Common IRA Errors

IRAs represent tremendous opportunities, particularly for the affluent and entrepreneurial.

 

Individual Retirement Accounts (IRAs) are often overlooked by advisors working with the affluent, because the amounts involved are often substantially lower than those in taxable portfolios.  But, IRAs are a significant planning opportunity for even the most affluent of clients because of their uniquely tax-deferred (or in the case of Roth IRAs, tax free) nature. Invested properly, IRAs can become a substantial part of any client’s portfolio and should be taken very seriously.  There are, however, some mistakes that can result in invalidating an IRA or a portion of its assets.

Purchase of municipal bonds in an IRA. Surprisingly common is the accidental purchase of municipal bonds in an IRA. Many affluent clients are so used to purchasing munis that they make the mistake of buying them in an IRA. This is among the worse things you can do, as the interest rates are so low on municipal bonds because they are federally (and generally state) tax free, but particularly because in a Traditional IRA, all untaxed gains, regardless of the source, will be taxed.

Disallowed investments. For clients with opportunities to make private equity or debt investments with substantial opportunities for outsized returns, an IRA or Roth IRA are ideal places to make such investments. However, there are strict rules governing these transactions and who can make investments. Review with a legal and financial advisor about any closely held or private opportunities you look to invest in.

Thinking that a will or a trust can facilitate the transfer of IRA assets. Most IRAs don’t pass to heirs through wills or trusts (a few rare exceptions aside). The beneficiary form takes precedence – the form the IRA owner filled out and signed when opening the account. Problems arise when

•    The IRA owner dies without designating a beneficiary

•    The designated beneficiary has also passed away

•    No one can find the beneficiary form (not even the IRA custodian, i.e., the financial institution that hosts the IRA)

In these circumstances, IRA heirs commonly end up playing by the IRA custodian’s rules. The resulting beneficiary may be the IRA owner’s estate – a very undesirable tax consequence. It might be a contingent beneficiary – perhaps a very undesirable emotional consequence. The lesson here is to keep the beneficiary form on file.

Taking lump-sum distributions. Too often, non-spousal IRA heirs see the inherited assets as money to spend. They withdraw the entire IRA balance in one fell swoop. Bad idea: all that money will be subject to federal income tax. Due to this move, they may lose a third of the IRA assets (or more).

The alternatives? Non-spousal beneficiaries can open an inherited Roth or traditional IRA and simply take Required Minimum Distributions (RMDs) from that inherited IRA under the appropriate schedule:

•    Traditional IRA: within five years of the account holder’s death if the account holder was under age 70½, or over your projected lifespan according to IRS tables if the account holder was over age 70½.

•    Roth IRA: within five years of the account holder’s death.

This decision can allow the invested IRA assets to keep compounding with the added benefit of tax deferral.

Not realizing your four options when you inherit your spouse’s IRA. If a spouse dies, the surviving spouse that inherits an IRA has some choices. He or she can

•    Roll over the assets into a beneficiary IRA

•    Convert the inherited IRA into your own IRA

•    Take a lump sum distribution

•    ”Disclaim” up to 100% of the deceased spouse’s IRA assets

There are compelling reasons to go with the rollover. The widowed spouse can set up an RMD schedule based on his or her life expectancy. This second point is really important, because the rollover allows the surviving spouse to put off the RMDs that would otherwise soon need to happen. In fact, the surviving spouse can wait until the year in which the original IRA owner would have turned 70½ to start taking required withdrawals from the IRA.

But there is also a compelling tax reason not to make a rollover if the widowed spouse wants to take distributions from the inherited IRA before age 59½. If that is the desire, those withdrawals will be slapped with the nagging 10% early withdrawal penalty plus the requisite income taxes.

If the spouse converts the IRA into his or her own IRA, the surviving spouse can name a beneficiary for the inherited assets, keep contributing to the IRA, and potentially avoid RMDs until he or she turns 70½.3

Alternately, a surviving spouse who doesn’t really need inherited IRA assets can “disclaim” them, meaning that they will go to a contingent beneficiary. Sometimes this can be a wise move for tax purposes.4

Non-spousal heirs fail to retitle an inherited IRA. If this isn’t done in the year following the year in which the original IRA owner passed, then there can be no direct rollover of the inherited IRA assets and no “stretch” for those assets.

What happens if a non-spouse beneficiary just rolls the inherited IRA assets into an IRA they own, one that isn’t retitled? Then it is not a direct rollover. The IRS treats those inherited IRA assets like a fully taxable cash distribution – 100% of it is subject to income tax.

Ask for help, and don’t be afraid to ask questions. Many families and couples have only a hazy understanding of the rules governing IRAs, and few really know all the options. Make aggressive, intelligent investments in these vehicles, but make sure that you’re making the right kind of investments. Confirm with your tax and legal advisors that beneficiary designations are appropriate for your estate plan. Make sure your IRA beneficiary form is up to date, and know how to handle the transfer of IRA assets when the time comes.