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Avoid these 3 IRA distribution mistakes

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Distributions from IRA accounts often appear to be simple — and they can be — but they also can be surprisingly complex.

I recently asked Denise Appleby with Appleby Retirement Consulting Inc. in Grayson, Georgia about the most common distribution errors she encounters.

Missing the NUA opportunity

Rolling over a 401(k) account to an IRA is generally a simple process. Clients fill out the required paperwork, the plan administrator processes the request and the funds transfer directly to the new account.

But if the client holds employer stock in his or her 401(k), that stock might present an opportunity to use the net unrealized appreciation (NUA) calculation; overlooking the NUA option can be an expensive error.

NUA is the difference between the stock’s current market value and the value when it was allocated to the account, assuming there is appreciation, of course. The treatment is available only as part of a lump sum distribution paid within one taxable year and rolling over the stock to an IRA eliminates the NUA opportunity.

Here’s a quick example: The client retires at age 65 with a $500,000 lump sum distribution that includes $200,000 (current value) of employer stock. The stock was worth $75,000 when it was allocated to her account. If she rolls the entire amount into an IRA, all future distributions will be taxed at the applicable ordinary income rate.

In an NUA strategy, she would roll the $300,000 to an IRA but take the employer shares as a distribution. The $75,000 will be taxed as ordinary income, but the remaining $125,000 will be taxed at long-term capital gains rates when she sells. The rates-differential could result in substantial tax savings so it makes sense to consider NUA treatment when it’s available before rolling over the entire account.

Misunderstanding the age 55 exception

401(k) distributions before age 59 1/2 are normally subject to the 10 percent early withdrawal penalty. But if the employee separates from service at age 55 or older and subsequently takes a distribution from the 401(k), he’ll pay income taxes on the withdrawal but not the penalty.

Here’s the catch: The penalty exception doesn’t apply if the retiree rolls over the 401(k) to an IRA. Appleby cites a case in which the retiree rolled over the 401(k) assets to his IRA, took distributions from the IRA but didn’t pay the penalty because he mistakenly believed the exemption applied. “When the IRS asked for it, he resisted,” Appleby adds. “He took the IRS to court and he lost. Why? Because the minute you roll over those funds to the IRA you lose that eligibility for that exception.”

Violating the new rollover limits

Previously, IRA owners could do one 60-day rollover per IRA per 12-month period. For example, IRS Publication 590 stated if you had two IRAs you could do a 60-day rollover with both the first and second IRAs. But the IRS is changing its publication to say that’s not the case anymore, says Appleby.

Now taxpayers can only do one of these 60-day rollovers regardless of how many IRAs they own during a 12-month period. “And, so, because many people have been doing multiple rollovers for each IRA that they have during a 12-month period, they’re going to continue doing that, not realizing that the rules have changed,” she notes.

“The consequence of this is very serious. If you break the rules, you think you have money in a tax-deferred IRA when you don’t, because that amount is no longer eligible to be held in an IRA once you break that rule.”