Do you know all you need to know about your IRA? You probably don’t. That’s because getting the most out of these tremendously popular retirement accounts—and avoiding traps that can cost you money—doesn’t just depend on which investments you choose and how much you contribute. It also requires that you follow some little-known rules that affect whether you can withdraw assets without penalty…how protected your money will be from creditors…and how much in taxes you eventually will pay.
Bottom Line Personal asked retirement-investing expert Bob Carlson to describe the most surprising things most people don’t know about IRAs and how you can use that information to your advantage…
Avoiding Withdrawal Penalties
You may know that most advisers recommend not tapping money in a traditional IRA before age 59½, in part because you might incur a 10% penalty on the withdrawn amount. But it is possible to avoid the penalty in certain circumstances. Examples…
- You agree to withdraw all the funds in your IRA in “substantially equal periodic payments,” known as SEPP payments. You must spread out the withdrawals over at least five years or until you turn 59½, whichever time period is longer. For more information, search for “SEPP” at IRS.gov.
- You use withdrawn IRA assets to pay unreimbursed medical expenses for yourself and/or your family that are in excess of 10% of your adjusted gross income (AGI). In that case, there is no penalty.
- You become permanently disabled, meaning that you are unable to perform any substantially gainful employment. In that case, you can use the withdrawals for any purpose without penalty, but your withdrawals will be taxed as income.
You generally can split up a traditional IRA into separate IRAs without tax consequences. This goes against conventional wisdom, which says that if you have several IRAs of the same type (such as IRAs rolled over from 401(k)s …or inherited IRAs), you should combine them into a single IRA to make it easier to manage investments and to calculate required minimum distributions (RMDs) starting when you turn 70½. But in some cases, having more IRAs is preferable. Examples…
- If you have several beneficiaries, you may want to split a large IRA into separate ones for each beneficiary. This would make it easier to choose and pass on particular investments for each beneficiary based on such factors as the beneficiary’s age, income and financial needs. For instance, you might want to leave one child a rental property and another one dividend-paying stocks.
- To use some of your IRA assets for an investment that requires a specialized IRA custodian, it may make sense to create a separate IRA for that investment. Example: Legal tender gold coins, mortgages or a small business may require a specialized custodian.
Contributing for a Nonworking Spouse
You can contribute to an IRA for your spouse—even if he/she has no income. You are allowed to put up to $5,500 into your own IRA as long as you had at least that much earned income for the year ($6,500 if you are age 50 or over)…and you also can contribute to an account in your spouse’s name regardless of whether the spouse’s income was enough to normally qualify. What matters is that your combined earned income must be at least as much as your combined contributions to the two accounts and that neither contribution can be more than the individual limits stated above. (Roth IRA contributions are allowed only if your income is below a certain level.)
401(k) contributions vs. IRA Contributions
You are allowed to contribute to both your 401(k) plan at work and an IRA in the same year. If your employer matches part of your 401(k) contributions, it typically makes sense to first contribute enough to get your full employer match. Contributions to a traditional 401(k) are not taxed until you withdraw money from the 401(k).
Caution: When you are covered by an employer plan such as a 401(k), the tax deduction you can take on your contributions to a traditional IRA depend on your modified adjusted gross income (MAGI).
Example: For married couples filing jointly, if they both have retirement plans at work, they can take a full deduction on IRA contributions up to the allowable amounts if their MAGI in 2016 is $98,000 or less…a partial deduction if their MAGI is more than $98,000 but less than $118,000…and no deduction if their MAGI is $118,000 or more. For 2017, the ability to take a deduction is phased out between $99,000 and $119,000. If only one spouse has a retirement plan at work, the ability to claim a deduction is phased out between $184,000 and $194,000 for 2016 and between $186,000 and $196,000 for 2017.
There may be limits on how much you can protect your IRA assets from creditors if you declare bankruptcy or get sued. This is different from the rules for some other retirement accounts, such as most 401(k)s, which may receive near-ironclad protection from creditors under federal law if you face bankruptcy or a personal-injury or other lawsuit. (You are not protected from federal tax liens or spousal/child support payments, among other exceptions.) Examples…
Inherited IRAs receive no federal bankruptcy protection unless you inherited the account from your spouse. For traditional and Roth IRAs, the amount shielded from bankruptcy creditors is capped at a total of $1,283,025 this year for all of your IRAs combined. Rollover IRAs from employer 401(k) plans, Simplified Employee Pension (SEP) plans and SIMPLE IRAs do get federal protection from creditors in a bankruptcy, but like all IRAs, state laws define the protection you get from other creditors such as an individual who wins a civil lawsuit against you.
Say you injure someone in a car accident…the injured person’s claims exceed your insurance coverage…and he/she sues you. Most states provide some protection for your IRA assets, but how much varies drastically.
Examples: In California, you can exempt only as much as a judge deems “reasonably necessary” to support your dependents. In Ohio, traditional and Roth IRAs are protected, but SEP plans and SIMPLE IRAs are not. For rules in your state, consult an estate-planning attorney.
Self-defense: If you have a very large amount of assets in your IRAs, you may want to consider a personal umbrella liability policy and/or malpractice insurance if, say, you are a surgeon or in some other occupation at high risk from creditors. Or if you plan to leave your IRA to a child who has financial problems and could wind up seeking bankruptcy protection, you may want to name a trust as beneficiary of the IRA instead and let the trust distribute the money to the child.
Funding an HSA
You can fund a Health Savings Account (HSA) with your IRA without facing a penalty or paying taxes. Transfer money directly from your IRA to your HSA using a Qualified HSA Funding Distribution (QHFD). You may take only one QHFD in your lifetime, and the transferred money can be used only for qualified medical expenses. For more information, including limits on the amount transferred, see Form 8889, Health Savings Accounts (HSAs), at IRS.gov. This transaction is not taxable or subject to the 10% penalty.
Making required minimum distributions (RMDs)
- You don’t have to liquidate an investment in your IRA in order to take an RMD. You can do this by making an “in-kind” distribution rather than a cash withdrawal. Have your IRA custodian transfer IRA investments with a value at least equal to the RMD amount into a taxable account. Example: You can transfer shares of a mutual fund or stock or, if you own real estate, you can transfer all or part of the property. Advantages: You get to keep investments that you want to hold long-term or that you might have trouble selling in a timely and profitable fashion, such as real estate.
- You may be able to avoid RMDs by using a “reverse rollover” to a 401(k) at your current employer. You might know that you can roll an employer retirement account such as a 401(k) into a traditional IRA. But some employers allow you to do the opposite—roll assets from an IRA into a 401(k). This strategy is attractive for individuals who have reached age 70½ but still are working and don’t need additional income. The IRS does not require you to begin taking RMDs from your 401(k) accounts until April 1 of the year following the end of your employment.