Is a Rollover IRA a Good Idea?

In addition to an increase in rollovers, there has been an increase in the mistakes people make when transferring retirement funds as well, reports The Wall Street Journal in a recent article, “The Biggest Mistake People Make With IRA Rollovers.” These are expensive mistakes, potentially adding up to tens of thousands of dollars in taxes and penalties.

Done properly, rolling the funds from a 401(k) to a traditional IRA offers flexibility and control, minus paying taxes immediately. Depending on the IRA custodian, the owner may choose from different investment options, from stocks and bonds to mutual funds, exchange-traded funds, certificates of deposits or annuities. A company plan may limit you to a half-dozen or so choices. However, before you make a move, be aware of these key mistakes:

Taking a lump-sum distribution of the 401(k) funds instead of moving them directly to the IRA custodian. The clock starts ticking when you do what’s called an “indirect rollover.” Miss the 60-day deadline and the amount is considered a distribution, included as gross income and taxable. If you’re younger than 59½, you might also get hit with a 10% early withdrawal penalty.

There is an exception: if you are an employee with highly appreciated stock of the company that you are leaving in your 401(k), it’s considered a “Net Unrealized Appreciation,” or NUA. In this case, you may take the lump-sum distribution and pay taxes at the ordinary income-tax rate, but only on the cost basis, or the adjusted original value, of the stock. The difference between the cost basis and the current market value is the NUA, and you can defer the tax on the difference until you sell the stock.

Not realizing when you do an indirect rollover, your workplace plan administrator will usually withhold 20% of your account and send it to the IRS as pre-payment of federal-income tax on the distribution. This will happen even if your plan is to immediately put the money into an IRA. If you want to contribute the same amount that was in your 401(k) to your IRA, you’ll need to provide funds from other sources. Note that if too much tax was withheld, you’ll get a refund from the IRS in April.

Rolling over funds from a 401(k) to an IRA before taking a Required Minimum Distribution or RMD. If you’re required to take an RMD for the year that you are receiving the distribution (age 72 and over), neglecting this point will result in an excess contribution, which could be subject to a 6% penalty.

Rolling funds from a 401(k) to a Roth IRA and neglecting to pay taxes immediately. If you move money from a 401(k) to a Roth IRA, it’s a conversion and taxes are due when you make the transfer. However, if you have some after-tax dollars left in the 401(k), you can make a tax-free distribution of those funds to a Roth IRA. Remember funds must remain in a Roth IRA for at least five years, before withdrawing any earnings or they’ll be subject to taxes and possibly penalties.

Not knowing the limits when moving funds from one IRA to another, if you do a 60-day rollover. The general rule is this: you are allowed to do only one distribution from an IRA to another IRA within a 12-month period. Make more than one distribution and it’s considered taxable income. Tack on a 10% penalty, if you’re under 59½.

Reference: The Wall Street Journal (Oct. 1, 2021) “The Biggest Mistake People Make With IRA Rollovers”

Can a Charity Be a Beneficiary of an Estate?

The interest in charitable giving increased in 2020 for two reasons. One was a dramatic increase in need as a result of the COVID pandemic, reports The Tax Advisor’s article “Charitable income tax deductions for trusts and estates.” The other was more pragmatic from a tax planning perspective. The CARES Act increased the amounts of charitable contributions that may be deducted from taxes by individuals and corporations.

What if a person wishes to make a donation from the assets that are held in trust? Is that still an income tax deduction? It depends.

The rules for donations from trusts are substantially different than those for charitable contribution deductions for individuals and corporations. The IRS code allows an estate or nongrantor trust to make a deduction which, if pursuant to the terms of the governing instrument, is paid for a purpose specified in Section 170(c). For trusts created on or before October 9, 1969, the IRS code expands the scope of the deduction to allow for a deduction of the gross income set aside permanently for charitable purposes.

If the trust or estate allows for payments to be made for charity, then donations from a trust are allowed and may be tax deductions. Otherwise, they cannot be deducted.

If the trust or estate allows distributions for charity, the type of asset contributed and how it was acquired by the trust or estate determines whether a tax deduction for a charitable donation is permitted. Here are some basic rules, but every situation is different and requires the guidance of an experienced estate planning attorney.

Cash donations. A trust or estate making cash donations may deduct to the extent of the lesser of the taxable income for the year or the amount of the contribution.

Noncash assets purchased by the trust/estate: If the trust or estate purchased marketable securities with income, the cost basis of the asset is considered the amount contributed from gross income. The trust or estate cannot avoid recognizing capital gain on a noncash asset that is donated, while also deducting the full value of the asset contributed. The trust or estate’s deduction is limited to the asset’s cost basis.

Noncash assets contributed to the trust/estate: If the trust or estate acquired an asset it wants to donate to charity as part of the funding of the fiduciary arrangement, no charity deduction is permitted. The asset that is part of the trust or estate’s corpus, the principal of the estate, is not gross income.

The order of charitable deductions, compared to distribution deductions, can cause a great deal of complexity in tax planning and reporting. Required distributions to noncharitable beneficiaries must be accounted for first, and the charitable deduction is not taken into account in calculating distributable net income. The recipients of the distributions do not get the benefit of the deduction. The trust or the estate does.

Charitable distributions are considered next, which may offset any remaining taxable income. Last are discretionary distributions to noncharitable beneficiaries, so these beneficiaries may receive the largest benefit from any charitable deduction.

If the trust claims a charitable deduction, it must file form 1041A for the relevant tax year, unless it meets any of the exceptions noted in the instructions in the form.

These are complex estate and tax matters, requiring the guidance of an experienced estate planning attorney for optimal results.

Reference: The Tax Advisor (March 1, 2021) “Charitable income tax deductions for trusts and estates”