What is the IRA Tax Trap?

As people reach retirement age, their IRA can become a minefield of tax issues. Failure to follow proper steps may cost thousands in taxes that could have been saved – potentially costing an individual much more in taxes than anticipated.

Tax professionals and financial advisers should regularly discuss with their clients how best to pass along retirement assets, take distributions and avoid unwanted tax results.

IRA-to-IRA rollovers

Direct rollovers allow you to transfer assets from a qualified retirement plan into an IRA without paying taxes or an early withdrawal penalty of 10%. However, if the distribution from the plan is made through checks payable directly to you or electronic funds transfers sent directly to your personal bank or brokerage firm account, 20% of the taxable amount must be withheld for federal income tax withholding purposes and you have 60 days after this receipt to deposit all distributions into your IRA or you face income taxes and an early withdrawal penalty of 10%.

An indirect rollover may help maintain your current tax bracket. When taking distributions from an employer plan, they could push you into higher tax brackets with potentially larger tax bills; an IRA rollover enables you to manage all your retirement savings in one convenient location and can prevent taxes and penalties that could otherwise apply by keeping all retirement assets together in one account.

IRA-to-company plan rollovers

As more 401(k) participants retire and change jobs at an increasing pace, their retirement savings become an increasing source of uncertainty. Although basic rules allow funds to move from company plans directly into an individual retirement account without incurring taxation penalties, several key considerations need to be taken into account before making this decision.

First, identify whether or not your company plan provides creditor protection. A quick way to do this is to ask your employer. If it does, Yieldstreet allows direct transfers into an IRA account which bypasses the 60-day rule.

If you decide to do a direct transfer, make sure that your account custodian withholds 20% for income taxes. Otherwise, you could owe both federal income tax and the 10% early withdrawal penalty plus lose out on tax-deferred growth in your IRA.

IRA-to-IRA direct transfers

Retirees who fail to manage their required minimum distributions (RMD), the amounts that retirement account owners must withdraw every year beginning the year they turn 70 1/2, will face a 50% excise tax penalty on any RMDs not taken on time.

Avoid this problem by opting for a direct trustee-to-trustee transfer between institutions. This method offers many advantages over regular rollovers, which require deposits into new IRAs within 60 days, including potentially avoiding excess contribution taxes of 6% if done correctly.

An IRA tax trap lies in having too much income from retirement accounts, which can push clients into higher tax brackets and lead to an increase in social security taxes. To mitigate this situation, they can take RMDs earlier, reduce provisional income or convert to a Roth IRA account.

IRA-to-company plan direct transfers

The IRS allows you to move assets between retirement accounts without incurring tax liabilities if certain rules are followed. For instance, when rolling over company plan balances to an IRA account, check should be payable directly to the financial organization and not directly to you personally. As such, the transfer won’t count against your contribution limit or trigger tax liabilities.

However, if you take direct distributions from company plans, the money will be taxed as income and subject to the 10% early withdrawal penalty if you’re under age 59 1/2. This could be detrimental to your retirement savings so to avoid this trap be sure to use direct trustee-to-trustee transfers when rolling over company plan funds as otherwise the IRS could tax them as withdrawals and assess taxes along with penalties on top.