According to the Investment Company Institute as of March 31, 2020, there were approximately $9.5 trillion in IRA assets. Given the sheer volume of Americans that own an IRA combined with the complicated IRS tax code that accompanies them, there are plenty of ways to trip yourself up when it comes to IRA planning throughout your life. In this article, we focus on the IRA mistakes I see most from those at or nearing retirement.
It should be noted that the following mistakes are not limited to DIY’ers. I have seen many of the following mistakes occur when the investor is working with an advisor. Consider your own circumstances when reading this to ensure that you are paying attention to these issues and bring it to your advisor’s attention if you think you are at risk of committing one of the following mistakes.
IRA Mistakes:
Mistake #1: Failing to Name Beneficiaries
Some investors incorrectly assume that if they have a will, they don’t need to designate beneficiaries and therefore ignore the beneficiary form. As a result, they are overlooking the shortcomings that come along with that misunderstanding. In fact, I believe that the IRA Beneficiary Designation Form is one of the most important (yet neglected) estate planning documents. It is important because (1) the IRA is one of, if not the largest asset for many people and (2) the investor may be unaware of some other significant benefits associated with formally designating a beneficiary such as the “10-year distribution rule” and maintaining their privacy.
Where do your assets go if you fail to name a beneficiary?
While this is dependent upon the IRA custodian’s agreement, if you fail to name proper beneficiaries, the default beneficiary will generally be the owner’s estate. In some cases, it may default to a spouse, but in many cases, it will go to your estate which you may not view as a big deal. However, if it is the estate, this could result in the reduction of distribution time from 10 years down to 5 years.
This can cause a significant tax complication as the IRA will be liquidated in a shorter period of time which can likely result in increased taxes due to the progressive tax structure of our tax system.
Your financial life would become a matter of public record:
Additionally, failing to name beneficiaries on your IRA can cause your IRA to become subject to probate. This can be an arduous and costly process. There are a variety of reasons that most people prefer to avoid probate such as cost, time, and the fact that all probate details become a matter of public record. So, if you are interested in maintaining your family’s financial privacy, you will want to name beneficiaries.
What if I just formally name “my estate” as the beneficiary of my IRA?
Same issues as above. An IRA that is made payable to an estate must be distributed within five years if you would pass before your Required Beginning Date (RBD) or during the remaining single-life expectancy if you would pass after your RBD.
You should consider reviewing and potentially updating your beneficiary designations annually or upon any significant life event.
Mistake #2: Outdated Beneficiaries
Imagine being on your second marriage and unexpectedly passing after being married a few years. Your spouse likely believes that he/she is the listed primary beneficiary of your IRA accounts. But what if you forgot to update your beneficiaries upon getting remarried? If that’s the case, it is quite possible that your ex-spouse will be the recipient of the funds. That is probably not how you or your spouse would like this to go. But once it’s done, it’s done.
I have personally found, unbeknownst to the account holder, ex-spouses as the beneficiaries on all kinds of assets to include IRAs, life insurance, and employer 401k plans. The looks I have seen when this fact is revealed have been interesting. This issue is most common with old 401k/403b plans because they are often ignored or forgotten about for many years at a time. That is another vote for consolidating old employer plans.
Many believe that as long as their will or estate plan reflects their new spouse, this will take care of the issue. It won’t. There are occasions where provisions in the 401k plan document or state laws will automatically revoke beneficiary designations upon divorce, but you may not want to rely on that. In reality, current beneficiary designations (that have not been revoked for some reason) on ALL financial products to include IRAs, life insurance, annuities, and the like will supersede your will and any other wishes laid out in your estate plan.
Like I said before, the easiest solution to this problem is to ensure that all beneficiaries are up to date.
Mistake #3: Naming an Improperly Structured Trust as Beneficiary
I’ll add the disclaimer that I am not an attorney and do not play one on the internet. With that out of the way, many of the most successful people I know establish trusts for the protection, preservation, and privacy of their estate. This is particularly important for folks who have beneficiaries who are unable to care for themselves financially speaking. Establishing a trust is often a sound strategy if the trust is properly structured.
One of the effects of the passage of the SECURE Act is the impact it has had when trusts are named IRA beneficiaries due to the change in IRA payout provisions. Due to this fact, it is critical that you have any existing trusts reviewed by a qualified estate planning attorney to ensure that the goals you had in mind when you established your Trust can still be accomplished in today’s legal environment.
See more info on Trusts and the SECURE Act here.
Mistake #4: Forgetting about your RMD or Taking Less than Required
You must start taking distributions from your Traditional IRA in the year after the year you turn 72. And you must take that first distribution by April 1st that year and then take a second distribution by December 31st that same year. You can avoid the double distribution year by taking your first RMD in the year you turn 72 and then take the next one the following year to spread out the tax bill. This is with exception to folks retiring in the year they turn 72 when it may be beneficial to take both distributions the following year due to large potential payouts in your final year of employment. Either way, following your Required Beginning Date, you will need to take a distribution each year by December 31st.
How much will I need to take out of my IRA each year?
How much you need to withdraw is based on the balance of your TOTAL tax-deferred retirement accounts (all IRAs and non-participating employer plans combined value). Once you know that number, you can divide it by your corresponding age factor on the IRA “Uniform Lifetime Table” (table below) to arrive at your Required Minimum Distribution Amount.
For example, if you are age 72 and had a prior year December 31st balance of $1,000,000, you would need to withdraw approximately $36,497 ($1,000,000 / 27.4).
If you do not take your RMD or take less than what is required, the IRS will impose the largest penalty they have, 50%, on the amount that was not taken plus interest. Yes, you read that correctly; the penalty is 50%. So, using the example above, if you failed to take your first RMD, your penalty would be approximately $18,249. Crazy, right?
Where this really tends to cause issue is when investors own multiple IRAs and tax-qualified plans spread all over the place. I see it all the time. A few IRAs at a brokerage firm, a few more in Certificates of Deposit at various banks and multiple old employer 401k plans. Most people don’t really think of the banks and old employer plans, but the IRS considers them to be the same pot of money that requires a distribution.
You may draw the conclusion that you’ll just do the math and take your total RMD from any one IRA, but that won’t satisfy old employer plans as they often require their own RMD to be calculated and appropriately withdrawn. This is one potential reason to consider consolidating all plans into one IRA as it makes calculating and distributing the RMD easier to manage.
What to do if you’ve already missed an RMD?
If after reading this, you realize you may have made a mistake with your RMDs, you will want to bring this to the attention of the IRS immediately and file all the amended paperwork. There is a chance that you may be able to avoid the penalties associated with this error if you file Form 5329 with a letter of explanation explaining that this was a mistake of “reasonable error” and that you are taking steps to remedy the situation. You will likely want to work with a CPA to help you rectify the problem to avoid additional mistakes. On the other hand, if you continue to ignore the mistake and the IRS makes this discovery, be prepared to pay the piper.
The IRS has a helpful RMD worksheet that you can use to calculate your RMD: IRS Required Minimum Distribution Worksheet (Note: This worksheet needs to be updated with the new age 72 RMD age.)
Mistake #5: Not utilizing (or incorrectly using) Qualified Charitable Distributions in Retirement
Many retirees are charitably inclined and so there is an ongoing discussion about how to bring additional tax-efficiency to the giving process. A common mistake I see is making large charitable contributions utilizing the after-tax income received from their RMD.
It’s typically done this way because that’s what they have always done. For their entire working lives, they’ve been making charitable contributions using after-tax pay and taking a deduction on their taxes. But by taking the IRA distribution, then giving those dollars to the qualified charity, you are likely leaving money on the table by paying unnecessary taxes especially given the recent change to the tax code. Once you reach age 70.5, you could utilize a Qualified Charitable Distribution (QCD).
A Qualified Charitable Distribution is a direct transfer of funds from your IRA custodian payable to a qualified charity. The keyword here is direct. The funds cannot pass through your hands as the IRA owner. The funds need to go directly from your custodian to the charity. This allows you to satisfy some or all of the RMD requirement depending on how much you wish to give.
Given the Tax Cuts and Jobs Act increasing the standard deduction, fewer retirees are itemizing their deductions. And since charitable giving is an itemized deduction, we will likely continue to see the QCD strategy grow in popularity. So, if you are above age 70.5 and are not itemizing deductions, a great way to receive a tax benefit for your charitable giving is to use the QCD. It is the only effective workaround that allows you satisfy your RMD requirement (beyond age 72), give to charity, and receive a tax benefit in the process. A win/win/win.
There are a few requirements that must be satisfied to utilize the QCD strategy:
- Must be 70.5 or older to be eligible to make a QCD. (This age requirement did not increase due to the SECURE Act.)
- It is limited to the amount that would otherwise be considered taxable income. In other words, it excludes non-deductible contributions.
- Maximum QCD is $100,000 total annually regardless of the number of charities.
- The QCD must be distributed from your IRA before the RMD deadline, generally December 31st.
So, you’ll want to be sure you follow the rules if you want to save yourself from taxes and the IRS.
Mistake #6: For those not in need of RMDs, leaving the RMD proceeds in your bank account rather than reinvesting them.
This one isn’t really a mistake per say, but a commonly missed opportunity. It is not unusual for a couple with significant guaranteed income sources to take their RMDs and just leave the proceeds in their bank savings account thinking they can no longer invest those dollars. But you can, just not back into an IRA. If there is no desire to spend these dollars or give them to charity, you could reinvest the after-tax proceeds in one of two ways:
- You can invest the proceeds into a taxable investment account. This could be a typical taxable account such a Joint / Single Registered or a Trust Account.
- Or if you have family members that are planning to attend college, you could invest those proceeds into a college savings plan for said family member(s).
Both of those options give you the potential to continue growing your wealth for the benefit of you and/or your family.
One Other Option For Investors Not Yet 72:
After you’ve estimated your retirement expenses and your guaranteed sources of income, you may realize in advance that you may not need your future IRA distributions. If this is you, you may consider converting some of those tax-deferred dollars to a Roth IRA to provide an asset that can be distributed tax-free to your heirs. A Roth IRA also has the added benefit of no RMDs. It won’t help to avoid the taxes per say, but it could very well lead to increased tax-efficiency when considering your estate distribution plan. Not surprisingly, the earlier you complete this, the longer those dollars can grow tax-free.
You could convert your IRA to a Roth IRA after age 72, but note that any amount converted does not satisfy RMD requirements.
Mistake #7: Paying unnecessary penalties on early IRA distributions
For investors that retire before age 59.5, there are two ways to get to your IRA dollars (and 401k in this case) that can allow you to make withdrawals from your tax-deferred assets before age 59.5 while avoiding the typical 10% penalty that accompanies early distributions.
Those two ways are (1) Utilizing Section 72(t) known as “substantially equal periodic payments and (2) withdrawing assets directly from your 401k plan if you retired from the company after age 55 rather than rolling those funds over.
Section 72(t) - Substantially Equal Periodic Payments:
Section 72(t) allows you to start taking payments from your IRA at any age. The payments must then continue for at least 5 years or until you are age 59.5, whichever period is longer. These payments must be substantially equal and therefore cannot be changed or stopped during the payment period, unless you would become disabled or die. Should you attempt to make changes to your payout setup, you may end up compromising the “penalty-free” part of the strategy.
There are three ways to withdraw funds from your IRA using the “substantially equal periodic payments. They are (A) Required Minimum Distribution method, (B) the Fixed Amortization Method and (C) the Fixed Annuitization Method. Rather than write a long report on this specific topic, there is a lot more detail on these three options in this article from Forbes. Due to the relatively complicated nature of this strategy, it is important to consult with a knowledgeable tax and/or financial advisor before you attempt to do it yourself.
Withdrawals from Your 401k Plan After 55:
If you retired from a company after the age of 55, but before age 59.5, you may be eligible to take penalty-free withdrawals from your 401k plan. This withdrawal would be considered taxable income just the same as an IRA distribution but could avoid the 10% early withdrawal penalty. It is a common strategy to immediately roll your 401k over to an IRA upon retirement, but there are special circumstances such as this when leaving your funds within your 401k could offer more flexibility than rolling them over right away.
If you left your previous employer before you reached age 55, this special provision does not apply. Again, you will want to consult with a qualified financial advisor or tax expert to ensure you will not be penalized.
Mistake #8: Unnecessary taxable distributions for those retiring after 72
Just as 401ks have slightly more flexibility when dealing with withdrawals prior to age 59.5, they also have some added benefits after age 72. And this is becoming more popular as fully retiring after age 72 is becoming more common. If this is you, you may be able to further delay Required Minimum Distributions by rolling your IRA dollars into your 401k. Many investors have no idea that this is even a possibility because it is rare.
Most people roll money out of their employer plan and into an IRA, but hardly ever the other way around. So, if you are earning enough from your job to where you would not need any income from your IRA assets, and you own less than 5% of the company that you work for, you may consider consolidating all your Traditional IRA assets into your 401k. This will allow your hard earned dollars to continue to compound inside the plan and by extension avoid paying taxes on those assets rather than being forced to withdraw them before you are ready.
Note: This is unnecessary for Roth IRAs because they do not have an RMD requirement.
Note Two: If this strategy appeals to you, you would not want to roll over any non-deductible basis back into your 401k. You would simply want to roll the remaining dollars over. This would allow you to convert the basis to a Roth IRA with no tax consequences, thereby further strengthening your overall position. This is a process known as “basis isolation”. It’s beyond the scope of this article, but wanted to be sure I mentioned it as that would just be another unintentional mistake.
Each one of these mistakes could be an article individually, so please do not consider the above information to be exhaustive. My hope is that this article brings about some talking points and perhaps a few things to consider when thinking of your IRA within the scope of your overall financial plan. Again, please seek the help of a qualified advisor or tax expert when implementing any of the more complicated issues above. After all, the whole point of this article is to help you avoid possible IRA mistakes.
Stay the Course,
Ashby
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This post is not advice. Please see additional disclaimers. Other disclaimers:
While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.
Please be aware that the early distribution penalty tax exception, substantially equal periodic payments, available via Section 72(t) of the Internal Revenue Code, is subject to very specific guidelines, and thus, various factors should be carefully considered. Investors should understand the account value (net equity and/or principal balance) could potentially be exhausted if the distributions exceed the earnings and growth of the investment(s) in the account. Also, the ability to sustain substantially equal payments can be compromised if the account is exposed to higher volatility through higher-risk or growth-oriented products. Always consult the advice of an independent tax professional prior to initiating 72(t) substantially equal periodic payments.
