Don’t let the complexity of these powerful retirement savings tools trip you up
Our experience has shown us that clients can miss opportunities, fail to take advantage of their options, or inadvertently get into trouble when it comes to their individual retirement accounts (IRAs). While each person’s situation is different, many of the missteps are the same. Here’s a look at common mistakes and potential solutions to help you get the most from your savings while avoiding potential pitfalls.
1. Eligibility Mishaps
According to the Internal Revenue Service, approximately 86% of all eligible taxpayers fail to contribute to an IRA. While poor saving habits may be the most simple explanation, another reason is that taxpayers confuse deduction eligibility with IRA eligibility.
There are only two requirements to make you eligible to contribute to a traditional IRA: earned income and being under 70½ years of age. If a Roth IRA is desired, then the underage-70½ requirement does not apply, but income must be less than or equal to threshold amounts.
Rember, contributions to a 401k or IRA on a pre-tax basis can potentially make you eligible for an IRA deduction.
2. Tracking basis when making after-tax contributions to an IRA
If an individual is not aware of how much aftertax money he or she has contributed to a traditional IRA, the account holder could face a nasty surprise: distribution may also be fully taxable. In general, given multiple potential scenarios, financial institutions do not track deductible IRA contributions, so the burden shifts to the taxpayer. You only file Form 8606 with your tax return, showing what was nondeductible on the way in, and Form 8606 again to reconcile the distributions and get the proper income credit on the way out. Form 8606 assists you by recording your remaining basis (i.e., the amount not taxed).
Knowing your basis is beneficial in minimizing any taxes payable if you choose to avail yourself of the Roth conversion opportunity.
The basis also is an important figure for your beneficiary to know because double taxation will occur when distributions after death are taken.
3. Required Minimum Distributions (RMD)
Many taxpayers are unaware that all IRAs (traditional, SEP, and SIMPLE) must be totaled to determine how much needs to be taken at age 70½, when taxpayers must begin making required minimum distributions (RMDs). There is an excise tax penalty equal to 50% of the RMD shortfall if not withdrawn in a timely manner.
4. Combining IRA Rules and Strategies Have Changed
Before the Economic Growth and Tax Relief Reconciliation Act [EGTRRA] of 2001, it was important to leave rollover and contributory IRAs separate if an individual wanted to roll an IRA account into a new employer’s retirement plan. EGTRRA now allows full portability of all traditional (non-Roth) IRA accounts as long as no aftertax monies are transferred to an employer plan receiving funds from an IRA.
By combining IRA accounts, a taxpayer can save custodial fees, and more easily monitor accounts.
5. Inheriting Options
When a spouse inherits an IRA and he or she is under age 59½, making the account his or her own reattached the 10% penalty for early withdrawals. In other words, this forces the inheriting spouse to wait until age 59½ to make penalty-free withdrawals. A way to avoid this issue is to leave the IRA in the decedent’s name, which allows the surviving spouse to make penalty-free withdrawals as needed.
6. Using your will to name your beneficiary
An IRA account owner must follow the custodian’s procedures when naming a beneficiary. The executor of the estate cannot present a will at the time of death and demand payment of the assets unless beforehand the will has the named beneficiary designated on a form deemed acceptable to the IRA custodian. Sometimes the custodian’s forms are required, while many custodians will accept a written statement that clearly delineates the intention. Not naming a beneficiary leaves the beneficiary determination to the terms of the custodial agreement, which can name the estate or distribute according to some succession order, such as spouse, children, grandchildren, or siblings, which may not be the owner’s intent.
7. Naming the estate as the beneficiary
If the account holder’s estate is the IRA’s beneficiary, the heirs will receive the proceeds, but potentially not in the most tax-efficient manner. If the account owner dies before his or her required beginning date (RBD)—April 1 following attainment of age 70½—the entire account must be distributed before December 31 of the fifth year after his or her death. If there is a lot of money in the account, distributions could be taxed at a very high federal tax rate.
8. Naming a nonperson (charity) as a co-beneficiary
When a charity is an IRA’s co-beneficiary along with a family member, for example, the ability to stretch the payout over the human beneficiary’s lifetime can be lost. This potential tax inefficiency can easily be avoided by splitting the IRAs before death and designating a charity as the beneficiary of a separate IRA.
9. Naming a trust as beneficiary when there are multiple beneficiaries
Under a scenario when a trust is the named IRA beneficiary and there are multiple beneficiaries, the RMD in the year following death is determined by basing it on the age of the oldest named beneficiary. When an individual is the beneficiary of an IRA, he or she is not locked into solely taking annual distributions. Rapid depletion of the account can occur at any time. A trust can be utilized to stop one or more beneficiaries from squandering their inheritance.
10. Failing to name a contingent beneficiary
A problem could occur if the beneficiary predeceases the account holder and the account holder does not replace that beneficiary and subsequently dies. The IRA custodial agreement may name the estate or require the distribution of the proceeds according to some succession order, such as spouse, children, grandchildren, or siblings, which may not be the owner’s intent.
As we can see, an IRA is not a simple product, but it can be a significant part of someone’s retirement savings. The erosion of an IRA’s value owing to an individual’s lack of knowledge is an unfortunate circumstance we hope all taxpayers can avoid
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.