Too many people leave too much money on the table when managing their individual retirement accounts (IRAs) but it should not surprise anyone.
IRA rules and strategies can be more complicated once the early contribution and accumulation years are behind us. There are various tricks and traps in the IRA rules, and strategies to maximize IRA values aren’t intuitive.
IRAs are among the most valuable assets many people own, especially after 401(k) balances are rolled over to IRAs. One mistake or even two lesser oversights can put a lot of extra money in the IRS’s hands.
Though many IRA owners aren’t aware of the pitfalls, the IRS knows them. A few years ago, an IRS study found many people don’t follow the rules properly and the agency was missing a lot of extra taxes and penalties by not closely auditing IRAs. The IRS has since modified its procedures and is taking a closer look at IRAs.
Here are some very common, and expensive, IRA mistakes to avoid.
Update beneficiary designations. There continue to be too many court cases and IRS rulings that result from failures to update IRA and 401(k) beneficiaries. Your will and other documents don’t control who takes over a retirement account after you. Only the beneficiary designation on file with the account custodian determines who inherits.
Many people haven’t updated their beneficiaries for decades. Their beneficiaries are an ex-spouse or someone who passed away. Or they didn’t add a child who was born after the IRA was opened, or they have other oversights. Also, the estate might have changed so that a different beneficiary makes more estate planning or financial sense.
Failing to name a beneficiary or naming your estate means tax deferral won’t be maximized. The retirement account will have to be emptied within five years.
Naming a trust as an IRA beneficiary also could accelerate the distribution schedule if the trust isn’t drafted to comply with the IRS’s rules for tax deferral.
Beneficiary designations should be part of your estate planning. You and your estate planner should determine which beneficiaries would receive the highest after-tax value from the IRA and be sure your forms are updated.
Inherited IRAs. Communicating with heirs is an important step in maximizing the value of an IRA to them. Casual mistakes and misunderstandings by beneficiaries trigger a lot of taxes and penalties.
For example, when an heir decides to move an inherited IRA to a different custodian, the rollover must be directly from one trustee to another. With changes for other types of IRAs, you can receive a check from the IRA custodian and take up to 60 days to deposit the same amount with the new custodian. But the 60-day rule doesn’t apply to inherited IRAs. If it’s not a trustee-to-trustee transfer, the entire amount is treated as a distribution.
The beneficiary needs to be sure the IRA is properly retitled. If the inherited IRA simply is converted to the beneficiary’s name, that will be treated as a distribution. The proper title contains the name of the original owner, the fact that he or she is deceased, and that the IRA now is “for the benefit of” (FBO) the beneficiary. Also, required minimum distributions must begin by Dec. 31 of the year after the year the original owner passed away.
There are a host of other things heirs need to know about inherited IRAs. I compiled them in my report, Bob Carlson’s Guide to Inheriting IRAs.
Taxable investments. There’s a category of investments that aren’t prohibited by IRAs but could trigger taxes on your IRA.
An IRA or other retirement account might have to pay taxes on unrelated business taxable income (UBTI). UBTI generally is income generated by an operating business owned by the IRA. The rules also apply when the IRA owns any interest in a pass-through business entity (partnership or limited liability company).
This rule most often trips up individuals who invest their IRAs in master limited partnerships (MLPs) or real estate partnerships. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are limited partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. When an IRA’s taxable income from MLPs exceeds $1,000, the IRA must pay taxes on that income. The IRA also might have to file Form 990 and pay estimated taxes.
When an IRA does own MLPs and earns income of more than $1,000 for the year, some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through income on the IRA owner’s individual tax return instead of preparing a separate return for the IRA.
Also, any type of income becomes UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from its custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. A mortgage on real estate also converts exempt income into UBTI. An IRA may own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage. However, the rental income becomes UBTI.
Important note: The UBTI rules also apply to Roth IRAs the same as traditional IRAs.
UBTI can be avoided by owning an open- or closed-end mutual fund or an ETF that itself owns publicly-traded MLPs.
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Until next time,
Robert Carlson is editor of the monthly newsletter, Retirement Watch. In it, he provides independent, objective research covering all the financial issues of retirement and retirement planning. Carlson also is Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System and the founder of Carlson Wealth Advisors, L.L.C.