If you’re like most people, a large portion of your wealth is set aside in individual retirement accounts (IRAs) or qualified retirement plans, such as 401(k) or profit-sharing plans. These accounts offer substantial tax advantages, but they’re also fraught with traps for the unwary. Here are five common mistakes to avoid:
- Missing required minimum distributions
The penalty for failure to take a required minimum distribution (RMD) from an IRA or qualified plan is among the harshest in the tax code: a 50% “excess accumulation” tax on the amount you should have withdrawn. (See “RMDs: When and how much?”)
Suppose you’re over age 70½ and you’re required to take a $50,000 RMD by December 31, 2016. If you miss the deadline, you’re liable for a $25,000 penalty tax.
- Naming your estate as beneficiary
If you designate your estate as beneficiary of an IRA or qualified plan, the RMD rules depend on when you die. If you die before the required beginning date for your RMDs, the entire account balance is required to be distributed no later than December 31 of the fifth year following the year that you die. In other words, for a death in 2016, the balance must be distributed no later than December 31, 2021. If you die on or after your required beginning date for taking RMDs, however, the rules are more complicated. Without going into all of the details, the RMDs for the estate (or the beneficiary/beneficiaries of the estate) will be determined by referring to IRS tables based on how old you would have been as of the end of the year in which you died.
It’s often preferable to name an individual beneficiary, such as a younger spouse or child, to avoid the confusion and to allow the beneficiary (or beneficiaries) to stretch the distributions over longer periods, maximizing tax deferral.
- Failing to take RMDs from an inherited IRA or qualified plan
If you inherit an IRA or qualified plan account from someone other than your spouse, and you roll the funds into an “inherited IRA,” you’re generally required to begin taking RMDs by December 31 of the year following the year of the account owner’s death. This rule applies regardless of whether you inherit a traditional or a Roth account. Failure to comply is subject to the same 50% penalty tax described above.
Typically, you’re permitted to stretch RMDs over your life expectancy, maximizing the benefits of tax deferral. Qualified plans are required to allow rollovers to a nonspouse’s inherited IRA, except in certain limited circumstances.
A common, but costly, mistake is to overlook the account owner’s final distribution. If the account owner was required to take an RMD in the year of death, but died before withdrawing the full amount, you as beneficiary must withdraw any remaining amounts by the end of the year.
- Titling an inherited IRA incorrectly
To take advantage of the tax-deferral benefits of an inherited IRA or qualified plan, it’s critical that the account be retitled properly upon the account owner’s death (unless you inherit from your spouse and execute a spousal rollover). Suppose, for example, that John Doe names his daughter, Jane, as beneficiary of his IRA. When John dies, the IRA must continue to be titled in John’s name, using language such as “John Doe (deceased) IRA for the benefit of Jane Doe.”
If you retitle an inherited account improperly — “Jane Doe IRA,” for example — it’s possible that the IRS may treat the transaction as a taxable distribution of the entire account balance.
- Falling into the spousal rollover trap
If you inherit an IRA or qualified plan account from your spouse, you have an opportunity to roll over the benefits into your own IRA. The advantage of a spousal rollover rather than an inherited account is that you need not begin taking RMDs until you reach age 70½.
But watch out for a potential tax trap: If you’re under age 59½, and you wish to access your spouse’s retirement funds now, you’ll be subject to a 10% early withdrawal penalty (unless you qualify for an exception, such as financial hardship). Under these circumstances, you’re better off keeping some or all of the funds in an inherited account, from which you can withdraw penalty-free.
Look before you leap
As you approach age 70½, or if you inherit an IRA or qualified account, consult your tax advisors before taking any action. They can help you understand your options and avoid unpleasant tax surprises.
RMDs: When and how much?
If you own a traditional IRA or a non-Roth qualified plan account, the tax code requires you to begin taking required minimum distributions (RMDs) once you reach age 70½.
Generally, you determine the amount of your RMD by taking your account’s fair market value as of the end of the preceding year and dividing it by your life expectancy (pursuant to IRS tables). For the year in which you turn 70½, you have until April 1 of the following year to take your first RMD. After that, RMDs are required by December 31 of each year.
There’s an exception for 401(k) and other defined contribution plans: If you continue to work after you turn 70½, and you own less than 5% of the employer’s company that sponsors the plan, you need not begin taking RMDs until April 1 of the year following the year in which you stop working.
Last, you’re not required to take lifetime distributions from Roth accounts, although your nonspouse beneficiaries are required to take RMDs after your death.