Dan Casey, for InvestorGuide.com, warns of 10 ways investors sacrifice their IRAs to the IRS.
1. Failing to understand “stretch” IRAs. With this technique, young beneficiaries can take smaller withdrawals based on their long life expectancies, allowing the IRA to continue growing after the original owner’s death. However, not all custodians honor this strategy, Casey writes.
2. Not naming a spouse as the sole beneficiary. A spouse has the unique right to roll over an IRA into his or her name, while other beneficiaries would have to begin taking withdrawals, Casey writes. Once the inherited IRA is in the spouse’s name he or she can put off taking withdrawals until they come of age.
3. Naming a trust as a beneficiary. Heirs may have to pay higher taxes than if they inherited the IRA outside the trust, according to Casey. And, the trust must qualify as a “look-through” or “see-through” trust; if the IRS decides it doesn’t meet the requirements, the heirs wouldn’t be able to stretch out distributions.
4. Procrastinating. It happens to everyone, but in this case, delay can be costly. Changes to beneficiaries should be made as soon as possible, especially if there are multiple heirs. One option, Casey notes, is to split the IRA while the owner is still alive, and name different beneficiaries for each. This way, the minimum distribution will be based on the new owner’s life expectancy, rather than the oldest of the beneficiaries.
5. Not converting to a Roth. Beneficiaries can’t convert a traditional IRA to a Roth IRA once it’s inherited, Casey warns. If the heirs are young and stand to gain from a Roth’s tax advantages, it may be better to convert the IRA now.
6. Not taking advantage of net unrealized appreciation. If your clients have company stock, they can put it in a taxable account, and roll 401(k) assets into an IRA. They would pay taxes on the stock, and the difference would be paid only when they sell the shares.
7. Ignoring special age-related tax-breaks. Ten-year averaging allows investors who are 73 or older, or who have inherited a plan, to lower their liability if they need to make an early withdrawal. “The 10-year averaging tax is figured separately from your regular tax, and the income is not added to your adjusted gross income,” Casey writes. And, it won’t trigger the alternative minimum tax.
To qualify, investors must be born before 1936. The distribution must be from a qualified plan, like a 401(k), and the plan must be at least five years old. The distribution of the entire plan balance must be made in one tax year, and 10-year average can’t have been used in any distribution after 1986.
8. Allowing double taxation. In the past, the IRS taxed an inheritance, claiming it was “income that the decedent earned, but had yet to pay tax on,” Casey writes. If your clients inherit an IRA where a federal estate tax has been paid, they may be entitled to the “Income in Respect of a Decedent” tax break. The IRS created this exception to prevent double taxation on estate and income taxes; however, it doesn’t apply to state estate tax.
9. Allowing beneficiaries to roll over an IRA into their name. As mentioned previously, only spouses named as the sole beneficiary have that right. Should a non-spouse beneficiary roll over an inherited IRA into their name, the IRS considers it null and void, and all taxes are due.
10. Forgetting to take the money. As you know, investors must begin taking distributions once they turn 70 1/2 . If they don’t, they may be subject to a 50 percent penalty on the portion of their distribution that they didn’t take.