3 Costly IRA Mistakes to Avoid

3 Costly IRA Mistakes to Avoid

Common Mistakes to Avoid with Your IRA

Mistakes happen. But when it comes to Individual Retirement Accounts (IRAs), mistakes can be costly. Missing a required minimum distribution (RMD) can result in a penalty of up to 25% of the amount not withdrawn. However, with proper knowledge and care, these mistakes can be easily avoided. In this article, we will explore three common IRA mistakes that can have significant financial consequences and provide tips on how to avoid them.

Beneficiary Mistakes

One of the most common and potentially costly mistakes with an IRA is making errors with beneficiaries. It is crucial to name the right beneficiary while you are still alive, as an IRA passes via beneficiary, not through the will. Failing to update beneficiary designations can lead to unintended consequences.

For example, imagine a situation where a deceased husband left his IRA to his ex-wife because he never updated the beneficiary designation. Now the widow is facing a legal battle to claim what she believes to be rightfully hers. To prevent such disputes, it is advisable to review and update beneficiary designations periodically, such as on your birthday or at the beginning of the year. Additionally, don’t forget to check beneficiary designations for group plans like a 401(k) or other accounts that require beneficiaries.

When naming beneficiaries, consider including contingent beneficiaries who will inherit the IRA if the primary beneficiary dies first. It is common to name a spouse as the primary beneficiary and children as contingent beneficiaries. In more complex cases, such as when financial protection is needed or when considering charitable donations, consulting with a qualified professional can ensure the proper beneficiary plan is in place.

Not Accounting for After-Tax Contributions

Contributing to a traditional IRA can be a confusing affair, especially when it comes to distinguishing between pre-tax and after-tax (post-tax) contributions. Pre-tax contributions are tax-deductible, reducing your current taxable income, while after-tax contributions are not tax-deductible but are also not taxable when withdrawn, with only the earnings subject to taxation.

Failing to properly account for after-tax contributions can lead to unexpected tax liabilities. It is essential to keep track of which contributions are pre-tax and which are after-tax. The responsibility for differentiating between the two lies with the IRA owner, as investment custodians usually report only the amount contributed.

Often, individuals make after-tax contributions inadvertently, exceed income limitations, or have specific conversion strategies in mind. If you have made after-tax contributions to a traditional IRA, make sure to file Form 8606 to record those contributions. Properly accounting for after-tax contributions is also crucial for Roth conversions. If you overlooked this aspect, corrective steps can be taken, such as filing an amended tax return. However, it is best to consult with a qualified tax adviser to navigate the process smoothly.

Using the Wrong RMD Table

Calculating your IRA required minimum distributions can be tricky, especially when you are unaware of the different tables available. Many people use the Uniform Table by default, not realizing that if their spouse is the sole beneficiary and ten or more years younger, a more favorable IRA RMD table exists.

Suppose you are significantly older than your spouse, with a significant age difference of, let’s say, 15 years. If you both have IRAs, using the Uniform Table might result in a higher RMD amount. By not utilizing the more favorable Table II, you could end up unnecessarily withdrawing funds and paying more income taxes.

To illustrate, let’s consider an example. If your IRA’s end-of-year value is $500,000, using the Uniform Table might require an RMD of $20,325. However, if you used Table II, the RMD would be $17,667, a difference of $2,658. By using the correct table, you can potentially avoid withdrawing and paying taxes on funds you do not need for living expenses.

Parting Thoughts

IRAs are excellent retirement savings tools, but they come with their fair share of rules and complexities. To avoid costly mistakes, take a slow and diligent approach, conducting thorough research and seeking advice from financial advisers, IRA custodians, and qualified professionals. The IRS website offers ample guides and resources to enhance your understanding.

Establishing a systematic review process is crucial. Create a checklist to review beneficiary designations, RMD accounting, and other essential IRA planning strategies at least once a year. Having a second set of eyes, whether it be from a trusted adviser or a meticulous review process, can help identify potential mistakes before they become costly.

While mistakes are an inevitable part of life, by adopting these practices, you can minimize the risks and ensure a smooth journey toward a secure retirement.

For more information, please email the author at [email protected].

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 consists of 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.