal deficit. The cuts took effect because Congress couldn’t come to an agreement on more sensible budget cuts. March 1st came and went and we didn’t really see or feel the effects of the budget cuts.

Then it hit the air traffic controllers. They were forced to take furloughs, days off without pay. Flights were delayed because of the staff shortages in the control towers. The security lines were longer because of staff shortages. And the media featured all of this very prominently. Congress responded to all of this negative publicity by restoring the budget cuts to the FAA almost immediately.

Now the sequester is coming to IRS, which is dealing with its own internal issues as most are well aware. IRS will be closing its offices for five days before the end of this year – May 24, June 14, July 5, July 22, and August 30, 2013. Everything will be shut down on those days – its offices, all toll-free hotlines, the Taxpayer Advocate Service and all taxpayer assistance centers. There will be no processing of tax returns, compliance-related activities or acceptance or acknowledgement of electronically-filed returns. But, you get NO extension of tax-related deadlines. Deposits made through EFTPS will be processed as usual.

Taxpayers will have extra time to comply with IRS requests if the due date is on a furlough day. Web- based tools and some automated services will be available on furlough days. IRS says they may need to schedule another day or two of furloughs in order to save enough in expenses to meet the amount the sequester cut from its budget.

Will there be a public outcry over these furloughs as there was over the FAA furloughs? I am guessing not. So if you have IRS business to conduct, make a note of these dates on your calendar. Once again, our government’s fiscal problems are not shared equally by all taxpayers.

-By Beverly DeVeny and Jared Trexler

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