The IRA Tax Trap

An IRA can be an essential tax-deferred investment tool; however, its complicated contribution rules and ongoing recordkeeping can trap investors with unexpected tax liabilities in their retirement years.

Similarly, if you make non-deductible contributions and fail to maintain adequate records of these contributions, your heirs could face tax on lifetime after-tax contributions made prior to Roth conversion benefits becoming available.

1. Ignoring Required Minimum Distributions (RMDs)

After age 70 1/2, RMDs must be taken from both individual retirement accounts (IRAs and some employer-sponsored retirement accounts) in order to avoid incurring a 50% penalty fee. Failure to take these distributions could incur this fee.

Rules vary slightly depending on whether you are the original owner, beneficiary, or non-spousal heir of an asset, but one thing they all share in common: failure to take RMDs when required will incur taxes upon withdrawal.

But, there is good news if you discover an RMD error and take make-up distributions; the IRS won’t treat them as taxable income on past returns (subject to other unrelated errors). That’s because individuals use cash-basis taxation and report their RMDs in current-year returns; that’s why it’s crucial that RMD errors be rectified quickly by self-reporting as soon as they arise.

2. Ignoring Step-Up in Basis

Making after-tax contributions to a traditional IRA may provide tax-deferred growth; however, when withdrawing it in retirement it will be taxed again and could push retirees into higher income tax brackets and impact Medicare means testing.

After leaving an old job, many investors will transfer balances from company retirement plans into an IRA for maximum tax efficiency. It is critical that this transfer be planned carefully in order to minimize tax bills; for example if Jack purchased Apple stock for $20k then James inherits it when he passes on. When James sells it at $100,000 without incurring capital gains taxes owing (due to step-up in basis), this would be great; but if withdrawing and not rolling over within 60 days you will incur a federal income tax bill!

3. Ignoring Roth Conversions

If you make after-tax contributions to an IRA, the IRS requires that they be reported and tracked. Otherwise, when withdrawing funds they could be considered taxable income and may incur penalties if you’re under 59 1/2.

Problems may compound if you hold multiple traditional IRA accounts. Under IRS aggregation rule, all traditional IRAs are treated as one tax entity for purposes of calculating taxes owed when making a Roth conversion – meaning nondeductible conversion amounts would come before tax-deductible contributions, possibly prompting an additional 10% tax bill. Fortunately, you can avoid this trap by keeping records and planning accordingly for conversions (including avoiding states with income taxes when possible).

4. Ignoring Beneficiary Designations

IRAs offer an excellent way of investing your after-tax dollars tax-deferred until retirement. But if you roll over too much from an unrelated account or neglect to file Form 8606 when making non-deductible contributions, the extra taxes could add up and cause you to overpay taxes twice.

Inheritance taxes can also be an unexpected pitfall. Prior to the SECURE Act, beneficiaries could spread out distributions from inherited retirement accounts over their lives in order to reduce annual tax bills; now however, all funds must generally be distributed within 10 years.

Avoiding traps with Qualified Charitable Distributions (QCDs). These count towards RMDs but must meet specific rules in order to qualify. Consulting a financial professional is also useful in helping navigate these tax traps and any retirement-related mistakes that might arise.

5. Ignoring Rollovers

Many investors underestimate the significance of devising tax-efficient strategies for their retirement accounts, leading their heirs to pay higher income tax than necessary.

The IRS mandates that after-tax contributions be tracked and reported annually through Form 8606. If your financial institution misreports non-deductible contributions on statements, double taxation could occur and you would end up paying twice in taxes for those same dollars.

Beneficiaries of IRAs and 401(k)s must pay income taxes on distributions based on their life expectancies. Prior to the SECURE Act, beneficiaries had the option of “stretching out” distributions over multiple lifetimes to reduce annual taxes paid; this provision has now been eliminated under SECURE Act; beneficiaries should take note. It’s an important change they shouldn’t ignore.


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