By Ian Berger, JD
The Internal Revenue Code is over 4,000 pages of often unintelligible tax jargon. So, it shouldn’t surprise anyone that the law contains more than its share of baffling and inconsistent provisions.
Here are four examples pertaining to IRAs and company retirement plans:
1. Non-spouse beneficiary Roth conversions. In 2006, Congress revised the tax code to allow non-spouse company plan beneficiaries to convert plan balances to inherited Roth IRAs. (These beneficiaries can also directly roll over funds to inherited traditional IRAs.). Although well-meaning, this change unintentionally created an inconsistency between non-spouse plan beneficiaries and non-spouse IRA beneficiaries. While the former group can convert plan balances to inherited Roth IRAs, the latter can’t convert IRA balances. There’s no logic to this different treatment.
2. Correcting excess IRA contributions. An excess IRA contribution can occur when you exceed the annual IRA contribution limit or make Roth IRA contributions when your income is too high. Excess contributions are subject to a 6% penalty each year the excess remains in the IRA. But you can avoid that penalty by removing the excess amount, along with associated earnings or losses (called “net income attributable” or “NIA”) by October 15 of the next year. What’s strange is that if you fix the excess contribution after the October 15 deadline and pay the 6% penalty, only the excess amount – and not the NIA – needs to be withdrawn. Makes no sense, but that’s what the tax code says.
3. NUA triggering events. If you’re a 401(k) participant with highly appreciated company stock in the plan, the net unrealized appreciation (NUA) strategy is worth considering. It allows you to defer tax on the stock’s appreciation until you sell it, and your tax is based on favorable long-term capital gains rates. One condition for using the NUA tax break is that you have a triggering event. These include reaching age 59 ½ and death. If you’re a regular employee, another triggering event is separation from service. But if you’re self-employed, separation from service is not a trigger, but disability is. It’s not obvious why there are two sets of triggering events. (Since the “disability” definition is so strict, maybe Congress assumed someone with a disability would always have a separation from service. But that isn’t always true.)
4. 10% penalty exceptions. If you’re under 59 ½, you may be hit with a 10% penalty when you receive an IRA or workplace plan distribution. Over the years Congress has carved out a number of exceptions to that penalty. Fair enough, but some of the exceptions (like disability or medical expenses) apply to both IRAs and plans, while some (like higher education and first-time homebuyer expenses) apply only to IRAs. There’s no rhyme or reason to this, and folks often wind up stuck with the penalty because an exception they thought was available didn’t actually apply.