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Retirement Perspectives

Don't let the complexity of these powerful retirement-savings tools trip you up.

Experience has shown us that taxpayers can miss opportunities, fail to take advantage of their options, or inadvertently get into trouble when it comes to their individual retirement accounts (IRAs). While each individual's situation is different, many of the missteps are the same. Here's a look at common mistakes and potential solutions to help investors get the most from their savings, while avoiding potential pitfalls.

1. Eligibility Mishaps
According to the Investment Company Institute (ICI), approximately 88% of all eligible taxpayers failed to contribute to an IRA in 2013. While savings habits may be the most familiar explanation, another apparent reason is that people are uncertain about IRA eligibility.

Individuals frequently confuse the eligibility to make contributions to an IRA and the eligibility to be able to deduct those contributions from their income taxes. They are two different things. Individuals whose incomes render them ineligible to deduct their contributions may still contribute to an IRA.

There are only two requirements to be eligible to contribute to a traditional IRA: having an earned income and being younger than 70½. The age limitation, though, does not apply to Roth IRA eligibility, but individuals cannot earn more than certain thresholds set by the IRS.

It is important to note that individuals can lower their adjusted income by contributing, on a pretax basis, to a 401(k), 403(b), SIMPLE IRA, 457 governmental plan, or other workplace retirement plan. That could factor into whether or not they qualify for a deductible IRA or a Roth IRA.

IRA eligibility requirements differ. All investors with earned income and who are younger than 70½ are eligible to fund a nondeductible (aftertax) IRA, regardless of the amount of their household income. But Roth IRAs and those IRAs funded with deductible (pretax) contributions  impose income limits. 

A number of variables apply in order to determine whether a taxpayer is eligible to make a deductible IRA, including filing status, modified adjust gross income (MAGI), and whether individuals and/or their spouses are active participants in a workplace retirement plan.

2. Tracking Basis on Aftertax (nondeductible) Contributions to an IRA
If an individual is not aware of how much aftertax money he or she has contributed to a traditional IRA, the accountholder could face an unwelcomed surprise: distributions may be fully taxable. In general, given the myriad potential scenarios, financial institutions do not track nondeductible IRA contributions, so the burden shifts to the investor/taxpayer.

Individuals simply need to file IRS Form 8606, “Nondeductible IRAs,” with their tax returns to report nondeductible contributions. They also should file Form 8606 to reconcile their later distributions and receive the proper income credit on the way out. Form 8606 calculates the remaining basis (i.e., amount not taxed). Knowing the basis is extremely helpful in minimizing taxes payable if individuals choose to avail themselves of the Roth conversion opportunity at some point. It’s also important to know the basis to avoid double taxation when the account owner dies and the beneficiaries start taking distributions.

3. Required Minimum Distributions
Many taxpayers are unaware that all IRAs (traditional, SEP, SAR-SEP, and SIMPLE) must be totaled to determine how much needs to be withdrawn annually starting at age 70½, when taxpayers must begin taking required minimum distributions (RMDs).

There is an excise tax penalty equal to 50% of the RMD shortfall if the full amount is not withdrawn in a timely manner. Roth IRAs (while the account owner, or spousal beneficiary, is alive) are exempt.

4. Combining IRAs 
Prior to 2001, it was important to separate rollover and contributory IRAs in the event that an individual wanted to roll an IRA into a new employer's retirement plan. Rollover rules have since been loosened, allowing for full portability of all traditional (non-Roth) IRA accounts as long as no aftertax (nondeductible) dollars are transferred to an employer plan.

By combining IRA accounts, a taxpayer can save account and tax beneficiary fees, more easily monitor accounts, and rebalance portfolios.

5. Inheriting Options
Spouses who inherit an IRA when they are younger than 59½ will incur a 10% early withdrawal penalty if they convert the inherited account to their own IRA. Alternatively, they could leave the IRA in the decedent's name, which allows the surviving spouse to make penalty-free withdrawals as needed. Once the surviving spouse reaches age 59½, the account can be transferred to him or her.

The advantage in making the IRA one's own occurs when an inheriting spouse decides to transfer that IRA, minus any aftertax (non-deductible) contributions, to his or her own qualified plan account. Less well known is the ability to postpone any RMDs until the deceased spouse would have reached age 70½. This is important in situations in which the inheriting spouse is older than the deceased spouse.

Failure to name a beneficiary results in the beneficiary determination defaulting to the terms of the IRA custodial agreement. The custodial agreement can name the estate or distribute according to some stipulated succession order, such as spouse, children, grandchildren, or siblings, which may not be the owner's intent.

6. Naming Your Estate as Beneficiary
If the accountholder's estate is designated as the IRA’s beneficiary, the heirs will receive the proceeds, but potentially not in the most tax-efficient manner. (If the account owner dies before his or her required beginning date (RBD)—April 1 following attainment of age 70½—the entire account must be distributed before December 31 of the fifth year after his or her death. Strange, but true: If the account owner dies after his or her RBD, the estate can make distributions based on the deceased’s remaining life expectancy, based on IRS actuarial tables

7. Naming a Nonperson (Charity) as a Co-beneficiary
When a charity is an IRA's co-beneficiary along with a family member, the ability to stretch the payout over the human beneficiaries’ lifetimes maybe lost.

The custodian has until September 30 (designation date) of the year following death to cash out the charity's interest, which will allow the remainder of the account to be distributed over the life expectancy of the human beneficiary(ies). Failure to meet the designation date will result in the assets being fully disbursed to all beneficiaries by December 31 of the fifth year after the death. The human beneficiaries will have no option to stretch their distributions. The custodian does not, however, have discretionary authority to effectuate this redemption.

This potential tax inefficiency can easily be avoided by splitting the IRAs before death and designating a charity as sole beneficiary in a separate IRA.

8. Failing to Name a Contingent Beneficiary
If a primary beneficiary predeceases the accountholder and the accountholder does not replace that beneficiary before his/her own death, the IRA custodial agreement may name the estate or require the distribution of the proceeds according to some succession order, such as spouse, children, grandchildren, or siblings, which may not be the owner's intent.

If the account holder and his/her spouse, who is also the designated beneficiary, die at the same time, the terms of the IRA custodial agreement could, in turn, name the estate or distribute the proceeds according to a familial succession order, which, again, may not be the owner's intent.

9. Naming a Trust as Beneficiary
Although naming a trust as an IRA beneficiary can be tricky, it gives the account owner control over post-death beneficiary payouts.

One type of frequently used trust is called a "see-through" trust. It creates a mechanism for the deceased to control account withdrawals, post-death. In addition, a see-through trust allows the underlying beneficiary to “stretch” distributions over their life expectancy.

When an IRA beneficiary designation is made, including whether or not a trust should be incorporated into that designation, the individual making the designation should review this serious matter with their tax or legal advisors before proceeding.

10. Violating the New 60-day IRA Withdrawal Rule
Since the beginning of 2015, IRA account holders are limited to one, tax-free, 60-day rollover between IRAs in any one year period (365 days, not calendar year) regardless of the number of IRAs owned. Violating this rule could result in taxes and/or penalties assessed on withdrawals now viewed as distributions.

In summary, it’s clear that an IRA is not a simple product, but it is a powerful one, and can be a very important part of someone's retirement savings. The erosion of an IRA's value owing to an individual's lack of knowledge is an unfortunate circumstance we hope all taxpayers can avoid.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information in this presentation is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A stretch IRA is for investors who will not need their IRA money during their own retirement. While the law does not restrict which taxpayers can select the stretch IRA option, the stretch strategy is appropriate only for those individuals who simply need and plan to receive the required minimum withdrawals, taken at the latest time the law allows, without penalty, at age 70½.

A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (reduction) contributions on a pretax or aftertax basis. Earnings accrue on a tax-deferred basis.

A 403(b) is a retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement income accounts can invest in either annuities or mutual funds. Also known as a tax-sheltered annuity (TA) plan.

A SIMPLE IRA plan is an IRA-based plan that gives small business employers a simplified method to make contributions toward their employees' retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or non-elective contributions. All contributions are made directly to an Individual Retirement Account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A 457(b) is a nonqualified, deferred-compensation plan established by state and local governments, tax-exempt governments, and tax-exempt employers. Eligible employees are allowed to make salary deferral contributions to the 457 plan. Earnings grow on a tax-deferred basis and contributions are not taxed until the assets are distributed from the plan.

A Simplified Employee Pension Plan, commonly known as a SEP-IRA, is a retirement plan specifically designed for self-employed people and small business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee's SEP-IRA.

Minimum distributions must be taken from traditional IRAs by April 1 following the year that a person turns 70½. A minimum distribution must be taken from the IRA in each subsequent year. Mandatory distributions that represent deductible contributions and all earnings are taxed as ordinary income. Mandatory distributions based on nondeductible contributions are tax-free.

Combining a rollover and a contributory IRA may result in the loss of income averaging and capital gains treatment with respect to the rollover assets, if applicable. It may also affect the calculation you may need to perform to exempt your rollover IRA from any claims in the event of bankruptcy . You should consult your tax advisor before combining accounts.

Withdrawals by the account holder or beneficiaries in excess of the required minimum distribution (RMD) will exhaust the account at a faster pace, reducing or eliminating the effectiveness of the stretch strategy. Distributions greater than the RMD could subject the payment to higher federal and, possibly, state income taxes. When investing assets that will be used to stretch IRA payments, the investor must be cognizant of any front-end or back-end sales charges that could reduce the assets available. During an extended period of declining investment returns, investors will experience income fluctuations that may cause additional withdrawals to be made that will exhaust the account at a more rapid rate.

Consolidating assets with an IRA rollover may have administrative fees as well as other costs.

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