By Andy Ives, CFP®, AIF®
IRA Analyst
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As already-complicated IRA rules spiral further into an abyss of confusion, it comes as no surprise that irregularities exist. Up is down and left is right. Green means stop, red means throw your hands up in exasperation. And those in charge recognize the lunacy. Case in point: “Many parts of the tax code are compromises, and all parts reflect the need for lines that can’t be deduced from first principles…The Code’s lines are arbitrary.” (Young Kim v. Commissioner; U.S. Court of Appeals, 7th Circuit, No. 11-3390; May 9, 2012). Here are three such random anomalies and exceptions baked into the “arbitrary” lines of the tax code.

Excess Contribution: Earnings Can Stay…After the Deadline

To contribute to any IRA, a person or her spouse must have earned income (compensation). But too much income precludes one from contributing to a Roth IRA. Oftentimes, confusion over the rules (or just plain negligence) leads to an ineligible deposit – i.e., an excess contribution. But no worries. There are corrective steps in place to alleviate the problem. An excess contribution can be fixed with no penalty by October 15 (generally) of the year after the year for which the contribution was made. If the fix is made prior to this deadline, the excess and any earnings (technically “net income attributable,” or “NIA”) can be withdrawn penalty-free. The earnings will be taxable, but no special tax forms need be filed.

Anomaly: In a strange twist, if the excess contribution is corrected after the October 15 deadline, the NIA does not need to be withdrawn. There is a 6% annual penalty on the excess, and that excess must be removed from the account, but any earnings can remain. This is true even if the IRA owner was totally ineligible to open the account in the first place.

Roth Conversion: Inherited IRA vs. Inherited 401(k)

When a traditional IRA owner dies and his IRA is passed to a beneficiary, that beneficiary must maintain the account as an inherited IRA. The inherited account cannot then be converted to an inherited Roth IRA. An inherited IRA owner could take withdrawals from the inherited account and use that money to make annual contributions to his own Roth IRA (assuming eligibility rules are met), but no direct conversions are allowed.

Anomaly: While inherited traditional IRAs cannot be converted to an inherited Roth IRA, employer plan designated beneficiaries (living people) can convert inherited plan assets – like from a 401(k) – to an inherited Roth IRA. Go figure.

Roth and After-tax Dollars: No Rollover from IRA to Plan

Speaking of Roth IRAs and plans, Roth and after-tax (non-Roth) money cannot be rolled from an IRA to a work plan, i.e., 401(k). Once those dollars hit an IRA, that is the end of the road. Only pre-tax monies can be moved from an IRA to a work plan. Sometimes referred to as a “reverse rollover,” this is an exception to the pro-rata rule and can be leveraged in cases when IRA owners are trying to separate their pre-tax IRA dollars from basis (after-tax dollars) in order to complete a “clean” tax-free Roth IRA conversion.

Why can’t Roth IRA dollars be rolled to a plan? Why do these anomalies exist? I have no idea. Left is right and white is black. To further quote the Young Kim v. Commissioner case: “This makes no sense.”