With the population aging and over 4000 people a day being forced to take IRA
distributions (such distributions are mandatory by April 1 after reaching age 70
1/2), mistakes in taking IRA distributions can total in the billions.
Yet, because people have had no prior experience, mistakes are rampant. Here
are 4 common IRA distribution mistakes to avoid.
IRA Distribution Mistake #1 Every IRA owner can name a beneficiary and
"stretch" the IRA for maximum tax deferral over the next generation. Informed
IRA owners believe that the following will occur with retirement assets they do
not use during their lifetime.
Say they leave $500,000 of retirement assets to heirs. They believe junior
will make small withdrawals each year (required by IRS) and at 6%, the account
with a 42-year-old beneficiary, will generate $2.5 million during junior's
lifetime (IRA distributions plus ending balance at life expectancy). This sounds
great but it may never happen.
There are at least 2 ways that the stretch IRA can fail. The first way is
because of a custodian with rules that do not permit lifetime IRA distribution
payments. This is particularly common in qualified plans where the rule may be
that "all IRA distributions to beneficiaries are to be completed within 5
years."
Since no one ever reads that fine print for their qualified plan, they have
no idea that a fast IRA distribution will be forced to non-spouse beneficiaries.
The other problem is the beneficiary. Just because mom and dad have the good
sense to understand tax deferral does not mean that junior will comply with this
wisdom. The minute junior finds out that he can close the IRA, distribute all
the money and buy a Ferrari and Lamborghini at the same time, he does so, pays a
fortune in taxes and blows the money to have fun.
The way to control this is to have leave retirement assets in an IRA trust.
In a trust, mom and dad can control how the heir gets paid.
IRA Distribution Mistake #2 I am leaving my IRA to my wife. I only have one
son and he can do with the IRA what he wants when we are both gone. My situation
is simple.When most people select beneficiaries for their IRAs, they select
their spouse or their children.
As simple as this seems, it can create problems. Consider these two
scenarios. When a plan owner leaves an IRA account to the spouse, it inflates
the spousal assets. And when the spouse later dies with an estate exceeding $2
million (the estate exemptions limit in 2006), they pay estate tax.
By leaving the IRA to the spouse, the deceased spouse has created unnecessary
estate taxes by making the survivor's estate larger. So instead, they leave the
IRA to the son. But as indicated before, this leaves the son total control over
the asset.
He may withdraw the funds immediately and decide to buy a mansion jointly
with his spouse (who was despised by mom and dad). To complete the misery, let's
say that the following week, the daughter-in-law files for divorce and gets to
keep the mansion in the settlement.
Mom and dad just gave the despicable daughter-in-law a mansion with their IRA
money. Even in death they have money problems.
To avoid the above two scenarios, they decide to leave the IRA to their
"estate." Many attorneys advise that you never leave a retirement plan to your
estate. Because at death, the IRS requires the account to be rapidly distributed
rather than enjoy the potential stretch over the lifetimes of beneficiaries.
Additionally, the IRA will now be a probate asset and subject to claims of
creditors. So what do rich people do to avoid the three gloomy scenarios above?
They leave their IRA in a trust and appoint a trustee like an accountant,
financial advisor, attorney, etc., a person that has good common sense and tax
knowledge.
Within the boundaries of mom's and dad's wishes and IRS-required minimum
distributions, the trustee will determine who among the beneficiaries will get
the IRA and how much they get. The trustee will determine how quickly this IRA
money gets distributed over and above the annual minimum amount of required IRS
IRA distributions.
Mom and dad can even give very detailed instructions. For example, they could
dictate no IRA distributions for purchases of homes with the despicable spouse.
Or if the money is to be used for education they may stipulate that up to
$15,000 a year can be distributed, or to start a business up to $25,000 can be
distributed, and they can go on and on with such instructions.
IRA Distribution Mistake #3 The IRA owner has checked with the custodian and
yes, they do allow lifetime distributions to non-spouse beneficiaries.
Additionally, their two unmarried sons understand tax deferral and there is no
need for a trust. Everything is okay.
Many plan owners don't consider what happens if their beneficiary
pre-deceases them.
Let's say you have two sons, Jack and Tom. Your name them as primary
beneficiaries for the IRA distributions by completing an "IRA Beneficiary
Designation Form" at the bank or securities firm. Jack and Tom each have a son.
Jack's son is Bob. Tom's son is Dan. So you write the grandson's names on the
line of the beneficiary designation form that says "secondary beneficiaries."
If Jack dies before his parents who own the plan assets, they probably think
Jack's share goes to his son, Bob. Wrong.
It goes to Tom, because on the beneficiary designation form, there is no
place to specify how the primary beneficiaries and secondary beneficiaries are
related. There is no place for you to explain your intentions or write "per
stirpes" to clarify intentions with respect to those beneficiaries. Those
beneficiary designation forms with the bank or the securities firm are not
sufficiently detailed to carry out your wishes.
At minimum, you should replace those forms with your own forms, called an
"IRA Asset Will." This can be inexpensively prepared by any attorney. And if the
custodian won't accept it, move your account to another custodian.
IRA Distribution Mistake #4 Failing to use IRA funds for charitable intent If
you want to leave even $1 to charity, do it from your IRA money. You can specify
one or more charities to receive portions of the IRA and the heirs will thank
you.
When taxpayers leave heirs a dollar of IRA funds, the heirs will pay, for
example, 35 cents to tax and have 65 cents left to spend. If the estate is over
$2 million, heirs will also pay estate tax on this money and may have only 30
cents left from each dollar.
However, when mom and dad leave heirs a dollar that is non-retirement money,
heirs can spend it with no income tax. Therefore, heirs would much rather have
"regular" money and not IRA money.
