Roth IRA Traps and Tips

Roth IRA Traps and Tips

By: Martin M. Shenkman, CPA, MBA, JD

Inherited Roth IRAs are Subject to MRDs.

A key principal of Roth IRAs, as contrasted with regular IRAs, is that there is no requirement to take distributions from a Roth IRA. After all, why should the IRS care when you distribute your Roth money, since it is generally not taxable. Surprisingly, for many heirs, this non-distribution rule does not apply to an inherited Roth IRA. So, after your death, the beneficiaries of your Roth IRA must start taking RMDs, but if the requirements are met their distributions will remain income tax free. Even more surprising to some really unhappy heirs, even though distributions from an inherited Roth IRA are income tax free, if those RMDs are not taken the 50% penalty applies!

Roth 401(k)s are Subject to MRDs.

The general rule again is that your client does not have to take RMDs from Roth IRAs. But, alas, another trap exists, and the confusing terminology might make your client trip up on this quirk. If your client has a Roth 401(k) account, that account will be subject to RMDs! Roths aren't, but Roth 401(k)s are! Your client has two choices.  He can roll over his Roth 401(k) into a Roth IRA before he attains age 70.5 (since he will have RMDs by his required beginning date, RBD, April 1 of the later of: 1) year following his attaining age 70.5; or 2) retiring from the employer sponsoring the plan. If the rollover is not completed, your client will have to begin RMDs from his Roth 401(k) or face penalties.

This requirement to pay required minimum distributions from a Roth 401(k) is an exception to the general rule that your clients don't have to take RMDs from Roths.

IRA Conversion Before Market Tanks May Be Unwound.

Converting to a Roth IRA is a great planning technique for many clients. When a client converts a traditional IRA to a Roth, they have to pay income tax on the taxable portion of the plan. The goal of the conversion process is to pay the tax now, and have all future growth avoid income tax within the Roth. To make this conversion viable, your client should have adequate resources outside the IRA with which to pay the income tax triggered on conversion. Also, the client's time horizon must be long enough for the conversion to make sense. But what if your client converted when the Dow was at 11,000 thinking that was a market bottom, and the Dow is not at 8,000? The income tax may have been incurred for naught! Don't despair, repair! Your client may be able to reverse the conversion, put the money back into their regular IRA, and avoid the income tax that with hindsight doesn't appear particular worthwhile incurring.  So, if your client converted and then market tanked, reverse the conversion. Your client should have until October 15, 2009 to re-characterize the transaction. PLR 200628032. (4/19/06).

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