Five Retirement Account Tax Traps to Avoid
Most people have set aside a large amount in individual retirement accounts (IRAs) or qualified retirement plans, such as 401(k) or profit-sharing plans. These accounts offer substantial tax advantages, but they’re also fraught with traps for the unwary. Here are five common mistakes to avoid:
- Missing Required Minimum Distributions
The penalty for failure to take a required minimum distribution (RMD) from an IRA or qualified plan is among the harshest in the tax code—a 50% “excess accumulation” tax on the amount you should have withdrawn. (See “RMDs: When and how much?” below)Suppose you are over age 70½ and you are required to take a $50,000 RMD by December 31, 2016. If you miss the deadline, you are liable for a $25,000 penalty tax.
- Naming Your Estate as Beneficiary
If you designate your estate as beneficiary of an IRA or qualified plan, the RMD rules depend on when you die. The RMD rules for the estate are complicated and can accelerate the timeframe of taking the required distributions.It is often preferable to name an individual beneficiary, such as a younger spouse or child, to avoid the confusion and to allow the beneficiary (or beneficiaries) to stretch the distributions over longer periods, maximizing tax deferral.
- Failing to Take RMDs from an Inherited IRA or Qualified Plan
If you inherit an IRA or qualified plan account from someone other than your spouse, and you roll the funds into an “inherited IRA,” you are generally required to begin taking RMDs by December 31 of the year following the year of the account owner’s death. This rule applies regardless of whether you inherit a traditional or a Roth account. Failure to comply is subject to the same 50% penalty tax described above. Typically, you are permitted to stretch RMDs over your life expectancy, maximizing the benefits of tax deferral. Qualified plans are required to allow rollovers to a non-spouse’s inherited IRA, except in certain limited circumstances. A common, but costly, mistake is to overlook the account owner’s final distribution. If the account owner was required to take an RMD in the year of death, but died before withdrawing the full amount, you as beneficiary must withdraw any remaining amounts by the end of the year.
- Titling an Inherited IRA Incorrectly
To take advantage of the tax-deferral benefits of an inherited IRA or qualified plan, it is critical that the account be retitled properly upon the account owner’s death (unless you inherit from your spouse and execute a spousal rollover). Suppose, for example, that John Doe names his daughter, Jane, as beneficiary of his IRA. When John dies, the IRA must continue to be titled in John’s name, using language such as “John Doe (deceased) IRA for the benefit of Jane Doe.”If you retitle an inherited account improperly — “Jane Doe IRA,” for example — it is possible that the IRS may treat the transaction as a taxable distribution of the entire account balance.
- Falling into the Spousal Rollover Trap
If you inherit an IRA or qualified plan account from your spouse, you have an opportunity to roll over the benefits into your own IRA. The advantage of a spousal rollover, rather than an inherited account, is that you need not begin taking RMDs until you reach age 70½.However, watch out for a potential tax trap: If you are under age 59½, and you wish to access your spouse’s retirement funds now, you will be subject to a 10% early withdrawal penalty (unless you qualify for an exception, such as financial hardship). Under these circumstances, you are better off keeping some or all of the funds in an inherited account, from which you can withdraw penalty-free.
Look Before You Leap
As you approach age 70½, or if you inherit an IRA or qualified account, consult your tax advisors before taking any action. They can help you understand your options and avoid unpleasant tax surprises.
Sidebar: RMDs: When and How Much?
If you own a traditional IRA or a non-Roth qualified plan account, the tax code requires you to begin taking RMDs once you reach age 70½.
Generally, you determine the amount of your RMD by taking your account’s fair market value as of the end of the preceding year and dividing it by your life expectancy (pursuant to IRS tables). For the year in which you turn 70½, you have until April 1 of the following year to take your first RMD. After that, RMDs are required by December 31 of each year.
There is an exception for 401(k) and other defined contribution plans: If you continue to work after you turn 70½, and you own less than 5% of the employer’s company that sponsors the plan, you need not begin taking RMDs until April 1 of the year following the year in which you stop working.
Last, you are not required to take lifetime distributions from Roth accounts, although your non-spouse beneficiaries are required to take RMDs after your death.
When an Inheritance is Too Good to be True:
How Income in Respect of a Decedent Works
Most people are genuinely appreciative of inheritances, and who wouldn’t enjoy some unexpected money? However, in some cases, it may be too good to be true. While most inherited property is tax-free to the recipient, this is not always the case with property that is considered income in respect of a decedent (IRD). If you have large balances in an IRA or other retirement account — or inherit such assets — IRD can be a significant estate planning issue.
IRD is income that the deceased was entitled to, but had not yet received, at the time of his or her death. It is included in the deceased’s estate for estate tax purposes, but not reported on his or her final income tax return, which includes only income received before death.
To ensure that this income does not escape taxation, the tax code provides for it to be taxed when it is distributed to the deceased’s beneficiaries. Also, IRD retains the character it would have had in the deceased’s hands. For example, if the income would have been long-term capital gain to the deceased, such as uncollected payments on an installment note, it is taxed as such to the beneficiary.
IRD can come from various sources, including unpaid salary, fees, commissions or bonuses and distributions from traditional IRAs and employer-provided retirement plans. In addition, IRD results from deferred compensation benefits and accrued but unpaid interest, dividends and rent.
The lethal combination of estate and income taxes (and, in some cases, generation-skipping transfer tax) can quickly shrink an inheritance down to a fraction of its original value.
What Recipients Can Do
If you inherit IRD property, you may be able to minimize the tax impact by taking advantage of the IRD income tax deduction. This frequently overlooked write-off allows you to offset a portion of your IRD with any estate taxes paid by the deceased’s estate and attributable to IRD assets. You can deduct this amount on Schedule A of your federal income tax return as a miscellaneous itemized deduction. However, unlike other deductions in that category, the IRD deduction is not subject to the 2%-of-adjusted-gross-income floor.
Keep in mind that the IRD deduction reduces, but does not eliminate, IRD. And, if the value of the deceased’s estate is not subject to estate tax — because it falls within the estate tax exemption amount ($5.45 million for 2016), for example — there’s no deduction at all.
Calculating the deduction can be complex, especially when there are multiple IRD assets and beneficiaries. Basically, the estate tax attributable to a particular asset is determined by calculating the difference between the tax actually paid by the deceased’s estate and the tax it would have paid had that asset’s net value been excluded.
If you receive IRD over a period of years — IRA distributions, for example — the deduction must be spread over the same period. Also, the amount includible in your income is net IRD, which means you should subtract any deductions in respect of a decedent (DRD). DRD includes IRD-related expenses you incur — such as interest, investment advisory fees or broker commissions — that the deceased could have deducted had he or she paid them. Thus, to minimize IRD, it is important to keep thorough records of any related expenses.
As you can see, IRD assets can result in an unpleasant tax surprise. Because these assets are treated differently from other assets for estate planning purposes, contact your estate planning advisor. Together you can identify IRD assets and determine their tax implications.