Avoiding Costly IRA Blunders

IRAs are among the most valuable assets most people own, and they become more valuable after receiving 401(k) rollovers. But they aren’t the vehicles they seemed when people were opening them.

There are many misunderstandings about IRAs. These misunderstandings frequently result in taxes and penalties that easily could be avoided. IRAs aren’t the simple vehicles they seemed to be when people were opening them.

Mistakes about the tax rules on IRA distributions can be very expensive. The IRS is on to how valuable IRAs are and how many people make mistakes with them, so it’s been stepping up enforcement and penalties for IRA mistakes. Be sure you don’t make any of these classic blunders.

Fixing rollover mistakes. Most people know the basics about rollovers. All or part of an account can be transferred tax free from a qualified retirement plan (such as a 401(k) plan) to an IRA or from one IRA to another. There is no deadline for a trustee-to-trustee rollover, when the balance is rolled over directly from one trustee to another. If the account owner receives the money, however, he or she only has up to 60 days to get the same amount deposited in the same or another retirement account to avoid taxes.

Custodians handle a lot of IRA transactions. Even the best occasionally make mistakes. The mistakes can be fatal to the IRA, triggering substantial taxes and penalties.

Often, the mistakes can be corrected if action is taken quickly. If a custodian incorrectly issues a check instead of transferring an IRA directly to another custodian, there is no penalty if the check is deposited in a new IRA within 60 days. If a custodian incorrectly transfers an IRA to a taxable account instead of another trans-action that the owner intended, there also is no penalty if it is corrected within 60 days.

The key is to open promptly and study account statements and transaction notices. Don’t look simply at the changes in your investments and balances. Look at the transactions and the account title. If the custodian made a mistake, have them reverse it quickly.

The IRS does have a procedure for waiving penalties when IRA mistakes were inadvertent and not the account owner’s fault. The IRS has discretion to grant waivers of the 60-day rule, allowing additional time for the owner to deposit the funds in a qualified retirement account. The IRS explained the process for obtaining a waiver in Revenue Procedure 2003-16. The procedure also states that a taxpayer gets an automatic extension of the 60-day rule without having to apply to the IRS when the financial institution was the sole cause of the problem.

But the penalty often is not waived if the account owner did not act promptly and do all he could to meet the deadlines in the tax law. Some people use the 60-day rollover period as a no-interest loan. They often don’t realize how strict the 60-day rule is and that there are no waivers when missing the 60-day deadline was the account owner’s fault. Miss the deadline and the amount taken from the IRA will be taxable and there will be a 10% penalty if the owner was under age 59½.

Taking required distributions. Traditional IRA owners over age 70½ are required to begin required minimum distributions (RMDs). A surprising number of people don’t know about this rule or implement it incorrectly. The IRS is cracking down on missed and incorrect RMDs.

The RMD requirement applies to all qualified retirement plans, though we’ll focus on IRAs in this visit. The first RMD must be taken by April 1 of the year after the owner turns 70½. Subsequent RMDs must be taken by Dec. 31 of each year, including the year that the first RMD was required by April 1. That means if you delay taking the first RMD until early in the year following the year you turned 70½, you’ll have to take two distributions that year. You take your initial RMD, and the RMD for that calendar year.

Distributions for a year always can exceed the minimum amount.

To compute the RMD amount, total the balances of all IRAs on Dec. 31 of the previous year. Then, consult the IRS’s life expectancy tables. These can be found on our members’ web site or in IRS Publication 590, Individual Retirement Arrangements, available on the IRS’s web site at www.irs.gov. Find your life expectancy in the table and divide that into the total of all IRA account balances. The result is the RMD.

When you have multiple IRAs, the RMD is calculated as though all the IRAs were one. You then choose to take the RMD from the IRAs in any combination you want. You can take an equal amount from each IRA, take it all from one IRA, or take different amounts from each. The only rule is that the total has to equal at least the RMD for the year.

Which account to take the RMD from is a key decision for many IRA owners.

Periodic investment rebalancing is one consideration.  Investments do not often move together, so the markets change your investment allocation from the planned allocation. It is a good idea to rebalance back to your target allocation every year or so. Reduce the investments that have appreciated the most or add to those that have declined or increased less.

The RMDs can help rebalance the portfolio. Take distributions from the investments that have appreciated until they are back to your target level.

Another issue is the time or the year to take the RMDs. From an investment view, it normally is best to leave an appreciating investment in a tax-deferred account for as long as possible. Since stocks appreciate more often than not, a general rule is to let stocks appreciate in the IRA until near the end of the year, then take the RMD.

T. Rowe Price did a study that revealed that from 1993 to 2003, an IRA owner who waited as late as possible in the year to take RMDs accumulated a bit more money than an owner who took RMDs at the start of the year.

Delaying the RMDs is an advantage when the portfolio is appreciating. In bear markets, it is better to take RMDs early in the year. In fact, in the Price study, the late-distributing IRA owner was far ahead of the other IRA owner through 1999. After that, the early-distributing IRA owner rapidly caught up. Only the bull market of 2003 pushed the late-distributing owner back into a clear lead.

A conclusion many will draw from the study is that RMDs should be taken late in the year unless early in the year the owner has a reason to believe the portfolio is likely to decline. Of course, if the owner had such foresight he would change the portfolio allocation and reduce the stock holdings.

A more important conclusion to draw from the study is that your IRAs should be diversified and invested with a margin of safety. The key to long-term investment success is to avoid large losses. The IRA owners in the Price study kept their IRAs invested in the S&P 500 even when the index clearly was at a high valuation and was declining rapidly.

RMDs don’t have to be in cash. Most IRA custodians allow you to set up a taxable account. Then, to comply with the RMD rule, you can have specific shares or other property transferred from the IRA to the taxable account. You still will owe taxes on the distribution as though it had been cash. But you won’t have to liquidate an investment you like or incur expenses to buy and sell and investment just to make the RMD.

Fixing beneficiary designations. Too many IRAs designate no beneficiary or the wrong beneficiary. (See our August 2011 visit for examples.) The result can be either the wrong person inheriting your IRA or beneficiaries being required to empty the IRA faster than they’d like.

You should review beneficiary designations regularly as part of your estate plan and whenever there’s a change in your family. You also should consider having your estate planner draft a customized beneficiary form instead of working with the limited form provided by the custodian.  You or your estate planner should communicate with the custodian to be sure there won’t be problems with your beneficiary designation, and be sure your beneficiaries know their options and responsibilities.