According to the Investment Company Institute as of March 31, 2018, there were approximately $9.2 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. Though not surprisingly, the focus of this article will be the IRA mistakes I see most from folks that are at or nearing retirement and those mistakes that could result in unnecessary taxes or penalties.
It should be noted that the following mistakes are not limited to DIY’ers. I’ve seen many of the following mistakes occur even when the investor is working with an advisor. So don’t think that just because you have an advisor that you are immune from these issues. Consider your own circumstances when reading this to ensure that you and/or your advisor is paying attention to these issues and bring it to their attention if you think you are at risk of committing one of the following mistakes.
1. Failing to Name Beneficiaries
Many investors incorrectly assume that if they have a will, they don’t need to designate beneficiaries and therefore ignore the beneficiary form. And as a result, they are overlooking the shortcomings that come along with that perception. In fact, I believe that the IRA Beneficiary Designation Form is one of the most important (yet neglected) estate planning documents. Its importance is due primarily to a couple factors. (1) The fact that 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 “stretch IRA” 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 is still your estate. Which you may not view as a big deal. However, if it is the estate, this results in the loss of the “stretch option” and spousal continuation.
Quick definition: A “stretch option” is the ability of the inheriting owner (spouse, children or whomever) to stretch the distribution of the funds over his/her lifetime. This stretch option allows for continued tax-deferred growth, potentially for decades, which is one of the great compounding benefits associated with the IRA.
So, failing to name a beneficiary could very likely result in the liquidation of the IRA (and will, therefore, be taxed) either all at once in a lump sum or over the period of five years following the death of the owner. The tax consequences associated with the distribution increase based on the size of the IRA balance due to our progressive tax structure.
Your financial life would become a matter of public record:
Additionally, failing to name beneficiaries on your IRA will cause your IRA to become subject to probate. This can be an arduous and costly process where the executor of the estate presents your will for probate in a courthouse in the county where the decedent lived or owned property. 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’ll want to name beneficiaries.
What if I just formally name “my estate” as the beneficiary of my IRA?
Same issues. 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. Again, this results in the loss of the “stretch option” as well as the requirement for your IRA to go through the probate process.
You should consider reviewing and potentially updating your beneficiary designations annually or upon any significant life event.
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 primary beneficiary on your IRA accounts. But what if you failed to update your beneficiaries upon getting remarried? If that’s the case, it’s quite possible that your ex-spouse will be the recipient of the funds. Probably not how you or your spouse would like this to go. And there is little to nothing that could be done about it at that point.
I’ve personally seen ex-spouses as the beneficiaries on all kinds of assets to include IRAs, life insurance, and employer 401k plans. The looks I’ve 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. One vote for consolidating old employer plans.
Many believe that as long as their will or estate plan reflects their new spouse, that this will take care of this 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.
3. Naming an Improperly Structured Trust as Beneficiary
I’ll add the disclaimer here that I am not an attorney, nor do I 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 that have beneficiaries that are either young or unable to care for themselves financially speaking for whatever reason. This is often a sound strategy if the trust is properly structured.
But if the trust is not structured properly, you could again be giving up the “stretch provision” (and the accompanied tax-deferred growth) that your IRA allows for. See #1 above for a brief definition of a “stretch IRA.” And given the reasons for the trust in the first place, this “stretch provision” may be very important to the long-term fiscal health of the trust itself. There is a way that a trust can be structured that will keep the possibility of the stretch provision intact.
You will want to ensure that your trust qualifies as a look through trust. A look through trust (or see-through trust) is a trust that has ONLY eligible and living beneficiaries. This means it cannot include any charities or any other non-living entities. In other words, the beneficiaries can only be living people.
There is a bit more nuance to it than just that and can get a little complicated. Therefore, you should consider having any existing trusts reviewed by a qualified estate planning attorney to ensure that all the “stretch IRA” provisions will remain intact if something should happen to you.
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 70.5. 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 70.5 and then the next one the following year to spread out the tax bill. This is with exception to folks retiring in the year they turn 70.5 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). You then divide this amount 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 70 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. There may be IRAs at a brokerage firm, IRAs 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 yet another vote for consolidating all plans into one IRA. It makes calculating and distributing the RMD so much simpler and 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
|(For Use by:
|Age||Distribution Period||Age||Distribution Period|
|92||10.2||115 and over||1.9|
Source: Internal Revenue Service, Publication 590-B, Table III, Uniform Lifetime
5. Not utilizing (or incorrectly using) Qualified Charitable Distributions in Retirement
Many of my clients 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 from prospective clients is making large charitable contributions utilizing the after-tax income received from a required minimum distribution rather than taking advantage of Qualified Charitable Distributions (QCD). It’s typically done this way because that’s what they are used to. For their entire working lives, they’ve been making charitable contributions via their 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 are required to withdraw money from your IRA, you could utilize a 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; they 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 choose to give.
Given the Tax Cuts and Jobs Act increasing the standard deduction, fewer retirees will be itemizing their deductions. So it’s likely that the QCD strategy will likely become more popular since charitable giving is an itemized deduction. So, if the tax law change means you are unlikely to itemize moving forward, then you would not receive a tax benefit for giving to charity unless you utilize the QCD. It is the only effective workaround that allows you to give to charity while satisfying your RMD requirement 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.
- 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.
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 more of a potential missed opportunity. It is not unusual for a couple with significant guaranteed income sources to take their RMDs and just leave it in their bank savings account thinking they can no longer invest those dollars. But you can, just not back into an IRA. As an alternative to spending these dollars or giving them to charity, you could consider reinvesting 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 529 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 70.5:
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 once you pass 70.5. 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 you are giving those dollars to potentially compound tax-free.
You could convert your IRA to a Roth IRA after age 70.5, but note that any amount converted does not satisfy RMD requirements.
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 are likely 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 often viewed as a common strategy to immediately roll your 401k over to an IRA upon retirement, but there are special circumstances such as this where leaving your funds within your 401k could have significantly 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.
8. Unnecessary taxable distributions for those retiring after 70
Just as 401ks have slightly more flexibility when dealing with withdrawals prior to age 59.5, they also have some added benefits after age 70.5. And this is becoming more popular as fully retiring after age 70 is becoming more and 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’s 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.
9. Not taking advantage of Net Unrealized Appreciation (NUA) rules for company stock
This is another situation when you might reconsider immediately rolling over your 401k to an IRA after retiring. If you are an investor that has been granted stock within your 401k through the years (particularly company stock that has appreciated significantly), it would be wise to understand the special tax rules that accompany such a scenario.
Typical distributions from 401ks and IRAs are taxed at your ordinary tax rates, but company stock is treated as a special situation. If you take the company stock as a lump-sum distribution from the qualified plan prior to rolling over the assets to an IRA, then only the cost basis of the stock will be treated as ordinary income. Note: This is only true if the distribution is taken in the form of stock, not sold and distributed as cash.
Once this company stock has been rolled out, the unrealized capital appreciation (meaning the difference between the cost basis and the current market value) is not taxed until the stock is sold. This is known as “Net Unrealized Appreciation.” The primary tax benefit, however, is that the appreciation of the stock would be treated as a long-term capital gain which is taxed at a lower rate than ordinary income.
Additionally, there is an often overlooked benefit to this strategy and that is once the company stock is distributed, it is no longer subject to Required Minimum Distribution rules.
It’s important to note though that NUA is not for everyone. This strategy generally makes the most sense only when the stock has appreciated considerably within the plan, and you have an immediate cash need. If you do not have an immediate cash need, you still may be better served by rolling this asset over into an IRA to avoid a possible over-exposure to this specific stock. It’s not uncommon for an individual stock to make up an inordinate percentage of a client’s wealth in these types of scenarios. And virtually everyone is familiar with large, seemingly stable companies going under practically overnight. If this situation describes you, you’ll want to consider your cash needs and your overall portfolio allocation to evaluate if this type of strategy is right for you.
If you’re interested in more detail on this topic and the qualifying events that need to take place for you to consider it, see this article on NUA from Fidelity.
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. If you have other questions regarding any of these issues, feel free to shoot me an email at email@example.com. 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.
Thanks for reading!
– Ashby Daniels
Disclaimer: Any opinions are those of the author and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional.
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