Mistakes can happen. When it comes to retirement assets, they can be costly.
This article will highlight some of the most common mistakes, and costs that can be associated with them. It will also show some preventable mistakes, and, where possible, those that can be cleaned up.
Mistake 1: Not understanding taxation of individual retirement account distributions.
Most money in clients’ traditional IRAs has not yet been taxed, so when it is distributed, it is taxed at ordinary income rates. Clients can, however, have after-tax money in their IRAs, either from making non-deductible contributions, or rolling after-tax money in an employer plan.
The mistake often made here is not understanding how an IRA distribution is taxed when the account contains both pre-tax and after-tax money.
Example: Dorothy has a traditional IRA totaling $150,000. Of that, $15,000 represents non-deductible contributions, and the remaining $135,000 is pre-tax (deductible contributions and earnings). She takes a $10,000 distribution. To determine how much is taxable and how much is tax-free, she must first determine the ratio of the pre-tax and after-tax dollars to the entire account.
$135,000 / $150,000 = 90%
$15,000 / $150,000 = 10%
A total of $9,000, or 90%, of the withdrawal will be taxable. The remaining $1,000, or 10%, will not be taxable.
Mistakes 2 and 3: Not understanding the exceptions to the 10% premature distribution penalty.
o Mistake 2 is not recognizing that the exceptions to the 10% federal income tax penalty for non-qualified annuities, IRAs and employer retirement plans are not the same. The chart shows all of the exceptions, and the accounts/plans to which they apply.
One of the most misunderstood exceptions concerns separation from service after age 55. This exception applies only to employer plans, not IRAs or non-qualified annuities. If a retirement plan participant separates from service in the year he or she attains age 55 or later, he or she can take distributions from the plan without incurring the penalty.
Note: If plan funds are rolled to an IRA, and then withdrawn, the exception does not apply.
o Mistake 3 centers around the substantially equal periodic payment exception to the 10% penalty.
Sometimes, clients find themselves in a position where monies need to be withdrawn from a retirement account prior to reaching the age 59 1/2 . An option is to use this exception to generate an income stream for the client.
There are stringent rules that must be followed when using the exception. First, payments must be taken for 5 years or until the client reaches age 59 1/2 , whichever is later. The following rules also apply:
–Additional rollovers cannot be done into or out of the account.
–No additional withdrawals can be taken from the account.
–Partial transfers cannot be made to a new custodian
–Once selected, the method for calculating the annual payout amount cannot be changed (except for one-time change from the amortization or annuitization method to the RMD method).
If any of these modifications occur, the IRS will deem the income stream to be “disqualified.” The 10% penalty, as well as interest, will be retroactively applied.
Mistakes 4 and 5: Not understanding the Required Minimum Distributions rules.
o Mistake 4 addresses the RMD rules while the client is alive.
The Internal Revenue Service requires that IRA owners and employer plan participants begin taking distributions from their accounts, generally at age 70 1/2 . Failure to take these distributions can result in a 50% tax penalty on the amount that was not distributed as required. Many individuals roll or transfer these assets after beginning to take RMDs. It’s very important that any RMD be taken before any rollover is executed in any given year, as RMDs are not considered eligible rollover distributions.
o Mistake 5 involves not understanding the requirements for beneficiaries, especially the differences in options for spouse and non-spouse beneficiaries.
Both spouse and non-spouse beneficiaries have 3 common options:
1. Take a lump sum.
2. Distribute the account by December 31 of the 5th year following the owner’s death.
3. Take distributions over the beneficiary’s life expectancy, with the first payment being made by December 31 of the year following the owner/plan participant’s death (also known as a Stretch).
A spouse beneficiary has two additional options, which are not available to non-spouse beneficiaries:
1. Roll the decedent’s account into his or her own IRA/retirement plan.
2. Defer taking distributions until the decedent would have turned 70 1/2 .
While many spouse beneficiaries roll the proceeds into their own accounts, that may not always be the best option.
If the spouse is under age 59 1/2 and needs to access funds, those distributions will be subject to the 10% federal income tax penalty, unless an exception applies. The substantially equal periodic payment exception is certainly an option in this case. However, as mentioned above, strict rules must be followed.
A better alternative may be to defer taking distributions until the decedent would have reached age 70 1/2 . This would enable the spouse beneficiary to take distributions as needed, without incurring the 10% penalty. At some point in the future, the spouse could roll the funds into his/her own account, presumably after attaining age 59 1/2 .
Jill B. Perlin, CLU, ChFC, CASL, is vice president-advanced marketing at Prudential Financial, Newark, N.J. Her e-mail address is firstname.lastname@example.org