Different ways to transfer your IRA

July 25, 2014

April 15 can be a bad day for a lot of people because they have to fork over money to Uncle Sam. However, it can be a lot worse for some rather than others.

Here’s a hypothetical example. John and Mary, who are brother and sister, inherited an IRA from their father upon his death. John and Mary received some bad advice from an adviser who told them to take the money from Dad’s IRA and put it into a new IRA to avoid taxes. The custodian for the inherited IRA cut them each a check that they deposited into the new IRA.

This spring, John and Mary received some bad news. Their accountant told them that they had made a mistake and would owe substantial tax due to that mistake. The mistake they made was opening new IRAs into which they deposited the proceeds from the inherited IRA. What they should have done was open the new IRA as an inherited IRA and have their father’s IRA custodian transfer the money through a trustee-to-trustee transfer.

This was a costly mistake because they each owed over $100,000 in taxes on a $500,000 IRA.

Rollover versus transfer

There are two ways of moving money between IRAs. With a rollover, you cash the money out of one institution and invest it with another. If you do this within 60 days, you will have no problem. In fact, you can view this as a 60-day interest free loan. However, if you go into the 61st day, you will be taxed on the money and will lose all further deferral. This is not a good thing, so why take chances?

A trustee-to-trustee transfer is typically a better way of moving money between IRAs. You open up an IRA with your new custodian and sign paperwork to have them transfer the money from the old custodian(s). You don’t have to worry about the 60-day rule as you do with an IRA rollover. Additionally, IRA rollovers are allowed once in a 12-month period (not to be confused with a calendar year). There are no limits on trustee-to-trustee transfers.

An IRA is a wonderful thing. Here’s why:

  1. When you put your money in, you may get an income tax deduction.
  2. Any earnings accumulate tax-deferred until you take it out, at which time it will be taxed as ordinary income. If with drawn prior to age 59 1/2, a 10 percent penalty may apply.
  3. In most cases, you will be in a lower tax bracket when you make withdrawals.

An IRA can be a good asset to pass on to heirs. Your heirs have a few options. They can take the money out in the year that they inherit it, and pay tax on it along with their regular income. Often, a better idea may be to s-t-r-e-t-c-h the distributions over their lifetimes.

Let’s say you’re 36 years old when you inherit an IRA worth $500,000. You elect to take the required minimum distribution based on your life expectancy. These distributions start at a little over $10,000 and become almost $120,000 at age 75. At age 75, assuming a 6% return, you will have received distributions of $1,720,512, and the account will be worth over $900,000. Whatever’s left in the account at your death can be left to a beneficiary. (Please keep in mind that this illustration is hypothetical and the 6 percent rate of return is not representative of any specific investment. Further, be aware that beneficiary distribution options depend on a number of factors such as the type and age of the beneficiary, the relationship of the beneficiary to the decedent and the age of the decedent at death and may result in the inability to “stretch” a decedent’s IRA. Costs including custodial fees may be incurred on a specified frequency while the account remains open.)

As mentioned and outlined above, in many situations, an IRA can be a good asset to pass on to heirs, but not in all situations. If the IRA is subject to estate taxes, it is hit with the 1-2 punch of income and estate taxes. One way of lessening the tax bite is to convert a traditional IRA to a Roth IRA. (Before converting, traditional IRA account owners should consider the tax ramifications, age and income restrictions. The converted amount is generally subject to income taxation.)

A Roth IRA is funded with after-tax dollars and any earnings in the account accumulate tax-deferred and can be withdrawn free of income tax once the account has been opened for a minimum of five years and the owner is at least age 591/2. This may be a much better asset to pass along to heirs than a traditional IRA. If you have earned income, you can start a Roth IRA, or, if you are eligible based on some complex rules, you can convert a traditional IRA to a Roth IRA.

However, there is a wrinkle. The IRA owner must make the change while they are alive because an inherited IRA cannot be converted to a Roth IRA.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann is a financial professional with and securities offered through LPL Financial, member FINRA/SIPC.