It doesn’t take much to squander a large piece of an IRA or 401(k) account. For many people, these are among their most valuable and important assets. Yet, the accounts often are taken for granted, and people don’t realize all the nuances of the rules and regulations. Every day both owners and beneficiaries who inherit the accounts make mistakes and oversights that cost them unnecessary taxes and penalties or result in missed opportunities.
You especially want to avoid what some experts call fatal mistakes. These errors can cause an entire account to be taxed right away. Other mistakes are less onerous but still deplete your retirement nest egg through avoidable taxes, penalties and interest.
This month we’re going to review the most frequent and avoidable IRA mistakes by owners and beneficiaries, and I think we’ll cover more than the 10 promised in the headline. We’ll review all stages of IRA ownership.
Rollover blunders. Rollovers are among the most common IRA transactions. You can roll over funds from one IRA to another IRA of the same type (traditional or Roth). You can roll over funds from a traditional IRA to a Roth IRA, known as a conversion. You also can roll over money from a 401(k) account to an IRA, or vice versa. Despite their frequency, the same mistakes regularly occur when rollovers are attempted. To make things more complicated, there were some rules changes the last two years.
One rule change is that for IRAs, only one “60-day rollover” is allowed every 12 months for each taxpayer. The 60-day rollover is when the IRA custodian distributes a check or assets to you in your name. If you deposit the same amount in that IRA, or another IRA or other qualified account within 60 days, there are no tax consequences; it is a tax-free rollover. But if you fail to deposit the same amount in a qualified account, even if you miss the 60-day deadline only by a day or two, you have a taxable distribution.
Many people are unaware that a couple of years ago the once-every-12-months limit was imposed on the 60-day rollovers. As a result, they are attempting multiple rollovers, incurring taxes and perhaps the 10% early distribution penalty.
Another mistake is not realizing the IRA custodian is required to withhold 20% of the distribution for income taxes. Yet, the amount you must roll over within 60 days to avoid taxes is the gross distribution amount before the tax was withheld. You have to come up with that 20% from another source and include it in the rollover. Otherwise, you include in gross income the amount you fail to roll over within 60 days.
One positive change is that in 2016 the Internal Revenue Service (IRS) essentially set up an honor system for waiving the 60-day deadline. Under the old system, to receive a waiver from the IRS, a taxpayer had to file a written request with the IRS, pay a filing fee and wait for the IRS to respond. There was no guarantee the IRS would grant the waiver, and it could take some time to receive an answer.
Under the new system, a taxpayer with a reasonable cause for inadvertently missing the 60-day deadline files a letter with the IRA custodian or trustee claiming a waiver. The taxpayer must meet one of 11 conditions that qualify for a waiver. The IRS still can audit the taxpayer later and withdraw the waiver. See our September 2016 issue for details.
The best advice for a taxpayer planning any type of rollover is to have the money or assets transferred from one plan administrator or custodian to another. Don’t take possession of the money yourself. Even then, there can be a problem if one of the custodians makes a mistake, such as depositing the money in a regular account instead of an IRA. You still need to monitor the paperwork carefully to be sure the transaction was done correctly and have any errors promptly corrected.
Inherited IRAs by non-spouses. Beneficiaries who inherit IRAs and other qualified plans often don’t know the rules and lose a lot of money learning them the hard way. There are different rules for a beneficiary who is the surviving spouse of the deceased owner and beneficiaries who aren’t.
To defer income taxes, a non-spouse beneficiary can’t roll over the IRA to his or her own IRA or have the IRA changed to his or her name. Take either of those actions and the IRA will be treated as though it were fully distributed. The balance will be included in gross income, and there isn’t a way to reverse it.
Instead, the inherited IRA needs to be segregated from other IRAs and retitled with a name that includes the original owner’s name, that he or she is deceased, and that the IRA is for the benefit of the beneficiary.
No contributions can be made to the inherited IRA. In addition, a beneficiary must take required minimum distributions (RMDs) from the IRA beginning no later than Dec. 31 of the year after the original owner died. Failure to begin RMDs means the entire IRA must be distributed within five years. The beneficiary usually has a choice of how to calculate the RMDs, and the choice depends on whether or not the deceased owner had begun RMDs. Details about RMDs are in free IRS publication 590-B available at www.irs.gov.
Surviving spouse beneficiary. A surviving spouse has several options for handling the inherited IRA. The surviving spouse can elect the same options as a non-spouse beneficiary. In addition, the surviving spouse is allowed a spousal rollover, also known as a “fresh start” IRA.
In a spousal rollover, the inherited IRA is rolled over into either a new IRA or an existing IRA in the surviving spouse’s name. In either case, the surviving spouse treats it as his or her own IRA without reference to the deceased owner. The surviving spouse names new beneficiaries and takes RMDs on his or her own schedule. If the surviving spouse isn’t at least at 70½ yet, RMDs aren’t taken until after he or she reaches that age.
Most surviving spouses should do the spousal rollover. An exception is when the surviving spouse is under age 59½. Then, the surviving spouse should choose one of the non-spouse options. The reason: When distributions are taken from a non-spousal inherited IRA, the 10% early distributions for taxpayers under age 59½ doesn’t apply, no matter how young the beneficiary is. But when the spousal rollover is used and the IRA is treated as the surviving spouse’s own IRA, the 10% penalty applies for distributions taken before age 59½. Once the surviving spouse turns age 70½, the spousal rollover can be used. There’s no time limit to when the spousal rollover can occur.
Beneficiary form disasters. The beneficiary designation form almost always controls who inherits an IRA. Even if a court decides there was an error and names a new beneficiary (a rare, time-consuming and expensive process), the IRS will follow the beneficiary designation form for its purposes. There are many instances of retirement accounts being inherited by ex-spouses, the estates of deceased people, and others.
For example, do an Internet search for “pension pickle” and you’ll find a New York Post article describing how a husband was disinherited because his late wife’s retirement plan administrator found an old beneficiary designation form naming her sister and parents as beneficiaries. She never updated the form.
Many people don’t review their beneficiary designation forms or have an estate planner do the review. Some completed their beneficiary designation forms years or even decades ago and haven’t reconsidered them since. You need to review and reconsider IRA and other retirement account designations after each major life change in your family
Non-traditional investments. Some assets can’t be owned at all in IRAs. Others can be owned only in some circumstances. In addition, there are prohibited transactions regarding retirement accounts you must know and avoid.
The details of these rules are tricky. For example, your IRA can own real estate, but not if there’s a mortgage or other debt involved. Your IRA can own a small business, but not if it pays you a salary or other compensation. Don’t add unconventional investments or strategies to your IRA without good advice or studying the rules very closely. We’ve discussed these issues in the past. See our July and August 2016 issues.
Charitable giving opportunities. Not enough people reap the benefits of charitable giving through IRAs. There are benefits for gifts made both during life and through your estate.
The charitable gift exclusion of up to $100,000 annually for IRA owners at least age 70½ was made permanent at the end of 2015. Eligible IRA owners can have their custodians issue donations to the charity or charities of their choice. The donation isn’t included in gross income, and the IRA owner doesn’t receive a deduction. But the donation counts toward the RMD for the year. For those charitably inclined, it’s probably the best way for someone age 70½ or older to make charitable donations.
When you plan to make donations through your estate, consider naming the charities as IRA beneficiaries instead of giving other assets in your estate. The charity takes the distribution from the IRA. Neither it nor the estate owes income taxes. If individuals, such as your spouse or children, inherit an IRA, the distributions are taxable to them in the same way they would have been taxable to you. That means they inherit only the after-tax value. But when they inherit non-IRA assets, they increase the tax basis to the current fair market value. They can sell appreciated assets and not owe any income taxes. They receive the benefit of the full market value of the assets.
RMD errors. People make a lot of mistakes with RMDs. That’s why a few years ago the IRS decided to examine RMDs more closely.
When you don’t take an RMD, the penalty is 50% of the amount that should have been distributed as an RMD but wasn’t. Some people don’t know about RMDs, so they don’t take them. Many others miscalculate their RMDs or don’t optimize the way they take RMDs. We’ve discussed the RMD strategies in detail in past issues. Review the October 2016 issue to avoid making common mistakes.
Waiting too long to plan for RMDs. Some people have large IRAs they consider to be primarily emergency funds and money to be left to their heirs. Often these people are surprised at how RMDs escalate over the years. The percentage of the IRA that must be distributed increases each year. This triggers higher income taxes that could have been avoided.
If you’re in this situation, plan early. The earlier you plan how to deal with a large IRA and its future RMDs, the more options you have. Among the strategies we’ve discussed in the past are emptying the IRA early, converting to a Roth IRA, buying qualified longevity annuity contracts, using the IRA to establish a family bank and turning the IRA into a charitable remainder trust. We’ve discussed these in past issues. Review our August and February 2016 issues.
You also can find details about handling unwanted RMDs in the report The Bombshell Battle Plan: How to Defend Against the IRS’ Secret Weapon by David Phillips and Todd Phillips. My readers can order a free PDF copy of the report at http://epmez.com/index.php/bombshell-battle-plan-report-request. Or you can order a hard copy for only $6.95, which is the printing and shipping cost, by calling 888-892-1102.