Regardless of the type of retirement plan (IRA, 401k, Roth IRA, Profit Sharing) that you may be contributing to, all of them have common rules and common pitfalls. Don’t get me wrong; the concept of saving for retirement is a noble endeavor. Unfortunately, you may be exposing yourself, giving away a large portion of your savings over your lifetime. How is that possible? There are many factors that contribute to this. Use the list below to create a checklist for you to do a thorough housekeeping of your retirement plan.
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1. Only using tax-deferred accounts. Take advantage of Roth IRAs and after-tax accounts.
Who says the best way to save for retirement is your company 401k or an IRA? Receiving a tax benefits up front may not be your best option in the long run. Most of us are told that we are deferring taxes today so we can take money out at retirement at a lower rate. However, if tax rates go up, you have deferred today to pay higher taxes later.
You should consider some strategies today that give you options later. By contributing to a Roth, you now have an option to take out funds tax-free with no required distributions and your beneficiaries receive funds tax-free. You may also want to consider putting money into an ordinary after-tax investment account. Unlike retirement accounts, there are no penalties for taking out money prior to 59 ½, and you do not have the restrictions of investment options
2. Improperly allocating asset classes
Investments have different types of tax treatment. Appreciating assets, stocks, mutual funds, and real estate have what are referred to as “capital gains.” Interest and dividends are considered investment income and are taxed at ordinary tax rates. Income tax rates are typically higher and, unlike capital gains, are not deferred until the sale of the underlying asset. Each year you receive a 1099 and pay tax on income you may not be using. Therefore, it might make sense to place income-producing assets in your retirement accounts not in your after-tax accounts, where possible.
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3. Properly establishing and updating beneficiaries
As routine as this may seem, most people are not able to name with absolute certainty, who they have listed as beneficiaries on their retirement accounts. Have there been any changes in your life, such as a marriage, birth of a child, divorce, job change or death? The first step is to conduct what we call a “Beneficiary Audit.” Contact every company and ask for an updated hardcopy of your beneficiaries for your files.
4. Naming your spouse as beneficiary.
I realize that this may seem counterintuitive. However, it may be the best option for you, your wife, and your family. There are a couple potential reasons. First, it can be more tax efficient for a surviving spouse to keep the IRA as an inherited beneficiary IRA or disclaim it to use the deceased spouses’ estate tax exemption. The other reason would be to make sure that your children are not disinherited. If the spouse assumes ownership, he or she can also change beneficiaries. By allowing access without ownership, you maintain your beneficiaries and eliminate the potential for errors by not allowing for changes.
5. Naming minor children as beneficiaries.
A minor cannot control funds. Court appointed guardians are in control. This will not only involve probate court, but may result in the designation of someone you did not want in control of the funds. Once the child reaches age of majority, 18 or 21, the only thing left to determine is what they will buy first and how fast they can spend it. You may also want to consider using a vehicle such as a living trust to control distributions to minors.
6. Taking lump-sum distributions.
The “stretch-IRA” is probably a term you have heard before. What this means is that IRS code allows for non-spouse beneficiaries to “stretch” distributions from the inherited IRA over their life expectancy. If the beneficiary takes a lump-sum distribution, they are required to recognize the entire amount as income for that year and pay all the tax. This can result in an instant 30% to 40% reduction in the account value and loss of future tax-deferral. If set up properly, the beneficiary can take a minimum distribution based on age, pay the lower tax and continue the tax-deferral.
7. Assuming a nonworking spouse cannot contribute.
Separate “spousal” IRAs may be established for spouses with little or no income. Typically, an individual is required to have earned-income to contribute. However, if one spouse has income the other spouse can establish and contribute to an IRA as well.
8. Not taking advantage of increased contribution limits.
Contribution limits for IRAs and 401ks have increased over the years. Additionally, if you are over age 50, you can make additional “catch-up” contributions. This means that you can put an additional $1000 per year into your IRA and $5000 into your 401k.
9. Rolling company stock into an IRA.
Special consideration is given to company stock held in a 401k. Generally, all distributions from 401ks are treated as ordinary income. However, there is a provision in the IRS code referred to as Net Unrealized Appreciation. When transferred, only the cost basis of the stock is taxed at ordinary income; the balance is taxed at capital gains tax rates. This does not occur until it is sold.
10. Taking the wrong required minimum distribution (RMD)
At 70 ½ the IRS code requires you to take a minimum distribution. The amount is determined by what is referred to as the Uniform Table. In order to determine your distribution, you need to divide the entire value of your retirement accounts as of December 31st of the prior year and divide by the number provided in the table. If you take too little, you are assessed a 50% penalty on the difference between your required amount and what you actually took out.
With almost 20 years of financial industry experience, Tom Fortino prides himself on providing clients with thorough and comprehensive financial advising. Founder of Alpha Wealth Group in Oakbrook Terrace, Illinois, Fortino and his team are committed to offering clients solutions to their retirement goals. Call Alpha Wealth Group for more information: (630) 873-6326.