Do You Know These Obscure IRA Rules?

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. IRS Publication 590 tells you everything you need to know about IRAs: contributing to them, withdrawing from them, and rolling over to them. Joining me to highlight some useful but little-known IRA rules is retirement expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine. Great to be back.

Benz: Good to have you. You know the tax code cold and especially as it relates to …

Slott: I wouldn't go that far.

Benz: Well, as it relates to IRAs. IRAs, you know this stuff. You say, though, there are some little-known rules regarding IRAs, that even sometimes advisors aren't familiar with. Let's cycle through a few of them. Starting with some that are related to contributions. And you say one that sometimes comes up is people say, well, I'm contributing to a company retirement plan, so I can't do an IRA. Not the case.

Slott: That's the most common question of all of these I get from advisors and accountants. They say they can't do a Roth, he's in a 401(k)--it's not true. Roth contributions, eligibility is only on having the income--and, obviously, if you're working for a company, you have the earnings--and income limit. But being active in a company plan does not stop you from contributing to a Roth. You know something else, it doesn't even stop you from contributing to a traditional IRA. It just may mean if income is high enough, it may not be deductible.

Benz: A related point of confusion relates to people who are later in life, they say, I'm too old to contribute to an IRA. Not the case with the Roth IRA.

Slott: That's right. It's an anomaly. We've talked about this before, where somehow when they created the IRA and Roth IRA rules, the tax writers for some reason say, let's do the opposite. Like everything's opposite. IRAs have no income limits; Roths do. IRAs have an age limit. You can't contribute to an IRA after 70 1/2; but Roths have no age limit, they have an income limit. If somebody is working at 75, they can still--if they have the earned income and they don't make too much money, enough but not too much--they can still contribute to a Roth even after age 70 1/2. Most people miss that. Not only that, you can do the spousal contribution even if the spouse is not working.

Benz: If you have one spouse working, the other one is fully retired, as long as the working spouse has enough to cover the contributions, we're good.

Slott: Right. They can each do $6,500.

Benz: One point of confusion you say comes up, this is a little bit of a head-scratcher for me, but this idea of deceased individual's family members wanting to make contributions from the deceased person's assets. Let's talk about that. Not allowed, basically.

Slott: A question does come up every year, normally from an accountant or advisors doing somebody's tax return, and the question is posed: My dad died last year, but he was working. He had the earnings. We have till April 15, can we still contribute to an IRA for him, because …

Benz: To try to reduce the tax?

Slott: Yeah. For whatever reason. The answer is no. IRS ruled on this many years ago back in the '80s, and they said you can't do it, and their reason really made sense. They said, we see no reason for a deceased person to fund for their retirement, which kind of makes sense. But here's the oddball thing. Let's say, if it was a self-employed person that had a SEP or a SIMPLE, those can be funded after death, but not IRAs. Just a strange twist of rules.

Benz: One interesting point is that in the case of a deceased military service person, there is an opportunity for the family to fund a Roth IRA. Let's talk about that.

Slott: This is not well-known. Military servicemen, who are deceased in service, they get either military death benefits or Servicemembers' Group Life Insurance, SGLI. When, let's say, a widow gets those benefits, that money, no matter how much it is, can be put right in a Roth IRA regardless of income or contribution limits, it doesn't even affect those, can be put right in a Roth IRA. Most people don't know that. It can be put in a Roth IRA and grow tax free.

And another good point about that--because people say, well, if the widow puts it in a Roth IRA, maybe she's young, what if she needs the money--that money can always be withdrawn. It's treated like contributions, tax-free. So, it's just something--everybody knows somebody, and if you pass this little tidbit on to somebody, it could really help.

Benz: Another point that you say trips people up a little bit is contribution amounts; people say, there are Roth IRAs and traditional IRAs and the contribution limit is $5,500. Can I put that in both account types?

Slott: No. The overall limit is an aggregate limit. If you put $5,500 in an IRA, you cannot also put $5,500 in a Roth. Now, if you want, you could put $2,000 in an IRA and, say, $3,500 in a Roth, but the overall limit is for IRAs and Roth IRAs.

Benz: Let's segue to talk about rollovers and transfers and so forth. You say that there's now this once-per-year IRA rollover rule that applies to spousal rollovers. Let's talk about that and talk about a work around or way that people can get away from that one-time, once-per-year rule.

Slott: Several years ago, IRS tightened up, and actually the courts based on a famous case, tightened up what's called the once-per-year IRA rollover rule. Now, this only applies when you take out the money and want to roll it over to another IRA in 60 days. You can only do that once per year, and its not a calendar year, its 365 days. There's no way out of this. So, if you do one, you can't do another one for 365 days. If you do, then that's taxable.

In a recent ruling--now it's not in the law, but it's the only guidance we have--is a recent private letter ruling. It actually came out from IRS a few years ago, said that it also applies to spousal rollover. Let's say the husband dies and he has an IRA and a Roth IRA, and the wife is the beneficiary, if she does both rollovers, one's no good because you can only do one.

So, what's the answer? Don't do rollovers. I say this in every one of my classes, my programs: Do direct transfers, direct trustee to trustee transfers where you don't touch the money in between. Because let's say in that situation, let's say there's two IRAs and one's no good, one rollover is no good. Now you don't have an IRA anymore. If it's a traditional IRA, all of that income is taxable. Just do direct transfers, especially after death. If you're a spouse inheriting from say your husband or your wife, you can do the spousal rollover, but do it only with direct transfers, then this is not an issue at all.

Benz: Is there any tax disadvantage, with the rollover versus the direct transfer, or am I missing anything?

Slott: The direct transfer is the way to go, it happens automatically. No, the problems happen when you take a check, now you have the 60-day rule, the once per year rules, too many bad things can happen. But people do it a lot, that's why I always make the case, whatever you have do because people tell me, I went to the bank, they said they'll only issue a check. No, you've got to go up the ladder and push for a direct transfer.

Benz: Let's talk about health savings accounts, HSAs. I wrote about this rule last year where we talked about what's called an HSA funding distribution. This is a once-in-a-lifetime way of funding an HSA, a health savings account with IRA assets. Let's talk about that, who might use it and when you might think about it?

Slott: People love HSAs and rightfully so, they're triple tax-free. You get a deduction when the money goes in; as the money grows, it's not taxable; when it comes out, if you use it for qualified medical expenses, also tax-free. But let's say, you don't have the money to make a contribution, whatever the limit is, you get one chance, a once in a lifetime, called a qualified HSA funding distribution, to take from your IRA and do a rollover to the HSA.

Now that is not taxable, and even though you may have received a deduction on the IRA, maybe it's pretax funds on the way in, it's not taxable going to the HSA, and you can go up to whatever the limit is, but it's a one and done. Once you've maxed out the limit, that's all and you can never do it again, but just something good to know, if you're short and you want to fund an HSA.

Benz: It's subject to the annual limit for the HSA amount that I can …

Slott: That's right. And your annual limit, whether you have a single or family plan, there are different limits.

Benz: One other point related to contributions is if someone is making a Roth IRA contribution, you're not going to find that flagged on the tax return, but you say it's still important to take note of that because it could trigger eligibility for another credit. Let's talk about that.

Slott: Right. That's the old trick question. The question is, where do I enter my Roth contribution on the tax return? And the answer is nowhere, it's invisible. That's what I love about Roth.

Benz: You'll see a traditional IRA contribution.

Slott: But not a Roth, it doesn't go on there. But anybody who does a tax return--pretty much everybody, I guess, there's some people do it by hand--but pretty much everybody uses a computer now. There's an entry point, an input to put in that Roth contribution, so if doesn't go on the return, why would you do it? Because there's something called a Retirement Saver's Credit. It doesn't apply to a lot of people. It's a low-income people, but here's who it might apply to.

Somebody who just got on their own, graduated college, has their first job, maybe didn't even work a whole year, has low income, but they're on their own, they no longer on their parents. They do a Roth contribution or maybe somebody put a contribution in for them because they have no money. They might qualify for up to $1,000 credit that otherwise would be missed if the Roth contribution wasn't entered. It's a great deal. You're making a contribution, you get no deduction for it, but you're building a tax-free account and getting a tax credit for it. Not for everybody, but if you don't put it in the software, in the program as you enter, you definitely won't get it.

Benz: Ed, great advice as always. Thank you so much for being here to discuss it with us.

Slott: Thanks, Christine.

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