Brocker.Org: 5 Ways to Lose Your Retirement Nest Egg

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There are two surefire ways for you to help your retirement accounts grow: maximizing your contributions as often as you can and properly managing the investments in your accounts. But there are also ways to significantly decrease the size of your retirement nest egg. Here’s a look at five actions that could lead to the loss of your retirement savings. Once you know what they are, it should be easier to avoid these mistakes.

1. Making Ineligible Rollovers to Your IRAs

Rolling over funds you receive as distributions from your retirement account helps you to defer including these distributions in your income, and to ensure that any earnings on such amounts accrue on a tax-deferred (or tax free, for Roth IRAs) basis.

However, this is the case only if the amount is rollover eligible. Ineligible rollovers can result in your owing severe penalties to the IRS, and any taxable portion of the amount rolled over to your IRA must be included in your income for the year the distribution occurred. To ensure that this doesn’t happen to you, you need to know which assets are not rollover eligible. They include the following:

  • Required minimum distributions (RMDs) – A common mistake people make when they roll over RMD amounts is to assume that the RMD amount can be taken after the rollover is made. This is not the case because the first amount withdrawn during a year for which an RMD is due includes the RMD amount. Here is an example:
An Example of RMD Rollovers and Withdrawals

John reached age 70½ in 2016. Because of this, John’s RMD from his 401(k) plan for the 2016 plan year, which was $10,000, had to be distributed from the account by April 1, 2017. In June 2016, John rolled over $30,000 from his 401(k) account to his traditional IRA. John believed the transaction was acceptable, as his first RMD did not have to be withdrawn until the following April. However, while John could have deferred withdrawing his RMD until April 1, 2017, any withdrawals made from his 401(k) during his first RMD year are considered to include his RMD for the year. As such, $10,000 of the $30,000 was not rollover eligible and created an excess contribution of $10,000 in his traditional IRA for the 2016 tax year. If John failed to remove the amount from his IRA in time, he would owe a 6% penalty ($600) on the amount for every year it remains in the IRA. Furthermore, John would need to have included the $10,000 in his income for the 2016 tax year.

  • Hardship withdrawals from qualified plans and 403(b) accounts
  • Excess contributions that are withdrawn or returned from your retirement account
  • Loans that are distributed because they are in default or do not satisfy other regulatory requirements
  • Distributions that are part of a series of substantially equal periodic pension or annuity payments made at least once per year for at least 10 years, and amounts that are calculated using your life expectancy or the joint life expectancy of you and your beneficiary
  • Distributions for the cost of life insurance coverage
  • Distributions made to you from a qualified plan, 403(b) account or IRA that represent distributions to you as a beneficiary after the death of the retirement account owner, unless you are the spouse beneficiary of the deceased. (For further reading, see Moving Retirement Plan Assets: How to Avoid Mistakes and Exceptions to the 60-Day Retirement Account Rollover Rule.)

2. Making Excess Contributions to Your IRA

IRA contributions are limited to the lesser of 100% of eligible compensation or the contribution limit for the year. Should you contribute more than the allowable limit to your IRA, you must remove this excess amount from your IRA by the applicable deadline. Similar to ineligible rollovers, failure to remove the excess amount by the deadline will result in your owing the IRS a penalty of 6% of the amount for each year it remains in your IRA. (To learn more, see An Introduction to Correcting Ineligible IRA Contributions, Tax Treatment of Ineligible IRA Rollovers and How to Correct Ineligible (Excess) IRA Contributions.)

3. Making Ineligible Roth Conversions

A Roth IRA conversion is viewed by many as a good financial-planning move because earnings accrue on a tax-deferred basis, while distributions are tax-free if qualified. If you make an ineligible Roth conversion, it can be corrected as a recharacterization. Should you fail to recharacterize an ineligible conversion on a timely basis, the amount will be treated as ordinary income from your traditional IRA and an excess contribution to your Roth IRA. Therefore, not only would you lose the tax-deferred status of your IRA assets, but you would also owe a 6% penalty for each year the excess contribution remains in the Roth IRA. (For further reading, see Did Your Roth IRA Conversion Pass or Fail? and Recharacterizing Your IRA Contribution or Roth Conversion.)

“There are many reasons why a Roth conversion may be ineligible, such as a premature reconversion after recharacterization or accidentally converting a required minimum distribution (including beneficiaries). In order to remedy the situation, individuals must recharacterize the conversion and any earnings by their tax-filing date,” says Mark Hebner, founder and president, Index Fund Advisors, Inc., Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

4. Failing to Distribute Your RMD

You must begin taking RMDs from your traditional, SEP and SIMPLE IRAs, qualified plan, and 403(b) accounts by April 1 after the year you reach age 70½, and must continue for each subsequent year. Exceptions apply to qualified plan accounts and 403(b) accounts if you are still employed and your employer allows you to defer beginning RMDs from such accounts until after you retire. (This applies only to that employer’s account, not other accounts you might still have from previous employers – see 401(k): Pressure’s On to Leave It at Your Old Job).

Failure to take your RMD by the applicable deadline will result in you owing the IRS an excess accumulation penalty of 50% of the RMD shortfall. While it is not required that this penalty be withdrawn from your retirement assets, you may have no choice but to use your retirement assets to pay it if you have no other financial resources. You may apply for a waiver of the penalty, but you are generally required to pay the penalty first and request the waiver thereafter. (For more information, see 3 Steps to Take If You Missed Your RMD Deadline.)

5. Engaging in Prohibited Transactions

You are prohibited from using your IRAs in certain transactions, such as security for a debt or to invest in collectibles. Engaging in these transactions could result in loss of tax-deferred status for the assets involved in the transaction and, in some cases, loss of tax-deferred status for the entire IRA. The following are a few examples:

  • If your IRA is pledged as security for a loan, the extent of the consequences is determined by whether the account is an individual retirement account or an individual retirement annuity. For an IRA, the amount pledged as security for the loan is treated as a distribution to the IRA owner. For an individual retirement annuity, the entire balance, as of January 1 of the year the pledge occurs, will be treated as a distribution to the IRA owner, regardless of the amount that is pledged as security for a loan. The distribution will be treated as ordinary income and be subject to a 10% early-distribution penalty, unless an exception applies.
  • If your IRA assets are invested in collectibles, such as artworks, rugs, antiques, precious metals, gems, stamps, coins and alcoholic beverages, the value of the investment is treated as a distribution to the IRA owner. The distribution will be treated as ordinary income and subject to a 10% early-distribution penalty, unless an exception applies. (See 5 Investments You Can’t Hold in an IRA/Qualified Plan.)

The Bottom Line

Most taxpayers now find it natural to consult with investment advisors, tax professionals and attorneys; however, the same cannot be said for those who need assistance managing their retirement accounts. Few people seek assistance from a retirement planning professional for issues such as moving IRA assets and making IRA contributions, but they should. The number of individuals losing the tax-deferred status of their IRA assets and paying large penalties because they’ve misunderstood the portability rules and eligibility requirements for certain transactions is increasing at an alarming pace.

“Making ineligible contributions to your IRA, not taking RMDs, and making excess contributions or prohibited transactions can absolutely decimate your retirement savings. But all can be rectified fairly easy if you take certain steps and hit the problem head-on. Waiting or avoiding is a behavior that could be your death knell,” says Dan Stewart, CFA®, president and chief investment officer, Revere Asset Management, Inc., Dallas, Texas.

Unless you are absolutely sure of the effect that a certain transaction will have on your IRA assets, you should consult with a financial professional who is well-versed in the rules and regulations of retirement plans. This is key to protecting and building your retirement nest egg.

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