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Little-Known IRA Fixes

Natalie Choate offers up some lesser-known remedies for common IRA mistakes.

Natalie Choate, 06/15/2012

There are lots of ways a client's retirement benefits can get messed up--and even more ways to fix the problems. Here are some of the remedies, mostly for IRA mistakes, with emphasis on those fixes most people have never heard of.

Recharacterization
Almost any contribution to a Roth IRA or traditional IRA can be "recharacterized" as a contribution to the other type of IRA, by moving the contribution (plus any earnings or losses accrued since the contribution was made) to the other type of account.

This remedy is well known as a way to reverse (undo) a Roth conversion, but it is not limited to that use. A client can recharacterize if he simply changes his mind about which type of IRA he wants to make his annual IRA contribution to; when a rollover that was supposed to go into a Roth IRA goes into a traditional IRA by mistake; or if the client erroneously makes his annual IRA contribution to a Roth IRA when he was only eligible to contribute to a traditional IRA (or vice versa).

There is a deadline for recharacterizing an IRA contribution: Oct. 15 of the year after the year the contribution was made. But if you miss that deadline for good cause (for example, a professional advisor's error), you can apply to the IRS for an extension.

Only two types of IRA contribution cannot be recharacterized. One is a tax-free rollover: For example, if a client rolls money from his traditional 401(k) plan account to a traditional IRA (a tax-free rollover), then later decides he would have been better off to transfer that money to a Roth IRA, he cannot make that change.

Also, the client can recharacterize only if he would have been eligible to make the original contribution to the other type of IRA. For example, if 73-year-old Joe, who is still working, makes a $6,000 regular IRA contribution to a Roth IRA, then realizes he is not eligible to do so because his income is too high, he cannot fix the problem by recharacterizing the contribution over to a traditional IRA because he is too old to contribute to a traditional IRA. He would need to use the next remedy:

Withdraw IRA Contribution by Extended Tax Return Due Date
Any regular contribution to an IRA that is withdrawn from the account (along with any earnings or losses that accrued to the contribution between the date it was made and the date it is withdrawn) by Oct. 15 of the year after the year of the contribution is treated as if it had never been made to the IRA. (There is one exception: The earnings withdrawn with the contribution are subject to the 10% penalty if the individual is under age 59½).

This "it never happened" treatment applies both for purposes of the 6% penalty on excess IRA contributions (which helps "Joe" in the previous example, who otherwise would have to pay a penalty for contributing to a Roth IRA when he was not eligible to do so), and for purposes of the income tax treatment of the distribution. So the distribution is not taxed under the "cream in the coffee" rule that normally causes IRA distributions to be deemed to come proportionately from pre- and after-tax money in the individual's IRAs. This "corrective distribution" remedy not only helps someone who is facing a penalty, it helps anyone who simply wishes after the fact that he hadn't made the contribution at all.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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