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Retirement Account Mistakes--Not For Dummies

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No, this is not another story lecturing you to save more, diversify, control your investment costs, or ignore the hot stock tip from your brother in law who did time for securities fraud. You're no dummy.

What this is, instead, is a guide to some of the traps created by the insanely complicated rules surrounding IRAs, 401(k)s and other retirement accounts ---traps that can snare not only smart investors, but also financial advisors, lawyers, accountants, and yes, even the Internal Revenue Service itself.

Lest you think that's hyperbole, consider this: a U.S. Tax Court judge  ruled last year that a tax lawyer couldn’t use an IRS publication in his defense, because the IRS itself  had misinterpreted a provision of the law relating to IRA rollovers. “Even the IRS is confused,’’ marvels CPA Ed Slott, who makes a nice living training other financial pros about IRA rules and fixing the mistakes they and their clients make.

The sad fact is a normal human being not in Slott's business can't know all the rules. But taking a few minutes to acquaint yourself with the more common mistakes can help keep you safe and out of the IRS' penalty zone. At the least, you’ll have a sense of when you need to consult IRS publications (which, despite that court ruling, you can usually rely on) or speak to a retirement account specialist at the financial institution where your IRA or 401(k) is held, or maybe even pay an expert for help.  Two key IRS Publications are  590a on IRA contributions and 590b on IRA distributions.  (There used to be just one publication 590, but it was so long, what with all the rules, that the IRS split it into two.) Note that part of what makes this all so complicated is that there are more than a dozen different types of retirement accounts, each with its own sometimes differing rules. So to be fair, Congress, not the IRS, deserves most of the blame for this mess.

To assemble my list of  25 Retirement Account Mistakes Smart People Make, I  consulted Slott and Robert Keebler, another CPA/IRA expert, and reviewed court cases, private letter rulings and government reports. Most of the mistakes  relate to early withdrawals, inherited IRAs, required minimum distributions and account rollovers. But  you can also get yourself in trouble putting the wrong thing in an IRA. (Tempted to hold gold in your IRA? The gold must be of a certain type and must  be kept with your IRA custodian, not under your bed.) Of course, this list of 25 mistakes is by no means exhaustive. Here's a bonus tip that's not on it: never ever, ever put a master limited partnership in a retirement account.

The discussion below offers some extra background on two areas where mistakes are particularly common.

Early withdrawal woes

Withdrawals taken from a traditional IRA or 401(k) before age 59 ½ are generally subject to not only ordinary income taxes, but also a 10% penalty  on the taxable amount. Fortunately, there are 11 separate exceptions, detailed here, that can get you out of the 10% extra hit. On their 2013 tax returns, 1.7 million taxpayers reported that they took early distributions, but only 1.2 million indicated they were subject to the additional 10% tax penalty, the IRS estimates.

The problem is that some of those 500,000 folks who reported themselves exempt from the penalty will get audited by the IRS and then hit with the 10% early withdrawal penalty and possibly an additional penalty for negligence.  That's because they got the exceptions wrong. One common mistake: thinking you can take an early penalty free withdrawal from a 401(k) to pay college or graduate school bills, or to buy a first home, when in fact these penalty exceptions only apply to IRA withdrawals.

In one classic case, an accountant who had left Deloitte to earn his PhD  got hit with the 10% penalty for using $30,000 from his 401(k) to finance his graduate studies and buy a first home. The tax court rejected his argument that since he could have transferred the 401(k) money to an IRA first, and then used it penalty free for those very purposes, he shouldn’t have to take the extra 10% hit. The judge said he sympathized with the accountant’s confusion, and agreed that the law is “highly technical,’’ but concluded that, well,  the law is the law.

Another common misconception Slott flags: that you can get out of the 10% penalty because you took the money out to deal with a general financial hardship. The widespread confusion may stem from the fact that some employers allow early “hardship” withdrawals from 401(k)s. But that doesn’t get the employee out of paying either tax or the 10% early withdrawal penalty.

If you have a financial hardship, there may be other ways to tap retirement money early penalty free. For example, if you're 55 or older and lose (or leave) your job, you can take money from your 401(k) penalty free-- so long as you don't roll it into an IRA first. (Yet another trap.)

Death traps

With a growing share of families’ assets in retirement accounts, mistakes made while passing them on are a big deal.  One easy to understand and fix mistake:  failing to keep your beneficiary forms up to date. The form on file with your IRA custodian, not any other estate document, and not an unfiled form you’ve stuck in your desk drawer, determines who gets your IRA.  If you want to make sure your ex-spouse (or an ungrateful child) doesn’t get your IRA, take him or her off that form as well as out your will.

Another batch of inheritance mistakes has to do with “stretch” IRAs. You can roll over an inherited IRA into your own name only if you inherit it from a spouse. (Although you should usually wait until you're  older than 59 ½ to roll over your late spouse's IRA  because withdrawals from an inherited IRA can be taken at any age without paying the 10% early withdrawal penalty. Once you roll an account over into your own name, you lose that early withdrawal flexibility.) But any individual beneficiary can retitle an IRA as an "inherited IRA" and stretch out withdrawals over his or her own life expectancy, thus gaining decades of tax deferred, or (in the case of a Roth IRA tax free) growth.

Although some in Washington, including the Obama Administration, would like to eliminate the stretch IRA,  this valuable tax break is available for now. Available, that is, so long as you (the IRA owner) or your heirs don’t make any mistakes.  One huge no-no is rolling an IRA inherited from someone other than a spouse into your own name. If you do that, the whole amount is immediately taxable. Instead, as a nonspousal heir, you must  retitle the IRA, including the original owner’s name and that it is inherited, e.g., “John X. Smith II,  deceased, inherited IRA for the benefit of John X Smith III.”  Similarly, if a trust is named as an IRA beneficiary, you can’t actually transfer the IRA into the trust. Instead, you retitle the IRA and deposit the yearly payouts in the trust. (Note that if you want to change the financial service company holding an inherited IRA,  you must do it in a trustee to trustee transfer.)

What about the mistakes IRA owners make that limit their heirs' ability to stretch out the account's life? A common one is naming your estate as your beneficiary on an IRA form. In many cases, that will force the IRA to be distributed within five years, cutting short the potential tax deferral or tax free growth. (The exact rule is this: funds in a Roth IRA left to an estate must be withdrawn within five years. Period. For a  traditional IRA left to an estate, if the deceased turned 70 1/2---the age at which a traditional IRA owner must start taking required minimum distributions--before his death, payments can be stretched out for what would have been his remaining life expectancy, according to IRS tables. That is usually more than five years, but it is probably less than the life expectancy of individual heirs, had they been named as individual beneficiaries.)

A related mistake is neglecting to name a contingent beneficiary. The problem? Should your primary beneficiary die before you, the IRA will likely go to your estate, again cutting short tax deferral. Moreover, if you name a primary beneficiary (say your child) and a contingent beneficiary (say your grandchild), then your child has the option of  "disclaiming" the IRA in favor of your grandchild.

Still other mistakes have to do with not taking the proper required minimum distributions from inherited IRAs. If you've just inherited an account, read William Baldwin's 11 Step Instruction Guide To Inherited IRAs, Inherited Roth Accounts And RMDs. And for in-depth advice on the best way to pass on a retirement account, spring for a copy of  Estate Planning Smarts by lawyer and former Forbes Senior Editor Deborah L. Jacobs.

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25 Retirement Account Mistakes Smart People Make