5 Common IRA Mistakes and How to Avoid Them
May 1, 2014 | Your Finances
You’ve worked hard to build your retirement savings; it makes sense that you want those assets to work hard for you and your family. IRAs (which means “individual retirement accounts” or “individual retirement annuities”) offer a great way to save because of the tax benefits they can provide. So what’s the catch?
While IRAs are simple to own and use, they can be trickier than you may think, especially if you aren’t aware of certain rules and regulations surrounding your account. To help you understand why, here are five common IRA mistakes plus ways to avoid or fix them.
1. Not jumping on board. It may seem obvious, but the biggest mistake you can make with an IRA is not opening one in the first place. After all, your ability to enjoy a financially secure retirement is dependent upon your diligence in socking away as much money as you can today. Both Traditional and Roth IRAs allow annual contributions of up to $5,500 in 2014, subject to income limits, plus a $1,000 catch-up contribution if you’re age 50 or older.
Consider this: Sign up for an IRA right away. And if you think you earn too much to open an IRA, think again. You can always take advantage of a nondeductible traditional IRA, which offers tax-deferred compounding of your investment earnings but no tax deduction for your contributions.
2. Letting your IRA sit in “idle.” When opening an IRA, many people fail to make a decision about how they want their contributions invested. As a result, their money is sitting on the sidelines in a money market fund rather than taking advantage of any potential market gains.
Consider this: Be sure to specify how you want your IRA contributions invested when completing your IRA form. But don’t set it and forget it. Review your investment mix with your financial professional at least once a year to ensure your money is being invested according to your needs, risk tolerance and time horizon.
3. Contributing too much. Strange as it may sound, it can be easy to put more into an IRA than you’re allowed. Maybe you made a contribution earlier in the year and forgot about it. Perhaps you earned less than you expected and ended up contributing more than your earned income for the year. Or maybe you turned age 70½ and forgot that you can no longer add to your traditional IRA account. Whatever the reason, here’s what you need to know: The Internal Revenue Service (IRS) strictly controls contributions, income and age limits and will penalize you 6 percent of your excess contribution for each year you fail to take corrective action. So if you contributed $1,000 more than allowed to an IRA, for example, you would owe $60 in penalties each year until you remediate the error.
Consider this: There are three options for fixing a contribution error. First, you can withdraw the excess amount, plus any earnings specifically tied to it, by the due date of your tax return (plus extension) for the year the contribution was made and avoid the IRS penalty. Second, you can “recharacterize” your excess contribution by opening another type of IRA (assuming you’re eligible). For example, let’s say you contributed the maximum allowed to a Roth IRA only to find you earned more than the income limits. You could open a traditional IRA and have your excess IRA contribution sent directly to that account. Finally, you can elect to carry your excess contribution into the next year and treat as next year’s contribution. You’ll still owe the 6 percent penalty for the current year, but you won’t have to hassle with taking other steps to remedy the problem.
4. Failing to name, review and update your beneficiary. Unlike other types of property, IRAs normally do not pass to your heirs through your will. Rather, they are passed according to the terms of your IRA beneficiary designation form. So, without a properly named beneficiary for your account, your IRA could pass to your estate and become subject to probate (and subject to your will). This can also result in the loss of important wealth preservation options, such as a spousal rollover and the ability to “stretch” the tax-deferred compounding potential of your IRA and any taxes due over many years.
Consider this: To save money and preserve your wealth, be sure you’ve named a primary and contingent beneficiary for your IRA. But here again, don’t “set it and forget it”; review your designation form at least annually or whenever you experience a major life event, such as the birth or adoption of a child, marriage, divorce or the death of a family member, to make sure your beneficiary designation accurately reflects your wishes.
If you’re thinking about naming a trust as your beneficiary, rather than an individual, keep this in mind: Having a trust, instead of a spouse, as beneficiary might hinder the surviving spouse’s ability to roll over the IRA into his or her name and thus take advantage of IRA ownership rules.
5. Taking the wrong required minimum distribution (RMD). If you’re age 70½ or you inherited an IRA, you are required to take distributions from the IRA each year (original owners of Roth IRAs are not subject to RMD rules). Failure to do so could result in a federal income tax penalty of 50 percent of the amount that should have been distributed but wasn’t, plus applicable ordinary income tax.
Consider this: Make sure you take your RMDs by December 31 each year. The one exception is the year in which you turn 70½; then you have the option to wait until April 1 of the following year to begin your RMDs. However, doing so will mean you need to take two RMDS that year, which will increase your taxable income—and perhaps your tax bill. RMD rules can be complicated, especially when you own two or more IRAs. Consolidating your retirement assets into one account can make it easier to manage those distributions.
When it comes to your financial security in retirement, it’s important to use every savings strategy you can for building wealth, and IRAs can play a vital role in your overall financial plan. The key is understanding IRA rules so you can safely maximize the tax advantages they offer both during your working years and throughout retirement.