Sometimes referred to as “ticking tax time bombs” IRAs are loaded with potential tax traps that can cause your IRA to blow up in your face. The secret to avoiding unnecessary tax on your IRA is to steer clear of these common mistakes.
60-day rollover. To the IRS a “rollover” is when you take custody of your IRA assets, usually in the form of a check made payable to you.
When you receive funds from your IRA, you have 60 days to “rollover” your funds back into your IRA. Failing to do so is a taxable event.
If you are under 59 ½ and fail to rollover your IRA funds within the 60-day window, your distribution will be taxable and you will pay a 10% penalty in most cases. After adjusting for federal and state income tax as well as the 10% early withdrawal penalty, a 60-day rollover mistake could cost you up to half your IRA.
Don’t over do it. The IRS allows only one 60-day rollover per taxpayer, per 12-month period. Previously taxpayers were allowed one rollover per IRA. With multiple IRAs you could do multiple rollovers. That is no longer the case. The rules on this were made more clear in a 2014 Tax Court decision that went into effect in January of 2015.
For more information on the rollover rules, click here.
Non-spouse rollover trap. If you follow IRA expert, Ed Slott, at all you know that he always makes one point very clear: Non-spouse beneficiaries (your kids, siblings, etc.) may NEVER do a rollover of the inherited funds into their own IRA. In this case, a rollover is a taxable event that can’t be undone.
A rollover, in the strict IRS definition, is described above.
If you are a non-spouse beneficiary (for example, of your parent’s IRA), you will need to do a direct trustee-to-trustee transfer to a properly titled inherited IRA. Most IRA custodians can help you with this.
The titling of the new inherited IRA account should be something like this: “Sue Nelson IRA (deceased January 1, 2016) FBO Jack Smith beneficiary” or words to that effect. Different IRA custodians may phrase it differently, but the key is that the original owner’s name remains on the account and it’s clear that this is an inherited or beneficiary IRA.
A direct trustee-to-trustee transfer of an IRA to a properly titled inherited IRA avoids any unnecessary tax and penalties.
Prohibited investments and transactions. IRAs are prohibited from owning certain types of assets. Life insurance and collectibles like artwork, antiques and coins are all examples of assets that the IRS prohibits you from owning in an IRA.
The IRS prohibits certain IRA transactions as well. Borrowing money from your IRA, using your IRA as security for a loan, and buying property for your personal use can cause your IRA to become “disqualified” and your entire IRA balance could be subject to tax and penalties.
Often it’s not the asset that creates the problem but what you do with it once it’s in your IRA.
For example, you may own real estate in your IRA. However, the rules surrounding exactly what you may and may not do with that real estate are complex. Get them wrong and your entire IRA balance can blow up due to taxes and penalties.
For more detailed information on the dos and don’ts IRA assets read IRS publication 590, and work with an IRA custodian that specializes in self-directed IRAs.
Missing an IRA RMD. This mistake will cost you 50% of your Required Minimum Distribution (or RMD). Your RMD can be taken from one IRA or several. The IRS considers your various IRA accounts to be one. They don’t care which IRA you take your RMD out of, just so long as you take your IRA RMD.
If you notice your mistake, take immediate action to correct it. The IRS has been known to waive the penalties. To fix your IRA RMD mistake follow the steps outlined in this previous blog post.
Beneficiary mistakes. One of the biggest IRA mistakes of all is to have no beneficiary listed for your IRA. Depending on the default rules of your IRA custodian, it’s possible your IRA may be paid to your estate if you fail to list a specific, named beneficiary.
Passing your IRA to your estate when you die is a taxable event. After the IRS takes their cut, the heirs of your estate get to fight over what’s left – usually not much.
This mistake can be easily avoided by making sure you always list a specific person or persons as beneficiary on your IRA.
Making mistakes with complex strategies. Rules like Substantially Equal Periodic Payments aka rule 72-T, and Net Unrealized Appreciation or NUA, can be very effective ways to minimize tax or penalties on your IRA – when done correctly.
However, if you make a mistake your entire IRA balance could become taxable and subject to the 10% penalty for early withdrawals if you are under age 59 ½.
Overfunding an IRA. Occasionally, funding an IRA can be a little too much of a good thing. You added to your Roth IRA, but your income turned out to be too high to make a contribution. Or maybe you took a tax deduction on your IRA, then found out you don’t qualify to deduct your contributions from your taxable income.
Overfunding an IRA is easy to fix, but if you fail to remove your excess contributions, the IRS will hit you with a 6% excess contribution penalty for each year that the money remains in the IRA. If you don’t notice your mistake right away, the taxes and penalties add up.
Kaboom. Funding your IRA or retirement plan is the easy part. It’s what happens afterwards that can cause your IRA to explode in a flurry of unnecessary taxes.
Avoid turning your IRA into a tax time bomb by steering clear of these 7 mistakes.