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Retirement Perspectives

Here are approaches to avoiding 13 potential pitfalls of these powerful, but complex, retirement savings vehicles.

Experience has shown us that investors typically overlook savings opportunities, fail to take advantage of available options, or make key mistakes when it comes to their individual retirement accounts (IRAs).

While each individual's situation is different, many of the missteps are similar. But taking a few minutes to acquaint yourself with the more common blunders can help keep your nest egg on the right side of various Internal Revenue Service (IRS) rules. As always, obtaining expert advice from accounting or tax professionals is a good idea when addressing these matters.  

Here's a look at 13 common traps, along with potential solutions, that may help retirement savers get the most from their savings, while avoiding significant financial pitfalls.

1. Eligibility Mishaps
Only 11% of U.S. households contributed to traditional or Roth IRAs in tax year 2017, according to the Investment Company Institute (ICI). While savings habits may be the most familiar reason for such low funding, another all-too-common reason is that individuals mistakenly think they are ineligible to contribute to a traditional or Roth IRA. Instead, almost everyone is eligible to fund a traditional IRA so long as they have reportable compensation and have not attained age 70½ (however, the contribution may not be deductible). Notably, the age limitation does not apply to Roth IRA eligibility, but an individual’s household income must satisfy an annual income threshold set by the IRS.

A number of variables apply in order to determine whether a taxpayer is eligible to make a deductible  traditional IRA contribution, including tax filing status, modified adjusted gross income (MAGI),1 and whether individuals and/or their spouses are active participants in a workplace retirement plan.

2. Tracking/Reporting IRA Basis
If an individual is not aware of how much aftertax money he or she has accumulated in his or her IRA, the accountholder could face an unwelcome surprise: distributions may be fully taxable. In general, given the myriad potential scenarios, IRA custodians do not track IRA basis—the funds in an IRA that already have been taxed, either as nondeductible IRA contributions or after-tax funds rolled over from plans. Therefore, the burden shifts to the investor/taxpayer.

Individuals in such situations should file IRS Form 8606, “Nondeductible IRAs,” along with their tax returns to report nondeductible contributions. They should also 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).

3. Required Minimum Distributions (IRAs)
Many investors are unaware that, beginning in the year they reach age 70½, all their IRAs (traditional, SEP, SAR-SEP, and SIMPLE) must be aggregated to determine how much needs to be withdrawn to satisfy their Required Minimum Distribution (RMD)2 annually.

There is an excise tax penalty equal to 50% of the RMD shortfall if the full amount is not withdrawn in a timely manner. Notably, Roth IRAs are exempt from lifetime RMDs

4. Required Minimum Distributions (401(k))
RMD rules differ for qualified plans, such as 401(k)s. Unlike IRAs (traditional IRA, SEP, or SIMPLE), certain 401(k) plan participants potentially can defer RMDs to the later of either the end of the calendar year in which they reach age 70½ or to the year in which they retire.

While the required beginning date (RBD) for RMDs is generally April 1 of the year following the year the account owner/plan participant reaches age 70½, there is an exception that may apply if an individual continues to work (i.e., “still working”) for the employer sponsoring the 401(k) plan. This exception is available only if it’s allowed by the plan and the individual does not own more than 5% of the company. In other words, a plan is not required to include the “still working” exception as part of the plan. Be sure to review the plan document or Summary Plan Description (SPD)3 to determine if this provision applies.

5. Roth Inheriting Options
As mentioned earlier, owners of Roth IRAs are not subject to RMDs—ever. However, their heirs—other than a surviving spouse—must take RMDs from an inherited Roth IRA. Notably, post-death RMDs from non-spouse inherited Roth accounts are calculated in the same manner as post-death RMDs for inherited traditional IRAs. There is one enormous difference: distributions from inherited Roth’s are generally (but not always) tax-free.

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 on or after his or her RBD, the estate can make distributions based on the deceased’s remaining life expectancy.

7. Naming a Nonperson (Charity) as a Co-Beneficiary
When a charity is named a co-beneficiary along with a person, the ability to stretch post-death payout over the human beneficiary’s lifetime may be lost.

The charity has until September 30 of the year following death to cash out the their interest, which will allow the account to be distributed over the life expectancy of the human beneficiary or beneficiaries. Failure to satisfy this requirement will result in the assets being fully disbursed to all beneficiaries by December 31 of the fifth year after the death. In other words, the human beneficiaries will have lost the ability to stretch distributions.

8. Failing to Name a Contingent Beneficiary
If a primary beneficiary predeceases the accountholder and the accountholder does not name a new beneficiary prior to his/her passing, the IRA custodial agreement dictates who inherits the accounts. For example, the agreement may state 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.

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. In this instance, it is critical that the trust qualifies as a "see-through" trust, thus allowing the trust beneficiaries to “stretch” post distributions.

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

11. Violating 60-day IRA Rollover Rule (Part II)
Only a spousal beneficiary can utilize a 60-day rollover, whereas 60-day rollovers do not apply to (all) non-spouse beneficiaries. A non-spouse that takes cash distribution is subject to immediate taxation with no recourse to “pay back” the distribution. Instead, the only way to move inherited assets (for a non-spouse) is via a direct trustee-transfer

12.  Thinking you can Recharacterize a Roth conversion
In 2018, as part of the Tax Cut and Jobs Act, recharacterization of Roth IRA conversions from traditional IRAs and qualified plans (e.g., 401(k)) was repealed. As a result, all Roth conversions taking place on or after January 1, 2018, are irrevocable. Notably, recharacterizing Roth contributions is still permitted. For instance, a traditional IRA contribution can be recharacterized to a Roth IRA contribution and vice-versa.

13. Qualified Charitable Distributions (QCDs)
The use of qualified charitable distributions (QCDs) continues to increase. A QCD is a provision that allows eligible individuals to transfer funds from their IRA to a qualifying charity while satisfying their annual required minimum distribution. However, there are a number of rules with which you must be familiar with  regard to qualifying for and reporting (on your tax return) QCDs. (See our article on QCDs for details.)

A Final Thought
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. Armed with the proper knowledge, and guidance from a retirement specialist and  qualified tax professionals, we believe investors can safely steer clear of these potential potholes on the road to retirement.

 

1Modified adjusted gross income (MAGI) is determined by taking adjusted gross income and adding back certain items such as foreign income, foreign-housing deductions, student-loan deductions, IRA-contribution deductions, and deductions for higher-education costs.

2The IRS requires that individuals withdraw a certain minimum amount of money from tax-advantaged accounts as required minimum distributions (RMDs). Under most circumstances, the IRS sets the required beginning date on which account holders must begin to take distributions at April 1 following the calendar year in which the account holder turns 70.5.

3A summary plan description (SPD) is a document that employers must give free to employees who participate in Employee Retirement Income Security Act-covered retirement plans or health benefit plans. 

 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 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. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

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 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 nonelective 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 simplified employee pension plan (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.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

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