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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 84% of all eligible taxpayers failed to contribute to an IRA in 2012. While poor saving habits may be the most familiar explanation, another reason is that taxpayers confuse deduction eligibility with IRA eligibility.
There are only two requirements to make you eligible to contribute to a traditional IRA: earned income and being under 70½ years of age.1 If a Roth IRA2 is desired, then the under-age-70½ requirement does not apply, but income must be less than or equal to IRS threshold amounts.
It is important to recognize that contributing to a 401(k),3403(b),4 SIMPLE IRA,5 or 457 governmental plan6 on a pretax basis can potentially make you and, if married, your spouse, eligible to have a deductible IRA or a Roth IRA, since participation can lower your income below IRS threshold amounts. Also remember that deductibility of IRA contributions is affected by whether you or you and your spouse are covered by a qualified retirement plan, but income has no effect if there is no plan participation. Other deductions, such as charity and mortgage interest, do not help toward Roth or traditional IRA eligibility.
2. Tracking basis when making aftertax 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 account holder could face an unwelcome surprise: distribution may also be fully taxable. In general, given myriad potential scenarios, financial institutions do not track deductible IRA contributions, so the burden shifts to the taxpayer. You simply file IRS Form 8606 with your tax return, reporting nondeductible contributions, and Form 8606 again to reconcile the distributions and receive the proper income credit on the way out. Form 8606 assists you by recording your remaining basis (i.e., amount not taxed). Knowing your basis is extremely helpful in minimizing any taxes payable if you choose to avail yourself of the Roth conversion opportunity.
The basis also is an important figure for your beneficiary to know because double taxation will occur when distributions after death are taken.
3. Required minimum distributions
Many taxpayers are unaware that all IRAs (traditional, SAR-SEP,7 and SIMPLE) must be totaled to determine how much needs to be taken at age 70½, when taxpayers must begin making required minimum distributions (RMDs).8 There is an excise tax penalty equal to 50% of the RMD shortfall if not withdrawn in a timely manner. Roth IRAs (while the account owner, or spouse if sole beneficiary, is alive) and Coverdell Education Savings Accounts9 are exempt.
4. Combining IRA rules and strategies have changed
Prior to 2001, it was important to separate rollover and contributory IRAs in the event that an individual wanted to roll an IRA account into a new employer's retirement plan. Tax law now allows full portability of all traditional (non-Roth) IRA accounts as long as no aftertax 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.10
5. Inheriting options
When a spouse inherits an IRA and he or she is under age 59½, making the account his or her own reattaches the 10% penalty for early withdrawals. In other words, this forces the inheriting spouse to wait until age 59½ to make penalty-free withdrawals. Instead consider leaving the IRA in the decedent's name, which allows the surviving spouse to make penalty-free withdrawals as needed. Once age 59½ is attained, the account can be made the surviving spouse's own.
The advantage in making the IRA one's own occurs when an inheriting spouse decides to transfer that IRA, minus any aftertax 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 more important in a case in which the inheriting spouse is older than the deceased spouse.)
The inheriting spouse can withdraw proceeds for up to 60 days, but must return the funds or be taxed on any dollars not returned on or before the time expires, minus any aftertax dollars.
It should be noted that nonspouse beneficiaries do not have this 60-day rollover privilege. Once a nonspouse beneficiary accesses the funds, the income is taxable, and the proceeds cannot be redeposited into an IRA.
6. Using your will to name your beneficiary
An IRA account holder must follow the custodian's procedures when naming a beneficiary. The executor of the estate cannot present a will at the time of death and demand payment of the assets unless beforehand the will has the named beneficiary designated on a form deemed acceptable to the IRA custodian. Sometimes the custodian’s forms are required, while many custodians will accept a written statement that clearly delineates the intention.
Not naming a beneficiary leaves the beneficiary determination to the terms of the custodial agreement, which can name the estate or distribute according to some succession order, such as spouse, children, grandchildren, or siblings, which may not be the owner's intent.
7. Naming the estate as the beneficiary
If the account holder's estate is the IRA’s beneficiary, the heirs will receive the proceeds, but potentially not in the most tax-efficient manner. (Whether the estate is the beneficiary or not, the IRA proceeds are included in the estate for determining estate taxes, if any.) 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.
What happens if the account owner dies after his or her RBD? Peculiar as it may sound, the estate can make distributions over the deceased person's remaining life expectancy based on actuarial tables prescribed by the U.S. Tax Code.
Here's an example: If an account owner with one heir died at age 75, his or her remaining life expectancy would be 13.4 years based on the actuarial tables prescribed by the U.S. Tax Code. Since distributions begin in the year following death, the estate would need to deplete the IRA account over the following 12.4 years. Had the same beneficiary of the estate (say, age 50) been named directly on the IRA, the distribution could have been spread over 34.2 years.
8. Naming a nonperson (charity) as a co-beneficiary
When a charity is an IRA's co-beneficiary along with a family member, for example, the ability to stretch the payout over the human beneficiary's lifetime can be lost.
The custodian has until September 30 of the year following death to cash out the charity's interest to allow the account to be distributed over the life expectancy of the human beneficiary(ies). Failure to do so will require the assets to be fully disbursed by December 31 of the fifth year after the death. The custodian does not, however, have discretionary authority to effectuate this redemption. Unless all the necessary paperwork is submitted, the custodian's hands are tied.
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.
9. Failing to name a contingent beneficiary
If the beneficiary predeceases the account holder and the account holder does not replace that beneficiary and subsequently dies, 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 or her beneficiary (spouse) die at the same time (in a car accident, for example) and the account holder's will stipulates the beneficiary who died first, then 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.
10. Naming a trust as beneficiary when there are multiple beneficiaries
Under a scenario when a trust is the named IRA beneficiary and there are multiple beneficiaries, the RMD in the year following death is determined by basing it on the age of the oldest named beneficiary.
Here's an example: A trust lists three beneficiaries of John Doe's $300,000 IRA. They are aged 50, 45, and 40, respectively. The minimum payout would be $8,772, split three ways.11
Establishing multiple trusts avoids this issue. Using the same example, the 50-year-old would receive $2,924, the 45-year-old would receive $2,577, and the 40-year-old would receive $2,294. This totals $7,795, or $977 less than the minimum payout if all of the beneficiaries were lumped together. Wider age spreads or larger account balances would produce more dramatic results.
When an individual is the named beneficiary of an IRA, he or she is not locked in to solely taking annual distributions. Rapid depletion of the account can occur at any time. A trust can be utilized to stop one or more beneficiaries from squandering their inheritance.
There are a few other items that require an IRA account the Internal Revenue Code §72(t) 10% penalty. In this situation, an individual must take annual distributions, based on his or her life expectancy, determined in the year distributions begin. Distributions must continue for at least five years or until the individual attains age 59½, if later. If these distributions are from mutual funds or a variable annuity, and the stock market is declining at the time, the account can be depleted more quickly, since most options require a fixed annual payment. Taxpayers are allowed a one-time adjustment to this fixed payout, which generally lowers the annual distribution considerably, preserving assets.
Account holders are often not aware of the other multiple penalty-free withdrawal options their IRA offers. For example, individuals may withdraw funds to pay higher-education expenses for family members and pay taxes, not the 10% penalty, on the distribution. Up to $10,000 (lifetime) can be withdrawn to purchase a home for themselves or immediate family members, again paying taxes, but no penalty. Other options involve medical expenses in excess of 10% of adjusted gross income, disability withdrawals, and the payment of medical insurance premiums, if unemployed.
Individuals inheriting a qualified plan account now can choose to roll over that account to an IRA and, if they choose, simultaneously convert the rollover to a Roth IRA. (If the rollover occurs first, and then the beneficiary requests a conversion, it is too late.) The account must be titled "Joe Doe, deceased, Jane Doe, beneficiary" so that the beneficiary cannot roll this account into his or her own IRA. If the account was converted to a Roth IRA, all distributions, provided the account is maintained for five years, would be income tax-free. Unlike the rules governing an individual Roth IRA, the account does not have to be held until age 59½, since death is the exception to age 59½.
Last—and we cannot emphasize this enough—any IRA account holder withdrawing funds and intending to repay the account within 60 days must be cognizant that this can be done only once in a 12-month period, beginning on the date of the withdrawal. (If funds are withdrawn on June 1, 2013, the withdrawal window is not open again until June 1, 2014.)
In addition, 60 days means 60 days. In the above example, dollars not returned by July 30, 2013, could be taxed or penalized. The IRS has the ability to waive the 60-day rule if it feels the taxable result would run counter to fair public policy. However, a Private Letter Ruling (PLR) is generally needed to obtain the exemption; the filing fee (what the taxpayer pays the IRS) for a PLR ranges from $500 to $3,000 depending on the taxpayer's income. This fee does not include the submitter's fee (e.g., an attorney).
As we can see, an IRA is not a simple product, but it 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.
Important Information: 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.
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 can 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.
A Note about Risk: Investing involves risk, including the possible loss of principal.
This material is provided only for general and educational purposes and is not intended to provide legal, tax, or investment advice or for use to avoid penalties that may be imposed under U.S. federal tax laws. Contact your attorney or tax advisor regarding your specific legal, investment, or tax situation.
The fees for mutual funds tend to be lower than fees for variable annuities because there is an additional charge imposed to pay the insurance company for the death benefit guarantee, the right to receive an income stream for life at guaranteed rates specified in the contract, and the guarantee that the insurance company may not increase its expenses under the annuity contract.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.