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12 Common IRA Mistakes To Avoid That Could Cost You Thousands

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"Did you know if you would have left your retirement in your 401k then you wouldn't have to pay the 10% penalty?"

My new client was 57 years old and already retired. He possessed decent liquid savings but an unexpected expense required him to pull money from his IRA.

Had he left his money in his 401k, he could have avoided the 10% early withdrawal penalty; but his previous advisor never bothered to let him know that detail.

Now he's left with a stiff penalty from the IRS that could have (and should) been avoided.

For many, IRA's represent a bulk of their retirement assets. Paying a stupid penalty here or not taking advantage of a loophole there could cost you thousands. To make sure you don't blow it, here are 12 common IRA mistakes to avoid.

1. Assume You Can't Have an IRA Because of Your Employer Plan

A lot of people assume that because they have a retirement plan at work, that they can’t have an IRA too. But in most cases that isn’t true. Up to certain income limits, you can have both an employer-sponsored retirement plan and an IRA. 

That can provide you with a tremendous advantage, particularly in the years leading up to retirement. It will give you the benefit of both tax deductible contributions and tax deferral of investment earnings on not one retirement account, but two.

And if you plan to retire early, having both plans is practically a must! You can make a tax deductible IRA contribution even if you participate in an employer sponsored retirement plan, up to certain income limits.

For 2015 your contribution will begin to phase out at $98,000 and completely disappear at $118,000 if you are married filing jointly. If you are single, the deduction begins phasing out at $61,000, and completely disappears at $71,000. Those are pretty generous income thresholds that would allow the majority of taxpayers to make an IRA contribution even if they have an employer sponsored plan. And if you can make the contribution, you should!

2. Not Making a Contribution Because it Isn't Tax Deductible

Even if your income exceeds IRS limits to make tax-deductible IRA contributions, you can still make contributions - they just won’t be deductible. Now a lot of people may not be interested in making an IRA contribution if it isn’t tax-deductible, but that’s a mistake! Even if the contribution isn’t tax-deductible, investment earnings in your IRA will still be tax-deferred. Take a look at how that can benefit you...

Let’s say that you have $11,000 - the maximum IRA contribution a married couple can make in 2015 - and you have a choice between putting it into IRA accounts, or regular taxable accounts. Either way, you plan to have the money invested in index funds that you expect to average a 10% return for the foreseeable future. If you put the money into IRA accounts, it won’t be reduced by your marginal income tax rates, and you’ll get the full benefit the 10% annual return.

In 30 years, that will produce an account worth $191,942. Now let’s say that you decide that not getting a tax deduction for an IRA contribution is a deal breaker. No IRA, instead you put the money into a regular taxable account. 

But now you have to figure an annual tax bite on your investment returns, since they will be taxable in the year earned. If you are in the 28% marginal tax rate for federal tax purposes, and 7% for your state, you will have to reduce your investment income by 35% each year. That means that the 10% return that you expect to get from your index funds will be reduced to just 6.5% per year. How does that change the outcome? $11,000 invested for 30 years at an effective rate of 6.5% will produce an account worth $72,760.

That means that giving up the tax deferral that an IRA provides will cost you nearly $120,000 over 30 years.

Moral of the story: When it comes to IRAs, tax deductible contributions are important, but tax deferral wins every time. Fund an IRA, even if you participate in an employer-sponsored retirement plan, and even if your IRA contributions are not tax-deductible. You’ll come out way ahead in the long run.

3. Not Maximizing Your Contributions

Because it is not sponsored by an employer, and is not payroll deducted, people will often take a haphazard approach to funding an IRA. They may put no more into the plan that may have sitting in a checking account, or have received in a recent windfall. But it’s important to understand that an IRA is a long-term plan. In order for it to work its magic, it needs to be handled on a consistent basis. It’s easy to talk yourself out of making the largest contribution that you’re allowed, but it will only hurt you in the end.

For 2015 the maximum IRA contribution is $5,500, or $6,500 if you are age 50 or older. You should target the maximum contribution each and every year. Once again, this is especially important if you hope to retire early one day.

"Remember, the money you contribute to your IRA is tax sheltered until you withdraw it from your account", offers Jude Wilson Founder and Chief Financial Strategist of  Wilson Group Financial.  The benefit to you is,  any earnings that you make within your IRA is not taxed. That's money you get to keep in your pocket instead of sending it to Uncle Sam. Those dollars stay invested in your IRA where it has the opportunity to grow.  Imagine the snowball effect and how much faster your account could increase in value!"

4. Not Taking Advantage of the Spousal IRA for a Non-Working Spouse

This is one of the very biggest and most common mistakes people make regarding IRAs. The assumption is that a non-working spouse cannot contribute to an IRA because he or she has no earned income. After all, one of the most basic rules of IRAs that they must be funded out of earned income. But there is an exception for non-working spouses. It’s referred to as a spousal IRA, and entitles a non-working spouse to make contributions to an IRA under virtually the same rules as a working spouse.

The provision is actually quite simple. As long as the working spouse is earning a sufficient amount of income to cover the contributions to both IRAs, the spousal IRA will be allowed. For example, if the working spouse contributes $5,500 to an IRA, and the non-working spouse makes the same contribution, that contribution will be allowed as long as the working spouse earned at least $11,000 in the year of the contribution. That can allow a working/non-working couple to double their IRA contributions each year, and even get a tax deduction for doing so, within general IRS rules for IRAs.

5. Not Taking Advantage of the Roth IRA

Once again we get back to that not-wanting-to-make-a-contribution-because-it-isn’t-tax-deductible thing. In all but two major respects, Roth IRAs are just like traditional IRAs, and one is that Roth IRA contributions are not tax deductible. But that brings us right to the second major departure from traditional IRAs, and that’s that withdrawals taken from a Roth IRA are tax-free. 

That’s a big part of the reason why your contributions to the plan are not tax-deductible. Withdrawals taken from a traditional IRA are only tax-deferred. That means that you have to include distributions from a traditional IRA in your taxable income when received. Not so with Roth IRAs! As long as you are at least 59 ½ years old, and your Roth IRA plan has been in existence for at least five years, the distributions from the plan can be taken tax-free.

And here’s another Roth IRA benefit: Roth IRAs are the only qualified savings plan that does NOT require you to take required minimum distributions beginning at age 70 ½. That means that you can continue to allow your Roth IRA to grow until you’re ready to begin taking money out of it.

This is a game changer, right? It means that at least some of your income in retirement will be tax-free, and that might be more important than you can imagine right now. The income limits to make Roth IRA contributions is different from traditional IRAs. With a Roth IRA, either you can make a contribution or you can’t, and it all comes down to your income level, whether or not you are covered by an employer-sponsored plan.

You can make a Roth IRA contribution even if you participate in an employer sponsored retirement plan, up to certain income limits. For 2015 your contribution will begin to phase out at $183,000 and completely disappear at $193,000 if you are married filing jointly

If you are single, the deduction begins phasing out at $116,000, and completely disappears at $131,000. If you are not making Roth IRA contributions, you are missing out on participating in one of the biggest tax give-aways of the 21st Century.

6. Not Taking Required Minimum Distributions (RMD) or Taking the Wrong Amount

You know all those generous IRS tax breaks for 401(k)s, IRAs, and other tax-sheltered retirement plans? Well, there’s payback for all of that generosity! Upon reaching the age of 70 ½ you must begin taking withdrawals from virtually all retirement accounts, except a Roth IRAs (because they’re not taxable anyway). And yes, that’s when you may have to pay tax on the distributions. 

Those distributions are referred to as required minimum distributions, or RMDs. Once you reach 70 ½ there will be two required distribution dates in the next year, April 1 and also on December 31. You can avoid the double distribution after the first year, by taking your initial distribution by December 31 of the year you turn 70 ½. After that first year, you will have only one RMD per year, which will be added to your taxable income. 

The RMD is calculated by dividing the account balance as of the end of the year immediately preceding the year in which you reach 70 ½ by your life expectancy, as determined by the IRS “Uniform Lifetime Table.” If you do not take any distributions, or if the distributions are not large enough, the penalty is steep. You may have to pay a 50% excise tax on the amount not distributed as required.

7. Paying Unnecessary Penalties on Early Distributions

There are a host of ways to avoid paying the IRS 10% penalty tax on early distributions. But we’re going to focus on one method - a series of substantially equal payments. This is a distribution method in which your distributions are made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary. It is referred to as Section 72(t) and it will allow you to avoid penalties on IRA distributions even if you are younger than 59 ½.

More specifically, the IRS allows you to set up this plan using one of three methods: 

  • The Required Minimum Distribution method. This method uses the IRA owner’s life expectancy, and makes distributions of the account balance over that time frame. The annual payment is redetermined each year since both the account balance and the owner’s life expectancy will be slightly less.
  • Fixed Amortization method. This involves amortizing the IRA account balance over a specified number of years equal to life expectancy (single life uniform life or joint life and last survivor), and at an interest rate of not more than 120% of the federal mid-term rate.
  • Fixed Annuitization method. This method involves applying an annuity factor to the IRA account balance to produce a monthly payment. The annuity factor is calculated based on an IRS mortality table and an interest rate of not more than 120% of the federal mid-term rate. Each of these three methods will produce a slightly different payment distribution, though each ultimately accomplishes the same goal, which is to spread the distribution payments over the IRA owner’s lifetime. Once established, the penalty tax on early distribution will be waived.

8. Placing an IRA in a Trust

Making a trust the actual owner of an IRA causes immediate taxation - including the 10% penalty tax if the IRA holder is under age 59 ½. That also means that any money that is placed in a trust from an IRA will have to be reduced by the tax liability upon the distribution of the IRA.

That means the amount of money actually making its way to the trust will be greatly reduced. But there’s an even bigger reason to not put an IRA into a trust, even if it’s done upon the owner’s death. Once the trust assumes ownership of the IRA, the owner’s spouse loses the ability to roll that IRA over into his or her own IRA without tax consequences.

This ability is the easiest way to avoid income taxes on an IRA in the event of the owner’s death. Once the IRA is placed in the name of the trust, that strategy will be lost completely.

9. Missing Important Dates on Inherited IRAs

Estate taxes, if applicable, are due nine months after the IRA owner’s death. The same deadline applies to beneficiaries who wish to disclaim IRA assets. By September 30 of the year following the year of the owner’s death, the beneficiary whose life expectancy will control the payout period must be identified.

Generally, IRA beneficiaries who want to receive distributions over a life expectancy must begin taking required distributions by December 31 of that same year. If you inherit an IRA, you’ll have to be prepared to move quickly.

10. Not Taking Advantage of “IRD” as a Beneficiary

Upon the death of the IRA owner, his or her IRA is included in the estate, creating an estate tax liability (if applicable) as well as an income tax liability for beneficiaries. Many IRA beneficiaries do not realize that IRAs are considered “Income in Respect of a Decedent” (IRD), according to Section 691(c) of the IRS Code. The IRD designation allows beneficiaries to take a federal income tax deduction for any estate taxes paid on the IRA’s assets, thus limiting double taxation of the IRA assets.

11. Not Naming or Updating IRA Beneficiaries

Not listing primary and contingent beneficiaries may result in the distribution of the IRA assets to the IRA owner’s estate, resulting in accelerated distribution and taxation. Not keeping beneficiary designations current and coordinating them with other estate planning documents can also lead to conflicts and unintended results. One major example is an ex-spouse. 

A former spouse could end up inheriting a retirement account if his or her name is still listed on the plan. People mistakenly believe that a divorce decree that specifically excludes an ex-spouse will solve that problem - it won’t. You must specifically remove your ex-spouse as a beneficiary, or that person can inherit the plan. Also, most IRAs list the owner’s spouse as the primary beneficiary. 

One of the most popular strategies for a spousal beneficiary is simply to roll the inherited IRA into his or her own IRA. But in some cases it can be more tax efficient for a surviving spouse to keep the IRA as an inherited beneficiary IRA or disclaim the assets, thereby allowing them to pass to the contingent beneficiary. It’s complicated, but you have to be ready for it.

12. Rolling Low-Cost-Basis Company Stock into an IRA

Distributions from a qualified plan such as a 401(k) are generally taxed as ordinary income. If company stock is rolled into an IRA, future distributions are taxed as ordinary income. If, instead, the company stock is taken as a lump-sum distribution from the qualified plan, only the cost basis of the stock is taxed as ordinary income. This is called Net Unrealized Appreciation(Note: The distribution must be taken as stock, not cash.) 

Unrealized capital appreciation (the difference between the cost basis and current fair market value) is not taxed until the stock is sold, upon which it would be taxed as long-term capital gains, which are taxed at a lower rate than ordinary income (at 2009 tax rates). Be sure to talk with your tax advisor.