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Individual retirement account tips and traps


IRAs come in two flavors, Individual Retirement Accounts and Individual Retirement Annuities. This article focuses on the planning opportunities and tax traps associated with Individual Retirement Accounts, commonly referred to as IRAs, though many of the discussion points below apply equally to the Individual Retirement Annuities offered by insurance companies.

An IRA is a retirement savings account that is established, generally, by the “IRA owner” through a bank, trust company or an IRS approved “non-bank trustee.”   A Roth IRA is essentially a type of IRA that has additional tax provisions.  For this article, we use the term “IRA” to mean both IRAs and Roth IRAs unless otherwise specified.

With the trend in corporate America to replace pension plans with 401(k) plans, one of the more important financial decisions a person may make is deciding whether to roll over employer 401(k) amounts into IRAs.  IRAs can be major assets for estate planning, and an individual may have several IRAs holding significant assets with different beneficiaries and different investments. Individuals that have multiple IRAs need keep track of them.  Understanding the number, types, and, to some extent, the purposes of the IRAs will help individuals and their tax and financial advisors with planning, and prevent unexpected taxes.

While many individuals invest their IRAs in stocks, bonds and mutual funds, some may invest their IRAs in many other types of assets, including real estate, LLC operating entities, and even certain types of “collectibles”.  Some may view IRAs as simply big savings accounts, but IRAs have onerous rules, as well as serious punishments for failing to follow those rules.  Individuals are usually familiar with the more obvious rules often enforced by IRA trustees or custodians; however, individuals are often unaware of the more complex rules and custodians may not have enough facts to enforce the requirements.  Advisors and their clients need to ask questions about their IRAs to ensure that both simple and complex rules are being followed, to avoid any potential penalties and pitfalls.

When individuals fail to follow the IRA rules, the consequences can include penalties, excise taxes, and even IRA disqualification.  As such, individuals and their advisors need to be familiar with the various IRA traps so they can understand the risks involved when they are considering making changes to their IRAs.

Congress had two main purposes for introducing IRAs in 1974.  First, IRAs allow workers who are employed but not eligible for an employer-provided retirement plan to save for retirement on a tax-deferred basis.  Second, IRAs allow individuals to roll over employer retirement plans from prior employment, making retirement savings more “portable” as an employee leaves an employer.  IRAs can hold the previously accrued retirement amounts and can then, if permitted by a new employer, roll the retirement savings amounts into the new employer’s plan.[1]

Congress later introduced “Roth IRAs.”  The Roth IRA rules are largely based on the IRA rules; in fact, the Roth IRA rules provide that the IRA rules apply where not specifically overridden by Roth IRA rules.

Like employer-provided retirement plans, IRAs function as separate trusts.  The individual IRA owner is a beneficiary of the tax-exempt trust and is one of the fiduciaries of the trust, but is not technically the direct “owner” of the assets in the IRA; the trustee is the “owner” of the assets.  This separate “trust ownership” issue is one of the sources of the confusion that comes up with IRAs and Roth IRAs.

Contributions and limitations

An individual can only directly contribute cash to a traditional IRA; rollovers are not treated as individual contributions and have different rules.  For individual contributions, an individual can only contribute based on the individual’s “earned income,” amounts included in gross income earned based on the individual’s personal services actually rendered.  This can be income earned as a sole proprietor or as an employee.   Over time, Congress and the IRS have broadened the definition of earned income for IRA contribution purposes to include taxable scholarship amounts, taxable alimony and separate maintenance payments, certain scholarship amounts (under the new SECURE Act[2]) and even nontaxable combat pay.[3]

In addition to the “earned income” limitation, Section 219 limits individual IRA contributions to no more than a specified amount each year.  For individuals under age 50, the limit is $6,000 (adjusted occasionally for inflation).  For individuals age 50 or older, individuals are eligible for a “catch-up” contribution equal to $1,000.    An individual who has earned income but has a spouse who is not working can also contribute to a separate IRA for the non-working spouse (known as a spousal IRA).

An individual is generally not permitted to contribute to an IRA after reaching age 70 ½.  However, this rule is eliminated under the SECURE Act.


The $6,000 limit is a single limit for all IRAs for the calendar year.  Thus, if an individual has four IRAs, the individual cannot contribute $6,000 to each IRA.  A Roth IRA counts as an IRA for this purpose; an individual cannot make a $6,000 contribution into a traditional IRA and a separate $6,000 into the Roth IRA.

Contributions over the contribution limit are excess contributions and are subject to excise taxes discussed later.


Taxpayers may believe that once they are over certain income limits they cannot contribute further to their IRAs.  However, an individual with earned income of any level can contribute to a traditional IRA. The income level limitation instead applies to whether or not that individual is eligible to receive a tax deduction for the contribution. 

Non-deductible IRA contributions are treated as “tax basis” and thus are not generally taxed again on distribution.  However, see the Distribution discussion below on the treatment of basis on distribution.

Roth IRAs do technically have contribution limitations based on income limits.  However, individuals with income above the income limit can still make “backdoor” Roth IRA contributions, discussed later.

Contributions to a Roth IRA are always “after-tax” (not deductible).  The earnings on a Roth IRA, unlike the earnings on nondeductible contributions to a traditional IRA, are not taxable on distribution, if all of the Roth IRA requirements are satisfied.


Employer contributions to a Simple Employer Plan (SEP) are actually made to the employee’s IRA.  However, the employer contributions are counted separately from the individual contribution limits.  Thus, even if an employer contributes to an individual’s IRA through a SEP, the individual employee can still contribute the full $6,000 (or $7,000 if at least age 50) for the year.


As noted above, because of a special “conversion” rule, an individual over the Roth IRA income limits can make a “back door” after-tax contribution to a traditional IRA and then convert that contribution to a Roth IRA contribution, because there are no income limits on converting a traditional IRA to a Roth IRA.

While an individual can do a Roth IRA conversion, the taxation of the amount converted depends on the character of the amounts held by the individual in the individual’s aggregate traditional IRAs.   See the discussion and example in Distributions, below.


If an individual contributes too much to an IRA, or contributes when the individual is not eligible to make a contribution, there is a 6% excise tax that applies for each year in which the excess contribution remains in the IRA.   If the individual is making maximum contributions each year, the 6% excise tax continues to apply until it is corrected.  If the individual makes smaller contributions, the individual can “soak up” some of the excess contribution by applying the excess against the amount that the individual is allowed to contribute for the year.  

  • Example:  Alice mistakenly contributes $7,000 in 2019, when she is 49 and only eligible to contribute $6,000.  She has an excess contribution of $1,000 for 2019.  On reaching age 50 in 2020, Alice’s contribution limit is $7,000.  If she contributes $6,000 in 2020, and applies the $1,000 excess contribution as a contribution for the year (up to the allowed $7,000 limit), the excess contribution is soaked up by year-end.  The 6% tax applies for 2019 but does not apply in 2020 because she does not have an over-contributed amount in that year.

This same excise tax applies to a mistaken rollover from a qualified plan.

Rollover Contributions

Rollovers from an employer’s qualified retirement plan to an IRA are not generally treated as taxable (if properly handled).  If an individual will be doing a rollover, he or she should generally choose a direct rollover from the plan to an IRA (sometimes called a “trustee to trustee rollover”), partly because the qualified plan must withhold 20% of the distribution (and deposit it with the IRS) if the employer does not do a direct rollover.   A direct rollover may include a distribution of a check to the individual but with the check payable to the individual’s IRA.

An individual can decide to rollover a qualified retirement plan distribution (401(k), defined benefit plan, etc.) into an IRA.  If the qualified retirement plan permits a distribution of non-cash assets (such as stock), the individual can rollover those exact same assets into an IRA or can sell them and substitute cash.  However, many qualified retirement plans only permit cash distributions AND many IRAs do not accept non-cash rollovers.


An individual can make a rollover from one IRA to another IRA.  In a full rollover the individual takes an actual distribution from an IRA and must contribute the money back into an IRA within 60 days.   However, it is important to note that an individual is now only allowed one IRA rollover per year.  This is not one rollover per IRA; the rule is one rollover per year for the individual.  Note that financial advisors and IRA plan administrators, trustees and custodians are not necessarily aware that individuals are rolling amounts over, and do not necessarily raise the one-rollover-per-year issue  unless they have specific information making it obvious that this is not the first rollover (such as if they already received one rollover in the year).

In the event that the rollovers are not direct rollovers, any IRA rollover after the first rollover for the year is reported as a taxable distribution.


This limit of one rollover per year does not apply to “direct” or trustee-to-trustee rollovers. Therefore, an individual can do a trustee-to-trustee rollover of the balance from an employer’s 401(k) plan directly to an IRA, for example, and still do one rollover from that IRA to another IRA in the same year.


IRAs are retirement savings plans.  Thus, the tax rules limit  tax-free distributions from IRAs for individuals who have not yet reached retirement age or penalize them, though there are a number of exceptions.  Where an individual who is not yet age 59 ½ takes a distribution from an IRA (and does not rollover the amount to another IRA within 60 days after the date of the distribution), the individual may be subject to a 10% additional income tax amount (often called the “early withdrawal penalty”).  There are a number of exceptions that might apply to reduce or waive the penalty, but each exception is fairly limited.  It is important to consider the reason behind a pre-59 ½ distribution, and to compare the reason to the section 72(t) exceptions.   These exceptions include (but are not limited to)

  1. Death
  2. Disability
  3. Payments made as part of a series of substantially equal periodic payments over life or the individual’s life expectancy.

When an individual takes a distribution from an IRA, the amount distributed (whether paid in cash or in property – such as shares) is taxable as ordinary income, not as capital gain.


If the individual made after-tax (non-deductible) contributions to the IRA, the after-tax contributions to a traditional IRA are treated as tax basis, but any earnings on the after-tax contributions are taxable as ordinary income when distributed.


In a traditional IRA, the individual cannot take a distribution of “just tax basis”.   Instead, under section 72, the individual is treated as taking out a pro rata portion of after-tax amounts and pre-tax amounts.

  • Example Dan contributed $5,000 per year as nondeductible contributions to a traditional IRA for 6 years.   Thus, he has $30,000 of taxable basis in the IRA.   Dan then rolled over another $20,000 from an employer 401(k) plan, which was all pre-tax contributions and earnings within the 401(k) plan.   In late 2019, Dan takes a $10,000 distribution from the plan (assume Dan is over age 59 ½).  Dan’s IRA has a balance of $60,000 at the time of the distribution.   Dan’s non-taxable portion of the $10,000 distribution is determined based on:

    $30,000 basis
    $60,000 Total balance x $10,000 = ½ of the distribution is nontaxable as basis.

    Dan has ordinary income of $5,000 from the distribution.  Dan has $25,000 remaining basis in his IRA after the distribution (and an aggregate IRA balance of $50,000).

This rule also needs to be considered when an individual wants to do a “back door” Roth IRA contribution.

  • Example: On January 2, 2020, Dan makes a $5,000 after-tax contribution to a separate traditional IRA and then converts that $5,000 as a Roth conversion the following day.   Assume Dan’s balance in his aggregate Traditional IRAs is $62,000 (after including Dan’s contribution for the year to the separate Traditional IRA).   His contribution to the Traditional IRA is an after-tax contribution and the amount is added to his tax basis.   Thus, his tax basis is back to $30,000 and his total balance is $62,000.  However, Dan then has to determine how much of the conversion amount can be treated as nontaxable “basis.”

    $62,000 × $5,000 = $2,419.36 of Dan’s conversion is nontaxable and the remaining $2580.64 is treated as a taxable IRA distribution in 2020.

As a note, Roth IRA distributions are treated differently, and generally allow a distribution of “basis first” until the basis is used up.

Required Minimum Distributions

Because IRAs are retirement savings vehicles, individuals are supposed to use the amounts for their retirement years.  While an individual is allowed to take penalty-free distributions from an IRA starting at age 59 ½, the individual is required to start taking distributions from an IRA once the individual reaches age 70 ½ (changed to age 72 starting on January 1, 2020).

IRS Publication 590 provides calculation tables that are used to determine the minimum amounts that must be distributed each year from the IRAs. Required Minimum Distributions, or RMDs, are determined using the FMV of the assets in the IRA on the last day of the prior tax year (Dec 31), not counting any contributions made during the year.

Failure to take RMDs can subject the individual to a 50% penalty on the amount that should have been distributed. However, some IRA trustees require that any RMD requests must be made more than a stated number of days before year-end (such as by December 20).  It is a good idea to send requests for minimum required distributions in writing (for example, via email), so the individual can show that they timely requested an RMD.  Likewise, it is a good idea to set up automatic distribution instructions with each IRA trustee, such as providing that the RMD should be calculated and made each year in late November.

The IRS allows a request for abatement of the 50% penalty, using a Form 5329, but there has to be a good reason for missing the deadline.  Where the error was caused by a trustee or custodian (for example, the trustee failed to distribute in accordance with timely sent instructions), have the IRA owner should ask the trustee or custodian to send a letter acknowledging the mistake.

If an individual follows all of the Roth IRA rules, there are no RMDs while the original IRA holder is still alive.   However, once the original Roth IRA holder dies, the beneficiary must generally begin distributions.


Once the individual reaches age 70 ½ (or age 72 after January 1, 2020), the RMD is payable.  For that first year, the individual may be able to wait and take the distribution before April 15 of the following taxable year.   However, the individual also has to take a required minimum distribution for that second taxable year, so the individual can end up with two distributions in the year.  It may be a good idea to determine whether taking the first RMD in the year in which the individual turns 70 ½ could be more beneficial.


If an individual has more than one traditional IRA, the individual must determine the required minimum distribution amount separately for each IRA.  Once each minimum amount is determined for each IRA, the individual can decide from which IRA or IRAs the minimum distributions will be made.  Thus, if the individual has an IRA with assets that are doing very well, and another with assets that are not growing well, the individual might decide to use the poorly performing IRA to satisfy the minimum required distribution for both IRAs.  However, it is a good idea to keep records of how each IRA’s RMD was satisfied (having a note with the RMD calculations stating from which IRA the amount was taken).



Occasionally, IRA assets decline in value, sometimes precipitously.  Individuals often want to know whether they can report these as losses on their Form 1040.  The general answer is that they cannot. The IRA trust has the loss, not the individual.


IRS guidance provides that if the last amounts are being distributed from the individual’s last traditional IRA, and the losses are larger than the total after-tax contributions to the traditional IRA, the individual can take a loss equal to the excess of the remaining after-tax contributions over the amounts distributed as the last IRA is closed.


There are various reporting forms providing information about a taxpayer’s IRA.  Some are generated by other parties, such as the IRA trustee or custodian, but some are part of the IRA owner’s Form 1040.

  • Form 8606 - reports the after-tax contributions to IRAs, conversions to Roth IRAs, and distributions that use tax basis.  It is part of the Form 1040 filing.   Generally, the Form is updated for each change in the IRA tax basis.
  • Form 5498 - is issued by the IRA /Roth IRA trustee or custodian for each IRA to report the Fair Market Value of each IRA.  It also shows contributions and rollovers to and from the IRA.   It is usually sent in May or June of each year. 
  • Form 1099 R - reports distributions from IRAs.  The Form is issued by the trustee or custodian to the IRA owner.   The Form provides codes that assist with some tax determinations, including reporting whether the distribution was directly rolled over to another IRA or qualified plan, whether the amount was paid out because of death, MRD, etc.  Check the Form 1099 R codes and understand the reason for the distribution.  The Form 1099 R does not necessarily determine the taxation of the distribution or whether a penalty may apply.  However, the IRS uses this form as a starting place in checking whether individuals have properly reported distributions as income and as subject to penalties.


As noted above, IRA accounts can be invested in various types of assets.  The rules generally prohibit an IRA from investing in most “collectibles” (coin collections, oriental carpets, etc.) but there are few other limitations on the types of investments that an IRA can make.  However, many IRA trustees and custodians do not accept difficult-to-value assets.  IRAs that do accept such assets often charge significantly higher fees for the difficulty of dealing with these assets.  Also, a trustee or custodian is required to report the FMV of the IRA to the IRS each year. As a result, a diligent trustee or custodian will often either refuse to hold an asset for which there is no determinable value, or may require the individual to pay for a valuation of such assets (such as interests in LLCs or other private companies).


IRAs are “tax exempt” trusts but may be subject to unrelated business income tax (UBIT).  If the IRA invests in limited liability companies (LLCs) or other assets that may engender unrelated business income, the trust is subject to and must pay UBIT on the unrelated business income (UBI).  It is a good idea to make sure the trustee/custodian is actually sending in the Forms 990T for IRAs that are invested in unusual assets.  Income from LLCs is almost always UBI.  Likewise, in the very rare instance in which an IRA can take on debt to purchase an asset (IRA owners are prohibited from guaranteeing IRA debts), income from a debt-financed asset is likely subject to UBI.   UBIT is generally taxed at the highest marginal tax rate, so it is a good idea to consider UBI before investing in an unusual asset, to make sure that the expected return on the asset is enough to make up for the higher IRA fees AND the UBI that will need to be paid on the income.


IRAs are subject to the section 4975 prohibited transaction tax rules. However, IRAs are treated differently than qualified plan prohibited transactions. When a qualified retirement plan has a prohibited transaction, the plan (or fiduciary) is subject to a 15% tax on a prohibited transaction. When an IRA has a prohibited transaction, the entire IRA loses its tax exemption and all IRA amounts are taxable as of the date of the prohibited transaction (not simply the amount that was involved in the prohibited transaction).


When Roth IRAs invest in unusual assets they may be subject to special scrutiny.   The IRS has issued

Listed Transaction warnings with regard to Roth IRA investments.   Mostly the warnings have to do with having a Roth IRA buy a business from someone tied to the Roth IRA, or buy a business using a low valuation (often barely skirting the prohibited transaction rules).  If the Roth IRA owns a business, the later sale of that business is not a taxable event.  This can build up an individual’s retirement proceeds rather substantially (it also becomes a significant estate planning tool).  It is possible for an IRA or Roth IRA to buy a business (though generally NOT from a disqualified individual under the prohibited transaction rules).  However, the transaction needs to meet the arms-length purchase standards (so the Roth IRA buys the business at FMV).  Otherwise there may be an excess contribution to the Roth IRA, or there could be a prohibited transaction.  In addition, if the Roth IRA buys a business, the IRA may have UBIT.

Inherited IRAs

The rules for inherited IRAs depend on the identity of the beneficiary; the inherited IRA rules are different if the beneficiary is a spouse, another human, or a trust or other non-human entity.  

A spouse can treat the Inherited IRA as if it was the spouse’s own IRA and take distributions when the spouse is eligible to take MRDs.


The spouse can instead take the Inherited IRA as a non-spouse beneficiary and take distributions as death distributions (which are not subject to the 10% early withdrawal tax).  Depending on the age and circumstances of the surviving spouse, this is sometimes the more beneficial approach.

Another human beneficiary (or a trust that has a clear look-through to identified humans) takes RMDs depending on the age of the original owner at death.

If the original owner was already taking RMDs:  

  • The RMDs continue but using the IRS table based on the age of the beneficiary.  
  • A nonhuman beneficiary has to use the original owners age and can continue to take distributions.

If the original owner was not yet old enough to take RMDs

  • A human can choose leave the money in the IRA for up to 5 years and must totally distribute by the end of the 5th year.
  • A human can instead choose to take distributions over the life of the beneficiary.
  • A nonhuman must take the amounts by the 5th year.

NOTE:  This rule has been significantly changed in the new SECURE Act.  Under the new law, the choice to take payments over life and the 5-year rule have generally been eliminated (for individuals passing away after December 31, 2019) and have been replaced by a rule requiring all amounts to be distributed to a non-spouse beneficiary within a 10 year period.  There are a few exceptions, such as an IRA for a disabled child.


An individual holding an inherited IRA cannot contribute to the IRA and cannot “rollover” the IRA.  Likewise, the inheritor cannot transfer the inherited IRA into the individual’s own IRA.


An individual holding an inherited IRA can move the Inherited IRA to another trustee or custodian by using a trustee- to-trustee transfer of the inherited IRA to another IRA administrator).

Transfers in Divorce

When an IRA owner is going through a divorce and the parties agree that an IRA will be divided, section 1041 applies. Typically, the owner of the IRA can transfer a portion of the IRA without the original owner paying tax on the transferred amount.  The receiving spouse then accepts the transfer of that portion of the IRA as the spouse’s own IRA.   Under this arrangement, any distribution from the transferred IRA is taxed to the spouse, rather than the original owner, at the time of distribution.


During a divorce, it is generally a bad idea to transfer the IRA assets by taking a distribution and transferring the distributed amount to the spouse. Doing so makes the distribution fully taxable to the original owner, rather than to the spouse. 


An IRA or Roth IRA is often an important part in a person’s overall approach to meeting their wealth accumulation, retirement, and estate planning objectives. However, as with any tax benefit, IRAs and Roth IRAs are subject to specific rules that need to be followed or the income tax cost of stepping into any of the traps described above can seriously diminish the ultimate value of the IRA. Individuals and their advisors need to plan carefully to sidestep these tax traps to avoid early taxation, penalties, excise taxes or loss of the IRA protections.

[1] There used to be differences between “conduit” IRAs (holding employer-plan rollover money) and “non-conduit” IRAs (holding an individual’s own contributions). Most of those differences are now gone, but the treatment of rollover amounts vs individual contributions can still be different, for example under certain state bankruptcy rules and for foreign individuals with US IRAs.

[2] On December 19, 2019, Congress passed the Setting Every Community Up for Retirement Enhancement Act (known as the “SECURE Act”) as part of the appropriations bills.

[3] Because of this broad definition, young adults can sometimes establish IRAs (or Roth IRAs) based on amounts the children actually earn from various sources (such as dog-walking or babysitting).


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