7 Things You Must Know About IRAs and 401(k)s

Almost everyone has an IRA and a 401(k) account. Many people have more than one of each. Yet, important facts about these accounts aren’t well-known. You need to know this information to maximize the after-tax value of the accounts.

I find that even many accountants, attorneys and financial planners don’t know these details. Knowing them will give you a leg up in having a successful retirement.

You might not have all the legal options.

I regularly hear from readers who, after reading about a strategy in Retirement Watch, were told by their 401(k) or IRA administrator that they couldn’t do the strategy.

IRA and 401(k) sponsors and administrators don’t have to offer all the strategies the tax code allows, and many choose not to do so. Usually your actions are restricted to make it easier and less expensive to administer the accounts. Other times there’s some paternalism at work. Employers or plan administrators are afraid some account holders would make bad choices and perhaps try to hold the administrator responsible for their mistakes.

In the past, we discussed how a true self-directed IRA can be invested in a range of unconventional assets, such as private businesses, mortgages, loans, real estate and others. (See our December 2018 and January 2019 issues for details.)

But most IRA sponsors don’t allow these investments. Their IRAs can be invested only in publicly listed stocks, bonds, mutual funds and some other assets. The list of allowed investments might be even shorter. 401(k) plans often are more restrictive than the tax code on investment options, plan loans, hardship withdrawals, distributions to beneficiaries who inherit accounts, in-service distributions to active employees after age 59½, rollovers in and out of the plan, and required minimum distributions.

Employers also don’t have to offer designated Roth accounts, though they’re allowed to do it. This is an especially important issue when you’re considering a new employer or deciding what to do with your 401(k) account when leaving an employer. Many people find out too late that they are restricted from taking an action that the tax law allows and would be beneficial to them.

Your will doesn’t affect how your IRA and 401(k) are distributed.

I mention this regularly, because it needs to be repeated.

The beneficiary designation forms for your accounts determine who inherits the accounts. Your will has an effect only when your estate is the sole primary beneficiary of the account. You probably don’t want to set the plan up that way, because the account would have to be fully distributed and taxed within five years after your death. Ask your IRA and 401(k) administrators who is listed as your beneficiaries in their records. It is not unusual for administrators to have records that disagree with the account owners’ records. Update the beneficiary designation form as needed and review the decision every few years.

Be sure your executor knows where the beneficiary designation forms are located.

IRAs can be split tax free.

Splitting an IRA can be a good idea when you have multiple beneficiaries, such as your children. After they inherit, it might be difficult for them to agree on investment strategies, distributions and other issues. Family harmony might increase if each beneficiary has a separate IRA.

You can split the IRA during your lifetime and name a sole primary beneficiary of each new IRA. Be sure to name one or more contingent beneficiaries in case the primary beneficiary doesn’t survive. If you don’t split the IRA during your lifetime, be sure the beneficiaries know they can do a tax-free split after they inherit. It is simple, easy and tax-free when done soon after they inherit.

Naming a trust as beneficiary is a perilous road.

Trusts are great features of many estate plans. Among other benefits, trusts ensure assets aren’t wasted through mismanagement, overspending and other common heir miscues. But a standard trust shouldn’t be a retirement account beneficiary, because the account then must be distributed and taxed within five years after the owner passes away. It is possible to name a trust as the beneficiary of an IRA or 401(k) account and continue the account’s tax deferral. But the trust must meet the requirements of IRS regulations, and most trusts don’t.

You have to work with an estate planner who knows how to create what’s generally known as a “see-through” or conduit trust. Also, the SECURE Act working its way through Congress would make things worse. We discussed the SECURE Act in detail in the July 2019 issue.

The bill would require all IRAs to be fully distributed within 10 years after the owner passes away. Because trusts reach the highest income tax bracket at much lower incomes than other taxpayers, the SECURE Act would cause more of an IRA to be drained away by income taxes than if individuals were named beneficiaries. You don’t want a trust to be an IRA beneficiary if the SECURE Act becomes law.

Rollovers are more complicated than most people realize.

The rollover is the most common IRA transaction, especially when a 401(k) of a former employer is rolled over to an IRA or a new 401(k). Nuances in the rollover rules often trap people and trigger unnecessary taxes and penalties on rollovers. The 60-day rollover in which the account holder receives the account value and personally deposits it into the same or another account within 60 days can be used only once every 12 months per taxpayer.

Every subsequent attempt to do a 60-day rollover after the first one during the 12 months becomes a fully taxable distribution. It is best to have all rollovers done directly from one account administrator or trustee to another. See our June 2018 and May 2015 issues for more details about rollover rules and options.

IRAs can be a tax-wise way to make charitable gifts.

Most people don’t consider their IRAs when planning charitable giving, and they leave a lot of money on the table.

When you’re age 70½ or older, consider making regular charitable gifts through qualified charitable distributions (QCDs) from your IRA instead of writing a check. The QCD is made when the IRA custodian transfers money or property directly from your account to the charity or gives you a check made payable to the charity which you deliver to the charity. The distribution isn’t included in your gross income, so it isn’t taxed. It also counts as part of your required minimum distribution (RMD). So, you effectively take a tax-free RMD. You receive no deduction for the charitable contribution. See our May 2016 issue for more details on QCDs.

If you plan to make charitable bequests through your estate, consider doing so by naming the charity as a beneficiary of an IRA or 401(k). When your children or other loved ones inherit a traditional IRA or 401(k), they have to pay income taxes on distributions from the account.

They really inherit only the after-tax amount. When they inherit other assets through your estate, the inheritance is tax free and they increase the tax basis of the assets to their current fair market value. They can sell the non-IRA and 401(k) assets tax free. When a charity receives a distribution from your IRA or 401(k), the charity pays no taxes because it is tax-exempt. When you plan to make charitable bequests, it usually is better to make them through an IRA or 401(k) account than from other assets in your estate.

The 10% early distribution penalty has many exceptions.

The general rule is if you take a distribution from an IRA or 401(k) before age 59½, you owe a penalty of 10% of the amount of the distribution in addition to the income taxes. But there are numerous exceptions to the 10% penalty, at least 13 of them. The most significant exception is for “substantially equal distributions.” It is best not to take money from your retirement account early.

But if you need the money, study the exceptions to the 10% penalty. You probably can structure the distribution to avoid the penalty. See our July 2009 issue for details.

Your loved ones need to avoid the traps for beneficiaries.

People who inherit IRAs and 401(k)s often inadvertently trigger income taxes. For example, an Inherited IRA can’t be rolled over to another IRA except under very limited circumstances. If a rollover is done the wrong way, the entire amount is treated as a distribution, and it can’t be reversed. Also, the legal title of an inherited IRA must be changed to a certain format. If a different format is used, the entire IRA is treated as distributed and subject to income taxes. Your heirs must be aware of these and other pitfalls, or on an after-tax basis their inheritance will be much less than you intended. See our May 2019 issue for more details.

RMDs can be optimized.

The RMD rules seem straightforward at first, but they have both traps and opportunities. Many people with multiple accounts aren’t clear on the rules for aggregating RMDs. Aggregation is when you have multiple accounts of a certain type of retirement plan, add the year’s RMDs for each account of that type and then take the RMD from the different accounts of that type in any ratio you prefer. You can aggregate RMDs for traditional IRAs that aren’t inherited IRAs.

But you can’t aggregate RMDs for employer accounts, such as 401(k)s and most other types of retirement accounts. For those accounts, the RMD must be taken from each account. RMDs can be taken in cash or property. You don’t have to sell an investment you like to create cash for an RMD. You can distribute the investment in-kind. The value of the property on the date of the distribution will be the amount of the RMD. You can find more details about RMDs in our February 2019 issue.

Life insurance can protect your IRA value.

Many people plan to leave all or a substantial portion of their IRAs to their heirs. But they worry that market declines could make those IRAs worth substantially less when they’re inherited. You can guarantee your heirs inherit the current value of your IRA by using permanent life insurance. I explained several strategies for doing this in the past, including in the July 2019 issue.