Three Potentially Costly IRA Mistakes That Are Easy to Avoid

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Mistakes happen. But mistakes with an IRA can be costly. Consider the fact that the penalty for missing a required minimum distribution (RMD) could be 25% of the amount not withdrawn (10% if the missed RMD is taken by Dec. 31 of the second year following the year it was due)!

While there are any number of common IRA mistakes, I find there are a handful of them that I see more often than the rest. They range from beneficiary mistakes and RMD errors to failing to file the correct forms.

Here are three of the mistakes that I’ve run into in my experience that are potentially costly — and yet totally avoidable.

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Beneficiary mistakes

An IRA passes via beneficiary, not through the will. For this reason, it is critical to name the right beneficiary — while you are still alive. Recently, I had a widow call me and tell me that her deceased husband left his IRA to his ex-wife. The late husband never updated the beneficiary, and now the widow said she was suing.

I check my clients’ beneficiary designations at least annually. I always ask them if anything changed and make sure they are current. You can set a reminder on your birthday or the first of the year. Also, be sure to check your group plans, like a 401(k) or any other account that has a beneficiary. Those count, too.

It’s also important to name contingent beneficiaries. Contingent beneficiaries inherit the IRA if the primary dies first. One never knows. I usually see the spouse as the primary and the kids as the contingent, split equally to keep the peace.

Sometimes a trust is the beneficiary. An IRA beneficiary trust can be used in special circumstances — financial protection from creditors, marital discord or in cases where a child might not otherwise be financially stable. Naming a charity as a beneficiary may make sense for larger estates, given the potential tax benefits. One option is the applicably named charitable remainder trust. Trusts are complex, so you should consult with a qualified professional.

Overall, I recommend taking a step back, reviewing the family dynamics and having your investment manager consult with your estate attorney and accountant for a proper beneficiary plan. Any way you slice it, naming the right beneficiary today is a good idea.

Not accounting for after-tax IRA contributions

This is one of those “gotcha” mistakes. If you contribute to a traditional IRA, the onus is on you to designate whether that contribution is pre-tax or post-tax. Pre-tax contributions are tax deductible — meaning they can lower your current taxable income today but are taxable when withdrawn. Contrast that with post-tax, or commonly known as “after-tax,” contributions, which are not tax deductible today, but are also not taxable when withdrawn (only the earnings are taxable).

Failure to properly account for which contributions are pre-tax and which are not will mean the after-tax contributions will be taxed at the time of withdrawal — while, remember, only the earnings should be.

With IRAs, it is not the investment custodian’s responsibility to differentiate whether it is pre- or post-tax. They usually only report the amount. In my experience, IRA owners make post-tax contributions either (1) inadvertently — not knowing they exceed the income limitation, (2) because they think it’s a good idea to contribute after-tax or (3) because they are planning for a “backdoor” Roth IRA conversion.

So, if you made post- or after-tax contributions to a traditional IRA, file Form 8606 to account for that contribution. After-tax contributions also affect Roth conversions, another reason the Form 8606 is so important.

I usually see this oversight when a new client switched accounting firms and the record didn’t carry over, or he or she does their own taxes and the tax software never prompted them to address it. This is an avoidable mistake, but you need to be aware of it.

There are corrective steps to take if you failed to file a Form 8606, such as filing an amended tax return. It’s best to talk with a qualified tax adviser.

Using the wrong RMD table

Here’s one I find most people don’t know about: There is more than one table to calculate your IRA required minimum distributions. An IRA owner whose spouse is the sole beneficiary and more than 10 years younger can use a more favorable IRA RMD table.

I saw this with a client recently. He is significantly older, by about 15 years. He was managing his own IRA while we were overseeing his wife’s assets. On one phone conference, we got to talking about RMDs. He told us how he calculated his RMD and explained how he used the end-of-last-year value and divided it by the factor from the Uniform Table. I recall asking him why he didn’t use Table II. He shrugged and didn’t know there was a Table II.

I then explained that the RMD Table II is used for married owners whose spouses are more than 10 years younger. I went on to explain that at his age, 75, the distribution factor from the RMD Uniform Table is 24.6 — whereas the factor is 28.3 from Table II. The IRA end-of-year value is divided by the factor. The larger the factor, the lower the RMD.

For example, if his IRA value at the end of the calendar year from last year is $500,000, the RMD from the Uniform Table is $20,325, whereas if he used Table II, the RMD is $17,667, a difference of $2,658. He didn’t need the extra $2,658 for living expenses, so he would have been better off keeping it in the IRA and not withdrawing and paying income taxes.

Parting thoughts

IRAs are a great place to save, but be mindful of the nuances. Given the number of rules and the complexity, try taking it slow and doing your research. There are many guides and resources available on the IRS website. Also ask your financial adviser or IRA custodian lots of questions, which may prompt them to double-check things. It’s always good to have a second set of eyes.

Make sure you have a systematic review process. For my clients, we have a checklist we go over at least once a year that prompts us to review beneficiary designations, RMD accounting and other IRA planning strategies.

Some mistakes in life are inevitable. But at least with IRAs, if you have a systematic review process, work with an experienced team and have checklists in place, mistakes should be avoidable.

For more information, please email the author at maloi@sfr1.com.

Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third-party websites are provided for your convenience and informational purposes only. Summit is not responsible for the information contained on third-party websites. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.

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Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Accredited Wealth Management Advisor℠ with Summit Financial, LLC. With 21 years of experience, Michael specializes in working with executives, professionals and retirees. Since he joined Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house estate and income tax specialists, Michael offers his clients coordinated solutions to scattered problems.