Retirement accounts often neglect to factor in lifetime income taxes for both themselves and their heirs, potentially costing a considerable portion of hard-earned funds in taxes paid over their lives.
Naming beneficiaries for an IRA account can have major ramifications. Here are a few strategies to avoid an IRA tax trap.
Ignoring Required Minimum Distributions (RMDs)
RMD rules can be complex, making them hard for owners (and beneficiaries) of tax-preferred accounts to satisfy them properly. A March 2010 report from the Treasury Inspector General for Tax Administration showed that over 250,00 individuals missed taking an RMD between 2006 and 2007.
Mistakes when filing RMDs may incur penalties of 50% of their shortfall and push individuals into higher income tax brackets, making professional advice necessary to successfully navigate mandatory, taxable distributions. Correcting past-year RMD shortfalls by making “make-up” distributions doesn’t necessitate filing an amended return; however, taxpayers should take care to document any corrective actions they take.
Ignoring Roth Conversions
Assuming your IRA investments will increase in 2019, but still fall under tax laws, ignoring Roth conversions could become a potential trap and cause more havoc than you think.
When rolling over traditional IRA balances to Roth IRAs with income taxes withheld, the IRS applies the pro-rata rule to determine whether they contain pretax or aftertax assets; any amount withheld that falls into this category will incur an additional 10% tax charge. This also occurs with rollovers from company retirement plans into Roth IRAs; as with IRA-to-IRA rollovers, pretax funds are withheld first.
Ignoring Step-Up in Basis
Individuals converting from an employer-sponsored retirement account to an IRA should ensure the funds are shifted directly from plan to account through trustee-to-trustee transfer in order to avoid excess distribution tax liability.
As soon as an original owner dies, their step-up in basis helps reduce capital gains taxes on any inherited assets that pass to their surviving spouse or joint owners.
At retirement age, taking too large of an RMD could create an unexpected tax liability and move a retiree into a higher tax bracket, potentially increasing Social Security benefits and Medicare premiums in turn. By carefully planning your IRA account, however, this trap can be avoided.
Ignoring Qualified Charitable Distributions (QCDs)
Qualified charitable distribution (QCD) is an attractive option for IRA owners over 72. This tax-free distribution can reduce federal income tax liabilities, but must be done correctly to qualify.
Advisers must advise clients that any tax-free benefits require careful coordination with RMDs. Any money taken out from an IRA in any year they must take an RMD must first go towards satisfying it before any QCD can be completed.
Tax-free transfers between trustees and charities, up to $100,000 annually per IRA owner are tax free benefits that Tanya was hoping would offset her 2022 RMD by making a $5,000 QCD donation in December – unfortunately the IRS rules prevented this from occurring.
Ignoring IRA-to-IRA Rollovers
When rolling over distributions from one traditional individual retirement account (IRA) into another or from your employer’s plan into an IRA, typically doing so tax-free is possible. However, if the retirement plan sends you a check payable directly to you or makes an electronic funds transfer directly into your personal account without your prior knowledge and approval, 20% of any taxable amounts must be withheld for federal income taxes and withheld as per federal income tax regulations.
After receiving your distribution, you have 60 days to collect the “missing” 20% and roll it all into an IRA or else face income tax and an early withdrawal penalty of 10% or higher. Therefore, direct trustee-to-trustee transfers are an invaluable solution.