2022 Tax Traps to Avoid

Christine Benz: Hi, I'm Christine Benz from Morningstar. We're coming into IRA season, and few people understand the ins and outs of IRAs as well as tax and retirement planning expert Ed Slott. He is here to discuss some mistakes and things to watch out for in the realm of IRAs.

Ed, thank you so much for being here.

Ed Slott: Great. Thanks, Christine.

Benz: I want to talk about some administrative IRA tax traps that people should be on the lookout for. I think there's probably no one better equipped to discuss that with us than you. So, let's talk about making sure that your IRA contribution, if you've just made one, making sure that it's applied to the right year. How should people check up on that, and what can go wrong there?

Slott: Yeah, this has been somewhat of a problem with the custodians only between Jan. 1 and April 15. But in the wake of the pandemic, there's staff shortages, people working from home at the custodians. I don't know. We start to see a little more in the way of errors. So, if you're making a contribution, remember you have until April 15 of this year, 2022, to make an IRA or Roth IRA contribution for last year. But a lot of people also are making their 2022 contributions. Make sure the contribution you make, if you're making one now between Jan. 1 and April 15, it could be for either year. Make sure whatever year, if it's 2021, it's earmarked, coded for 2021. And if it's for 2022-- that's where I see the mistakes--people making an early 2022 contribution and it automatically gets coded '21 because that's what most people are doing. This happened to somebody in my family a few years ago. Even though it was a small IRA contribution, we had to redo the 1099, so it was a real mess. Make sure--follow up on your transactions, talk to the custodian. Some of them you could see online. We just had this with somebody. They checked and got an answer. They said no, in fact, it was for 2022. What I tell people--just a practical rule, you don't have to do it. I know it's good to make your contribution early in the year. I would say don't make your 2022 IRA contribution until after April 15. Then it cannot be coded for '21 because you can't do that anymore. Then you can't make a mistake or other people can't.

Benz: Good to know. Another area of confusion certainly is the eligibility for contributions, that depends on a few things but mainly your income level. What do people know about that and how can they kind of stub their toes sometimes if they're not necessarily aware of the rules there?

Slott: There's a couple of things you can do wrong. You could contribute too much. You could have IRAs in different institutions. They don't know what the other people are doing. You could have Fidelity, Vanguard. You have one at both. All of a sudden, somehow you did a Roth contribution to both, and now you're over. They don't know you already did one. Even a tax preparer can tell you, because when you have a good tax program, it will have a diagnostic that said, "Oh, you did a Roth conversion, you have too much" or "Your income was over the limit; you don't qualify." Remember, when you make a Roth contribution--some people do it themselves online with the fund company--they don't know that you don't qualify because of income. That's on you. So, you have to make sure you qualify and you don't overcontribute.

Benz: What's the mechanism? Say, someone does make the wrong type of contribution. They weren't eligible to make, say, a traditional deductible IRA contribution and they need to do Roth. What's the mechanism for undoing the wrong contribution type?

Slott: Well, there's a couple of things. If you contributed to an ineligible--let's say, you made too much for a Roth, but you contributed anyway--you could recharacterize that as an IRA contribution if you qualify for the IRA. By the way, some people make contributions, and they don't even--they're not even eligible. They don't have compensation. Some people, retirees, say, "Well, I have pension income. Doesn't that qualify?" No, it has to be earnings from a job or a self-employment. So, again, the financial institution, or if you're going online and doing yourself, they don't know if you have income. But if you do that, you have an excess contribution, and it has to be taken out generally by Oct. 15 of the year after to avoid a 6% penalty.

If you qualify for one and not the other--let's say, you don't qualify for the Roth, you have the compensation, but you made too much money, and if you still qualify for the traditional IRA and you want it--you can just recharacterize it. You'll have to deal with your custodian, your financial institution, to tell them, "No, switch that to my IRA," and it will be treated as if it was always there.

Benz: You mentioned that earned income requirement, Ed. I wanted to just have you briefly touch on spousal IRA contributions. I think sometimes people look for spousal IRA on the form, and they won't find it. What do they need to know if they want to make a contribution on behalf of a nonearning spouse?

Slott: Yeah, that's a good point. That's an exception to having to have compensation. If you're married, filing a joint return, and let's say, only one spouse is working. Let's say, they're 50 or over so they could do $7,000, say, to a Roth IRA, and they qualify under the income limits, but only one spouse is working. The other nonworking spouse can actually use the working spouse's compensation to qualify. So, they could each do $7,000 even though the nonworking spouse doesn't have his or her own income. Most people miss that. A couple like that could put away $14,000, $7,000 each, in their Roth IRA, for example, even if only one spouse is working. And you're right, there's no line for spousal contribution. It's your own IRA. You just qualify. That's what it's called. Actually, there's another word for it in the tax code. They named it after somebody. I think it was Kay Bailey Hutchison, but nobody says Kay Bailey Hutchison IRA. They still call it the spousal IRA, but that's just the name. It's your own IRA. Let's say, you're the spouse without the income: It's just your own IRA; you put in based on the working spouse's income.

Benz: Good to know. I want to touch on beneficiary designations. People can run into trouble there. I think people often wonder who to name as a beneficiary for their IRAs. What should people know as they think about and review those beneficiary designations?

Slott: Well, you should always name the person you want. Most married couples name each other, and that's fine. But the main thing is, you pick who you want. You shouldn't pick beneficiaries based on the tax law. It should be the people that you want, and then you work around whatever the tax rules would be for those beneficiaries. The main thing is to make sure your beneficiary form, which is for many people now online, is correct and current. There are things that happen, especially after the pandemic, what I call life events. You have a birth, a death, a marriage, a divorce, a remarriage, you had a new grandchild, change in the tax law, or somebody forgetting your birthday. There are reasons to change beneficiaries. So, just make sure whatever form you have and if it's online, I would even print it out to have a copy so your beneficiaries can have it. They're the people that will need it, and we see in this digital world now, a lot of beneficiaries can't get in if it's online. Some people even have facial recognition. So, you better give passwords or digital access. That's why I like the idea of printing it out.

Benz: Print it out and maybe keep it safe. I want to talk about online conversions from traditional ...

Slott: That's where the big problems are now.

Benz: Let's talk about that.

Slott: Yeah. Remember the Tax Cuts and Jobs Act made Roth conversions permanent. There's no backsies, no do-overs, no "recharacterizations" we used to call them. Once you convert, you will owe the tax even if your financial situation changes later on. Now that shouldn't be a reason to deter you from converting, but you want to have a good tax projection so you know what it will cost. But now, a lot of people doing it yourself. It's one of the negatives of the financial technology. They make it so easy to go on there, and we've already heard stories. I had one story, and they weren't able to resolve it, where a guy went online, he hit the wrong button and converted--he had about a $2 million IRA, wanted to convert $150,000. He hit the wrong button, converted the whole $2 million. He owes tax on the $2 million. He went back to the institution. They said we can't change something you did. So, I would say, let the financial institution or let the advisor do it if there's enough money involved. If they were to make the mistake, there's a good chance it could be undone. But we're seeing this--there is no cure for this in the tax code because there's no recharacterization, no undoing. And even though people have been screaming about it, we see no relief from IRS, and I think it's because IRS doesn't want to open that door. Once they open the door and say, "Well, you can undo it for certain reasons," everybody that has buyer's remorse might say, "Well, I made a mistake." So, be very careful before you convert online. You will owe the tax. Or get the help of the financial institution. Get somebody else to blame.

Benz: Ed, that's great advice. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.