IRA Mistakes to Avoid in 2016
The new year is almost here. Let’s en-sure it is off to a good start. Your IRAs probably are your most valuable assets or will be after you rollover a 401(k) to one. We review the most frequent and expensive mistakes people make with IRAs. Study them now and resolve not to do them in 2016.
Failing to use IRAs as gifts. Once an IRA is set up in someone’s name, anyone can contribute to it. The total contributions can’t exceed the limit for that person for the year, and the person whose name is on the IRA must have earned income at least equal to the contributions. Making contributions to IRAs on behalf of someone else are a great way to make gifts.
The best strategy is to contribute to a Roth IRA for a youngster. Tell him or her that you’ll match earnings from jobs up to the contribution limit or a lower limit you set. The contribution qualifies for the annual gift tax exclusion. Earnings compound tax free in the IRA, and they are tax-free when removed by the youngster if they remain in the IRA for at least five years. There might be a 10% early distribution penalty if earnings are withdrawn before age 59½. Ideally, the child will let the money compound within the IRA until retirement.
Delaying RMD planning. Once you’re over age 70½, required minimum distributions are required each year. The first RMD isn’t due until April 1 of the year after turning 70½, and the others are due by December 31 of each year. Too many people delay planning for their RMDs. They figure if the RMD isn’t due before December 31, there’s no reason to worry about it until at least Thanksgiving.
You should compute the amount of your RMD early in the year. You know the amount, because an RMD is computed by taking the December 31 balance of the preceding year (2015 for 2016 RMDs) and dividing it by your life expectancy factor in the table in IRS Publication 590. At a minimum, calculating the RMD early in the year gives you a better idea what your income for the year will be and helps with your tax planning through the year.
An RMD can be taken in either a lump sum or a series of distributions during the year, as long as the total at least equals the RMD. When you have more than one IRA, you can decide whether to take the RMD from one IRA, from each of them proportionately, or in any other combination. You also don’t have to take an RMD in cash. You can have property in the IRA distributed either to you or to a taxable account.
RMDs can be used to rebalance your portfolio. For example, when stock market appreciation has made stocks too high a percentage of your portfolio, sell stock holdings or have them distributed to you to satisfy the RMD. Or if you’re going to reduce an investment holding for strategic reasons, perhaps that should be part of your RMD.
Also, consider what you’ll do with the RMD. You don’t have to spend it. The RMD can be reinvested through a taxable account or given to someone as part of your estate plan.
Finally, plan ways to reduce future RMDs. For details, see our March 2015 visit.
Holding less-than-optimal investments. Many investment mistakes are made with IRAs. Some people hold assets in their IRAs that already are tax-advantaged. A prime example is to invest for long-term capital gains in an IRA instead of in taxable accounts. All gains earned in an IRA eventually are taxed as ordinary income, so there’s a disadvantage to invest for long-term gains in IRAs when you have sufficient cash to own them outside the tax-qualified account. When possible, IRAs should hold assets that generate ordinary income, such as bonds, real estate investment trusts, and mutual funds or strategies that generate short-term capital gains.
Also, think carefully about owning master limited partnerships in an IRA. It’s not a prohibited investment. But income from an MLP is unrelated business taxable income. If an IRA earns more than $1,000 of it in one year, it will have to file a tax return and perhaps pay income taxes. Also, MLPs have built-in tax advantages that you’re foregoing by owning them through an IRA.
Making poor beneficiary decisions. Longtime readers should know to keep beneficiary designations up to date. You don’t want an ex-spouse, for example, named as beneficiary. But there’s much more to consider.
When you’re going to make one or more charitable gifts through your estate, consider making them by naming the charities as IRA beneficiaries. Your estate still receives the charitable gift tax deduction, and the charity receives the full value of the contribution without owing taxes. But when one of your children, for example, inherits part of an IRA, he or she is taxed on the distributions just as you would be. The child inherits only the after-tax value of the IRA. It’s better for a charity to inherit an IRA while your children inherit other assets that are likely to be tax-free to them.
Also, since distributions from traditional IRAs will be taxable, carefully consider who should be named beneficiaries. It might be better not to name a child who is in a high tax bracket when there are other assets to leave him or her. You can equalize the after-tax value of the inheritance by naming a low-bracket child to receive all or most of an IRA while giving other assets to a higher-bracket child.
Not advising beneficiaries. Many people spend time choosing carefully the beneficiaries for their IRAs and developing plans that will help the beneficiaries maximize the tax deferral of IRAs. Yet, IRA sponsors report that a very high percentage of IRA beneficiaries empty the IRAs and spend them shortly after inheriting them. Other beneficiaries make simple mistakes that trigger unnecessary taxes or penalties on the IRAs. It’s important that you let beneficiaries know what you plan for them to do with the IRA and how you set it up. Also, be sure they are well-advised about the actions they should and shouldn’t take after inheriting the IRA, which we discussed in our July 2014 visit.
Not reconsidering conversions. Converting a traditional IRA to a Roth IRA can be a powerful tool in some circumstances. Many people carefully consider a Roth IRA conversion only once. After concluding that the Roth IRA isn’t the best option, they stop considering the issue.
But situations change. Your financial situation might change to make a conversion a good idea. You might fall into a lower tax bracket for some reason. Or one year you might have tax deductions that are significant enough to offset all or most of the amount of the conversion that will be included in gross income. Other changes could make a conversion a good idea. Review the decision periodically.
Making nondeductible IRA contributions. When your income is too high to deduct a traditional IRA contribution, you still can make a nondeductible contribution. The income and gains will compound tax-deferred in the IRA.
There are two problems with nondeductible IRAs. One problem is that they convert tax-advantaged long-term capital gains into ordinary income, as we discussed earlier. The other problem is that after age 70½ they generate RMDs, whether you need the money or not. For higher income individuals it often is better to forego the nondeductible IRA contribution and put the money in a taxable account. The only real advantage of a nondeductible IRA contribution is when you are able to immediately convert the IRA to a Roth IRA tax free.
Not coordinating a 401(k) and Roth IRA. This is an especially good strategy for people who earn too much money to contribute directly to a Roth IRA. (Singles with adjusted gross income above $116,000 in 2015 and married couples filing jointly with AGI above $183,000.) Your employer’s 401(k) plan might allow you to make after-tax contributions to the account that exceed the $18,000 maximum that can be contributed pre-tax in 2015 and 2016. An additional $6,000 of pre-tax contributions is allowed for those age 50 and older. The law allows total 401(k) contributions for the year to equal $53,000 ($59,000 for those 50 and older). If you’re over 50 you can contribute $24,000 of pre-tax dollars and another $35,000 of after-tax dollars. You include those after-tax dollars in gross income and pay taxes on them.
The main advantage is that when it is time to retire, you can roll over the after-tax contributions directly to a Roth IRA and the rest of the 401(k) directly to a traditional IRA. You’re setting things up to have a sizeable Roth IRA in the future. Details of the strategy were discussed in our September 2015 visit.
RW December 2015.
