The IRA Tax Trap

Individual Retirement Accounts (IRAs) provide tax advantages, yet breaches in compliance could lead to steep penalties. Beneficiaries must take Required Minimum Distributions (RMDs) within each calendar year or face hefty fees and penalties.

Strategic withdrawal plans can help mitigate RMD-related taxes by enabling beneficiaries to spread out the amount they take each year – this strategy is known as the “Stretch IRA.”

1. Not Contributing to an IRA

Taxes can be complex, particularly when it comes to retirement savings. Mistakes can easily occur that compromise both your retirement income and savings; one such error is failing to take RMDs from an IRA.

Individuals aged 70 1/2 or younger and who have earned compensation are generally eligible to contribute to an IRA; however, contributions made above a certain limit are only tax deductible up to that point; any overage is subject to penalty taxes.

Note that any money withdrawn from an IRA prior to age 59 1/2 is considered income and taxes must be paid, plus possible 10% penalties may be added as well. By filing Form 8606 Part III, account owners can avoid these penalties by treating their distribution as equalizing to non-taxable contributions and earnings.

2. Naming a Trust as a Beneficiary

When making changes to an IRA account, if they wish to make a trust the beneficiary of it, the account owner must complete a beneficiary form at their brokerage institution. While their online portal usually provides instructions, it would always be prudent to seek expert tax and/or legal advice when making this decision.

Assigning assets to a trust can complicate the transfer of an IRA to beneficiaries, but may be necessary due to second marriage issues or family structures that do not allow for lifetime payout options or treat-as-own privilege with direct heirs of deceased owners of an IRA.

Trusts also can speed up distributions of an IRA asset more rapidly. Required distributions from trust-held IRAs must be calculated using the life expectancy of their oldest trustee, in contrast to direct beneficiaries or lifetime payout options for spouses who receive assets directly.

3. Rolling Over an IRA to Another Account

As people change jobs or retire, it can be advantageous to transfer money from their workplace retirement account into an IRA. While this process is frequently done, if done incorrectly it could prove costly.

Timing and knowing which accounts to distribute are of key importance when making distributions. A direct trustee-to-trustee transfer is often the easiest and simplest way of moving funds between trusts; here, funds from one trustee go directly to another one and are then deposited by them into their accounts.

Indirect transfers tend to be faster, but can quickly turn into tax surprises if you fail to observe the 60-day time limit or make mistakes with them. Furthermore, the IRS only permits one indirect rollover every 12-months; any subsequent indirect rollovers would count as withdrawals (and potentially incur an early-withdrawal penalty). Staying aware of these rules can help avoid unexpected tax surprises that could cost thousands.

4. Naming a Trust as a Beneficiary

Many assets that transfer by beneficiary designation, including IRAs and retirement accounts, have complex tax rules that must be carefully observed by an experienced tax professional.

At times it may make sense to name a trust as an IRA beneficiary. For instance, this could be beneficial when providing support for someone with special needs who cannot own property directly or may lose out on government benefits if their IRA assets were held directly by them.

Nominating a trust as the beneficiary of an IRA may also bring unintended ramifications. Because trusts do not qualify for IRS’ stretch option, required minimum distributions (RMDs) will be calculated using life expectancies of their oldest trust beneficiary rather than as would have been the case had it been left directly to someone; this could result in much larger RMDs later down the line compared with leaving it directly to someone. This could create unexpected difficulties down the road for beneficiaries.


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