1. Not taking advantage of the stretch distribution option or not establishing it properly.
The “stretch IRA” is a way for each IRA beneficiary to maximize payouts over his or her entire life expectancy. Properly designating beneficiaries and informing them of the IRA owner’s “stretch” intentions are key to making this strategy work.
2. Not naming or updating IRA beneficiaries.
Not listing primary and contingent beneficiaries may result in the distribution of the IRA assets to the IRA owner’s estate, resulting in accelerated distribution and taxation. Not keeping beneficiary designations current and coordinating them with other estate planning documents can also lead to conflicts and unintended results.
3. Making inappropriate spousal rollovers.
Most IRAs list the owner’s spouse as the primary beneficiary. One of the most popular strategies for a spousal beneficiary is simply to roll the inherited IRA into his or her own IRA. But in some cases it can be more tax efficient for a surviving spouse to keep the IRA as an inherited beneficiary IRA or disclaim the assets, thereby allowing them to pass to the contingent beneficiary.
4. Not taking advantage of “IRD” if you are a beneficiary.
Upon the death of the IRA owner, his or her IRA is included in the estate, creating an estate tax liability (if applicable) as well as an income tax liability for beneficiaries. Many IRA beneficiaries do not realize that IRAs are considered “Income in Respect of a Decedent” (IRD), according to Section 691(c) of the IRS Code. The IRD designation allows beneficiaries to take a federal income tax deduction for any estate taxes paid on the IRA’s assets, thus limiting double taxation of the IRA assets.
5. Rolling low-cost-basis company stock into an IRA.
Distributions from a qualified plan such as a 401(k) are generally taxed as ordinary income; federal income tax rates range from 10% to 35% (as of 2009). If company stock is rolled into an IRA, future distributions are taxed as ordinary income. If, instead, the company stock is taken as a lump-sum distribution from the qualified plan, only the cost basis of the stock is taxed as ordinary income. This is called Net Unrealized Appreciation. (Note: The distribution must be taken as stock, not cash.) Unrealized capital appreciation (the difference between the cost basis and current fair market value) is not taxed until the stock is sold, upon which it would be taxed as long-term capital gains, which are taxed at a lower rate than ordinary income (at 2009 tax rates). Be sure to talk with your tax advisor.
6. Not taking advantage of a Roth IRA.
A Roth IRA is a potentially valuable retirement resource. Not only are qualified withdrawals tax free, but Roth IRA distributions do not impact the taxability of Social Security, and Roth accounts pass to beneficiaries tax free as long as the account passes the five year rule for qualified distributions. There are income limits that affect eligibility for a Roth IRA, so be sure to talk this option over with your financial advisor.
7. Not taking advantage of increased contribution limits.
The contribution limits for 2009 are $5,000. IRA owners age 50 or older can make an additional $1,000 “catch-up” contribution in 2009. Roth IRA limits and traditional IRA limits are the same.
8. Assuming that a nonworking spouse cannot contribute.
The truth is that separate “spousal” IRAs may be established for spouses with little or no income up to the same limits as the working spouse.
9. Missing important dates.
Estate taxes, if applicable, are due nine months after the IRA owner’s death. The same deadline applies to beneficiaries who wish to disclaim IRA assets. By September 30 of the year following the year of the owner’s death, the beneficiary whose life expectancy will control the payout period must be identified. Generally, IRA beneficiaries who want to receive distributions over a life expectancy must begin taking required distributions by December 31 of that same year.
10. Taking the wrong required minimum distribution (RMD).
IRA owners in their seventies are required to take the RMD out of their accounts each year, based on the value of all their non-Roth IRAs. Those who do not take enough out each year may be subject to a federal income tax penalty of 50% of the amount that should have been taken as an RMD but was not. Consolidating retirement assets may make it easier to manage these distributions. Current law allows a one-time suspension of the requirement to take an RMD for 2009. RMDs must resume in 2010.
11. Placing the title of an IRA in trust.
Making a trust the actual owner of an IRA causes immediate taxation — including the 10% penalty tax if the IRA holder is under age 591⁄2.
12. Paying unnecessary penalties on early (pre-age 591⁄2) IRA distributions.
As long as withdrawals are made in accordance with the requirements of IRS Code Section 72(t), there is no need to pay penalties on distributions from IRAs before the owner is age 591⁄2. Section 72(t) allows for three calculation methods to determine substantially equal periodic payments based on the owner’s life expectancy. Payments must continue for 5 years or until age 591⁄2, whichever is the longer period of time.
Other things to Remember
IRA’s Are Not Investments
That means that the IRA serves as a retirement “account” not a retirement investment. Many people have the belief that IRA’s are like a CD and they pay an interest rate. This is most likely true if you invest in an IRA at your local bank. In this case, you are purchasing a CD within the IRA because CD’s are the only investment option that is available (some banks now do have in house brokerage firms that allow you to put money into other investments).
IRA’s Are The “Investment Vehicle”
I have always explained the IRA as your own personal investment vehicle. You then choose what passengers go inside your vehicle. The mental image of the clowns at the circus piling into the little car always comes to mind. You can have as many clowns in your IRA as you want to as little as you want. You could have all your money invested into Walmart stock or spread out across 100 different stocks (You would have to have a substantial amount of money in the IRA to do this). If you open an Traditional or Roth IRA at a brokerage firm, you may invest into just CD’s, but you also open the door to many other investment choices i.e. stocks, bonds, mutual funds, EFT’s, annuities. Then what your IRA pays is determined on the actual return of the investment.
*Restrictions, penalties and taxes may apply. Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.