What is the IRA Tax Trap?
Millions of people own retirement assets that they want to pass down to future generations, but this can pose tax complications that are easily avoidable if planning is done properly.
Common mistakes for IRA investors involve purchasing Master Limited Partnerships (MLPs), which result in unrelated business taxable income (UBTI). As this income becomes taxable to them, their IRA owner must file IRS Form 990-T with estimated taxes throughout the year and file Form 1040 for estimated payments to IRS.
Not Contributing to an IRA
An IRA can help accelerate retirement savings by deferring taxes on investments. By contributing the maximum deductible amounts each year, it could save hundreds of thousands in taxes over your life time.
People who do not qualify for traditional IRAs because of income qualify for an alternative solution: Simplified Employee Pension plan IRAs offer shelter from earnings generated through self-employment.
If you make after-tax contributions to an IRA, it is your obligation to inform the IRS that tax was withheld on these funds by filing Form 8606. Otherwise, any time those funds are withdrawn in their entirety it will be subject to taxes at their full amount.
Avoid falling into another tax bracket through too many withdrawals by carefully planning and taking RMDs before age 70 1/2.
Not Taking RMDs
Over time, your IRA or 401(k) assets become subject to income taxes, making taking RMDs in the appropriate amounts and at the right pace an invaluable strategy to minimize lifetime taxes for yourself and your family.
Many retirees opt to postpone taking their first RMDs until later because they expect to fall into a lower tax bracket later. Unfortunately, doing so could push them into higher tax brackets and make distributions more costly.
Uncommon mistakes that people often make is to combine RMDs from multiple accounts into one total figure – this is known as the aggregation rule.
Not Rolling Over Money from a Former Employer’s Plan
When it comes time to leave a job, one of the smartest moves you can make is transferring all your retirement assets into an Individual Retirement Account (IRA). That way, everything can be kept organized and makes managing and taking RMDs simpler than ever.
By opting for direct rollover, the check from your former employer’s plan will be sent directly to the financial institution that administers your IRA rather than to yourself; this is designed to avoid having 20% withheld for income taxes and eliminates this potential source of confusion and indecision.
At any one time in a given 12-month period, you can make unlimited IRA-to-IRA rollovers within that timeframe, and combine contributions from different employer plans into one IRA account. However, the IRS sets income limits each year that determine whether you can deduct all, some, or none of your IRA contributions – these restrictions depend on your modified adjusted gross income (MAGI), with any excess exceeding this threshold leading to reduction of deductions over time.
Not Having a Beneficiary
IRAs are designed to help retirees build wealth for the future, but they can be tax traps if required minimum distributions (RMDs) aren’t taken in retirement, leading to a potential tax bill that could be quite substantial.
Failing to change beneficiaries before an economic emergency strikes is another error in judgment. Without designated beneficiaries for their IRA accounts, when an owner dies without leaving an estate beneficiary designation in place, their account could be distributed all at once and immediately subject to income taxes – rendering its tax deferral potential useless.
Beneficiaries who inherit an IRA may take advantage of the stretch IRA strategy, which allows them to delay post-death distributions until after their life expectancy. However, this only applies if their inheritor dies before 2020; those inheriting one from estates, trusts or charities don’t qualify and must take distributions much sooner; which can significantly decrease its value.