Every day, retirement account owners and beneficiaries trigger unnecessary taxes and penalties through mistakes, oversights and missed opportunities. IRAs, 401(k)s and other retirement accounts are among the most valuable assets most people own and also are among the most complicated and misunderstood.
The mistakes and oversights can occur at every stage of IRA ownership, and it doesn’t take much of an oversight to deplete your retirement nest egg through avoidable taxes, penalties and interest.
Beneficiary form disasters.
I put this first, because I continue to see court cases, IRS rulings and other evidence that the mistake occurs frequently. The beneficiary designation form almost always controls who inherits an IRA or other retirement account. Your will or living trust rarely controls what happens with your retirement accounts. There are many instances of retirement accounts being inherited by ex-spouses, the estates of deceased people and other unintended beneficiaries.
This happens because someone made the beneficiary designation years ago and never updated it. Review and reconsider IRA and other retirement account beneficiary designations after each major life change in your family and every time your estate plan is reviewed. Rollover blunders. Rollovers are among the most common IRA trans- actions (there are dozens of types of retirement plan rollovers in the tax code), yet also are prone to costly mistakes.
Many people still don’t realize the IRS changed the rules a few years ago so that for IRAs only one “60-day roll- over” is allowed every 12 months for each taxpayer. Attempt more than one 60-day rollover and all but the first will be taxable distributions. The 60-day rollover is when the IRA custodian distributes a check or assets directly to you. If you deposit the same amount in that IRA, another IRA or another qualified account within 60 days, 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. An individual can do this only once every 12 months, but many people still attempt multiple rollovers within 12 months.
As a result, they incur income taxes, plus the 10% early distribution penalty when they are under age 59½. Another mistake is not realizing that when the 60-day rollover is attempted, the IRA custodian is required to withhold 20% of the distribution for income taxes.
Yet, for the rollover to be tax free, you must roll over the gross distribution before subtracting the tax withholding. You must come up with that 20% from another source and include it in the rollover. Otherwise, you include in gross income the amount you failed to roll over within 60 days.
The best advice for a taxpayer planning any type of rollover is to have the assets transferred from one plan administrator or custodian to another. Don’t take possession of the money or assets yourself. Even in such a custodian-to-custodian rollover, one of the custodians might make a mistake, such as depositing the money in a regular account instead of an IRA.
You need to monitor the paperwork carefully and have any errors promptly corrected. Inherited IRAs by non-spouses. Beneficiaries who inherit IRAs and other qualified plans often lose a lot of money learning the rules the hard way. There are different rules for a beneficiary who is the surviving spouse of the deceased owner and non-spouse beneficiaries.
A non-spouse beneficiary shouldn’t roll over the IRA to his or her own IRA or have the IRA changed to his or her name. Either of those actions is treated as a full distribution of the IRA. 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 re-titled 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 an inherited IRA. It also can’t be rolled over to another IRA or converted to a Roth IRA if it is a traditional IRA. Most non-spouse beneficiaries must distribute the entire IRA within 10 years after inheriting it. This applies to both traditional and Roth IRAs. See our January 2021 and March 2020 is- sues for details about the 10-year rule.
Beneficiaries who aren’t subject to the 10-year rule must begin annual RMDs beginning by December of the year after the year in which the owner died. They need to learn their options, choose an RMD method and begin distributions on time. Surviving spouse beneficiary. The 10-year distribution rule doesn’t apply when a surviving spouse inherits an IRA. Instead, the surviving spouse has several options.
One option is to treat the IRA as a non-spouse inherited IRA and elect to take annual RMDs using one of two methods. The methods depend on whether the deceased owner was taking RMDs before his or her death. The other option is to do 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 age 72 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% penalty for distributions taken before 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 can apply to distributions taken before age 59½. After the surviving spouse turns age 59½, the spousal rollover can be executed.
There’s no time limit to when the spousal rollover can be made. Non-traditional investments. Some assets can’t be owned by IRAs. Others can be owned only in some circum- stances. In addition, there are prohibited transactions regarding retirement accounts you must be aware of. 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 this topic in the past. See our July and August 2016 issues.
Charitable giving opportunities. Charitably inclined people often leave a lot of money on the table by not making their gifts through IRAs.
There are benefits for gifts made both during life and through your estate. The qualified charitable distribution (QCD) for IRA owners at least age 70½ has been permanent since 2015. Eligible IRA owners can direct their custodians to distribute money to the charity or charities of their choice. The donations up to $100,000 annually aren’t included in gross income, and the IRA owner doesn’t receive a deduction.
The QCD counts toward any RMD for the year. For those who are 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.
When 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. 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. RMD errors.
A few years ago, the IRS decided to examine RMDs more closely, because people make a lot of errors with them. 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. Review the May 2021 issue to avoid making common mistakes or overlook- ing opportunities. 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 have a large IRA, plan for RMDs early.
Though RMDs aren’t required until age 72, 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. Review our March and April 2020 issues and May 2021 issue.
You also can read the report from David Phillips, “The Bombshell Battle Plan: How to Defend Against the IRS’ Secret Weapon.” It is available free to Retirement Watch readers by logging into the members’ section of the website. In the dropdown menu on the top left of the page, click on “Special Reports.” The link to the report is on the second page of that part of the website.
Avoiding the 10-year rule.
The Setting Every Community Up for Re- tirement Enhancement (SECURE) Act enacted at the end of 2019 ended the Stretch IRA. Now, most non-spouses who inherit an IRA must distribute the entire IRA within 10 years. Even Roth IRAs must be depleted within 10 years. This means the tax-deferred com- pounding of the IRA can’t be extended for decades. The beneficiaries must pay income taxes on distributions from traditional IRAs within 10 years.
That often results in higher lifetime income taxes than when the distributions could have been stretched out over a longer period. Fortunately, many of the strategies for reducing taxes on lifetime RMDs also are ideal strategies for planning around the 10-year rule and the end of the Stretch IRA.
You can empty the IRA early, convert a traditional IRA to a Roth IRA, or re- position the IRA as a charitable remainder trust or a permanent life insurance policy. Read the sources referred to in the section above this one and review this month’s Estate Watch article on including life insurance in estate plans.