1. Beneficiary Mistakes
Having a proper beneficiary named, is very important. The assets will avoid probate and go straight to the intended beneficiary.
a) Blank designations forms.
b) No contingent beneficiary. If all beneficiaries disclaim or predecease the owner, the assets are distrusted as the IRA document or as state law provides.
c) Outdated personal information is very common. I have seen people have ex-spouse named as their beneficiary. Yikes! Most common, they have their parents as beneficiary, but are recently married and should have their spouse named. Remember to add your children as well.
d) Times to review beneficiaries:
- Annually – This is a standard part of our process at Riverbend Wealth Management
- Marriage – Add your spouse.
- Birth – Add your child as contingent beneficiary.
- Death – Update your primary or contingent beneficiary.
- Divorce – Remove your ex-spouse.
- Retirement – Consolidating IRA and 401k accounts are a good time to review beneficiaries.
2. Not Planning on Taxes on an Inherited IRA
An inherited IRA can potentially have large income tax liability. This makes planning for taxes very important.
a) 10-year rule – Most beneficiaries will have to liquidate IRA within 10 years. Keep in mind they have to be a “designated beneficiary” which means, they need to be on the IRA form. Naming an estate does NOT count as a designated beneficiary. A trust may or may not count as designated beneficiary. It depends on how it was written.
- Designated beneficiary does not need to take out money from inherited IRA each year. They have to take all of the money out by the end of the year of the 10th anniversary of death. However, if you have a large IRA and wait to take all the money out in the 10th year, it could be a tremendous tax consequence. This is why it is important to deal with an advisor that not only does tax planning, but also, multigenerational planning as well. We sit down with each beneficiary to design a distribution plan for their portion of the inherited IRAs. Each plan is personalized, based on their needs, income, taxes, and goals.
b) Spousal options – They can roll the IRA into their own name or leave as inherited IRA. Which is best depends on a number of factors, discussed later.
c) 5-year rule – If you name an estate or another beneficiary that is not a designated beneficiary, that beneficiary will have 5 years to liquidate the IRA. The shorter the time frame, the less an opportunity to spread taxes over multiple years. This is why it is important that things are setup properly on the front end and updated regularly.
3. Spousal Rollovers
The surviving spouse has the option to “roll over” the IRA to their own IRA. Many times this is the best option, but not always. Here are some exceptions:
a) Surviving spouse is over 72 years old and deceased was not- If they did the rollover, the IRA would be subject to Required Minimum Distributions. Better option would be to have as inherited IRA and they would not be subject to RMDs until the deceased would have turned 72.
b) Surviving spouse is under 59 ½ years old and may need to take income- If they rolled IRA over into their own IRA and took distributions, there may be a 10% penalty. That penalty could be avoided if they took money from an inherited IRA.
c) Surviving spouse wants to disclaim IRA- Will not be able to disclaim assets once moved into their own IRA. Why would someone want to disclaim an IRA? They don’t need the money and they want the asset to pass to the other designated beneficiary. So, make sure you have everything setup properly to have as many options available to your heirs!
These options are complex. You want to make sure you deal with someone qualified. Feel free to setup a time to talk with us to see what options are best for you. Click here to setup a call.
4. Not Using a Direct Transfer
There are two ways to move funds between IRAs:
a) Indirect rollover – You withdraw funds from one IRA and deposit the same amount into another IRA. This must be completed within 60 days and can only be done once a year. Also, a non-spouse beneficiary cannot do an indirect rollover. A failure to follow these rules could result in a taxable distribution.
b) Direct transfer – A financial institution issues payment directly to another financial institution; this is not subject to the 60-day/once-a-year rules of indirect rollovers.
5. Net Unrealized Appreciation
If you roll your low-cost basis company stock into an IRA, that could eliminate your ability to use a special tax treatment called Net Unrealized Appreciation. Here is how it works.
Distributions from a qualified plan, such as a 401(k), are generally taxed as ordinary income. If a portion of your 401(k) is invested in company stock and it is rolled into an IRA, future distributions will be taxed as ordinary income. However, the IRS allows distributions of company stock to be taxed at the capital gains tax rate instead. Here’s how it works.
If the company stock is taken as a lump-sum distribution and deposited into a regular (non-IRA) brokerage account only, the cost basis of the stock is taxed as income at income tax rates. (Note: The lump-sum distribution must be taken as stock, not cash, and long-term capital gains are typically taxed at a lower rate than ordinary income.) The unrealized capital appreciation (the difference between the cost basis and current fair market value) is not taxed until the stock is sold, and it will be taxed as long-term capital gains. Cost basis is the amount the qualified plan pays to purchase the employer securities over the period of years that the retiree is a participant in the plan.
There are very specific rules you need to follow to take advantage of NUA. Feel free to talk your tax advisor or contact us at Riverbend.
6. Not Taking Advantage of a ROTH IRA
A ROTH is like a traditional IRA but in reverse. You pay taxes on the money you contribute to ROTH, but the withdrawals come out federally income tax free. Think of it like this, you pay taxes on the seed and not the harvest. This is a big deal in retirement, in that, the distributions do not impact the taxability of Social Security. In addition, if you inherit a ROTH IRA, the distributions are also federally tax free, which could be very good for your beneficiaries. Another advantage is that ROTH IRA do not have a RMD requirement at age 72. There are some income limits on ROTH contributions, but there are other ways to take advantage using other rules. Feel free to give us a call to discuss at 843-970-1043 or email at Jeremy@RiverbendWM.com.
7. Not Maximizing Contributions
The amount you can put in your retirement plans change based on the type of plan, your age, and your income. Be sure that you update your contribution location and amounts at least annually to take advantage to what is available to you.
8. Not Taking Advantage of Spousal Contributions
A non-working spouse can make an IRA contribution up to the same limits as their working spouse. However, taxes must be married filing jointly and working spouse income needs to be high enough to cover both spouses.
9. Taking the Wrong Required Minimum Distributions
The SECURE act changed the age of RMDs to 72 for IRA owners (the later of age 72 or actual retirement for participants of employer-sponsored retirement plans). Under the CARES Act, Required Minimum Distributions (RMDs) were waived for 2020.
There’s good reason to be careful when calculating RMDs. If you take out too little, a 50% penalty could be owed to the IRS on the amount that should have been distributed.
Here is another reason to be careful: IRA trustees are required to do more thorough reporting to the IRS, including reporting RMDs due and year-end IRA balances through Form 5498, making it easier for the IRS to spot individuals who are taking out too little.
No one wants to pay a 50% penalty on anything, especially on hard-earned retirement assets.
Here are three tips to avoid the 50% penalty.
a) The amount of your RMD each year is based on the balances of all your non-Roth IRAs. Although all your non-Roth IRAs are considered in calculating your total RMD, you may withdraw the RMD from whichever non-Roth IRA(s) you choose. Multiple IRAs at multiple firms may make it harder to remember and calculate RMDs. Consider consolidating IRAs to minimize this risk.
b) Some investors take regular distributions prior to age 72, then at 72 assume they are taking enough. They don’t realize they may need to take more to meet RMD requirements. For example, an investor who was previously taking $600 per month turns 72 and is subject to an RMD that equals $700 per month. Neglecting that additional $100 per month could result in a 50% penalty on a $1,200 shortfall for the year, or a $600 penalty.
c) RMD requirements from a 401(k) or other employer-sponsored retirement plan cannot be satisfied with a distribution from your IRA or vice versa. If you still have assets in a former employer’s plan, be careful and talk to your tax advisor.
Some firms may offer an automated service which provides automated calculation and distribution of your RMD each year. At Riverbend as part of our annual reviews with our clients, we go over these options.
10. Not Considering Qualified Charitable Distributions
Once you reach age 70 ½, you can make donations to a qualified charity directly form you IRA. If done correctly, the distributions is not taxable income. This may result in lower tax liability than withdrawing the money, paying taxes, and then making the donation. Keep in mind there may be a limit on how much you can do per year.
11. Paying Unnecessary Penalties
Paying an extra 10% in taxes isn’t very fun. IRS code Section 72(t) allows for individuals who are not yet 59½ years old to take a “series of substantially equal periodic payments” from an IRA without incurring penalties (income taxes, however, would still be due).
Under Section 72(t), withdrawals must be made from an IRA for five years or until the owner turns age 59½, whichever is later. Distributions are calculated using one of three methods:
- Life expectancy (which generally results in the smallest distributions)
- Amortization (which generally results in the largest distributions)
As long as withdrawals are made in accordance with the requirements of Section 72(t), there are no penalties on distributions from IRAs before the owner turns age 59½.
Be careful. A failure to follow the rules can cause a retroactive 10% penalty on all the distributions. So BE CAREFUL!
Contact us if you have any questions.
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Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor; DBA Riverbend Wealth Management.
This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.