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IRA Distribution Mistakes--How To Blow Your Retirement Money
By: Larry Klein
With the population aging and over 4000 people a day being forced to take IRA
distributions (such distributions are mandatory by April 1 after reaching age 70
1/2), mistakes in taking IRA distributions can total in the billions. Yet,
because people have had no prior experience, mistakes are rampant. Here are 4
common IRA distribution mistakes to avoid.
IRA Distribution Mistake #1
Every IRA owner can name a beneficiary and "stretch" the IRA for maximum tax
deferral over the next generation.
Informed IRA owners believe that the following will occur with retirement assets
they do not use during their lifetime. Say they leave $500,000 of retirement
assets to heirs. They believe junior will make small withdrawals each year
(required by IRS) and at 6%, the account with a 42-year-old beneficiary, will
generate $2.5 million during junior's lifetime (IRA distributions plus ending
balance at life expectancy). This sounds great but it may never happen.
There are at least 2 ways that the stretch IRA can fail. The first way is
because of a custodian with rules that do not permit lifetime IRA distribution
payments. This is particularly common in qualified plans where the rule may be
that "all IRA distributions to beneficiaries are to be completed within 5
years." Since no one ever reads that fine print for their qualified plan, they
have no idea that a fast IRA distribution will be forced to non-spouse
beneficiaries.
The other problem is the beneficiary. Just because mom and dad have the good
sense to understand tax deferral does not mean that junior will comply with this
wisdom. The minute junior finds out that he can close the IRA, distribute all
the money and buy a Ferrari and Lamborghini at the same time, he does so, pays a
fortune in taxes and blows the money to have fun.
The way to control this is to have leave retirement assets in an IRA trust. In a
trust, mom and dad can control how the heir gets paid.
IRA Distribution Mistake #2
I am leaving my IRA to my wife. I only have one son and he can do with the IRA
what he wants when we are both gone. My situation is simple.When most people
select beneficiaries for their IRAs, they select their spouse or their children.
As simple as this seems, it can create problems. Consider these two scenarios.
When a plan owner leaves an IRA account to the spouse, it inflates the spousal
assets. And when the spouse later dies with an estate exceeding $2 million (the
estate exemptions limit in 2006), they pay estate tax. By leaving the IRA to the
spouse, the deceased spouse has created unnecessary estate taxes by making the
survivor's estate larger.
So instead, they leave the IRA to the son. But as indicated before, this leaves
the son total control over the asset. He may withdraw the funds immediately and
decide to buy a mansion jointly with his spouse (who was despised by mom and
dad). To complete the misery, let's say that the following week, the
daughter-in-law files for divorce and gets to keep the mansion in the
settlement. Mom and dad just gave the despicable daughter-in-law a mansion with
their IRA money. Even in death they have money problems.
To avoid the above two scenarios, they decide to leave the IRA to their
"estate." Many attorneys advise that you never leave a retirement plan to your
estate. Because at death, the IRS requires the account to be rapidly distributed
rather than enjoy the potential stretch over the lifetimes of beneficiaries.
Additionally, the IRA will now be a probate asset and subject to claims of
creditors. So what do rich people do to avoid the three gloomy scenarios above?
They leave their IRA in a trust and appoint a trustee like an accountant,
financial advisor, attorney, etc., a person that has good common sense and tax
knowledge. Within the boundaries of mom's and dad's wishes and IRS-required
minimum distributions, the trustee will determine who among the beneficiaries
will get the IRA and how much they get. The trustee will determine how quickly
this IRA money gets distributed over and above the annual minimum amount of
required IRS IRA distributions. Mom and dad can even give very detailed
instructions. For example, they could dictate no IRA distributions for purchases
of homes with the despicable spouse. Or if the money is to be used for education
they may stipulate that up to $15,000 a year can be distributed, or to start a
business up to $25,000 can be distributed, and they can go on and on with such
instructions.
IRA Distribution Mistake #3
The IRA owner has checked with the custodian and yes, they do allow lifetime
distributions to non-spouse beneficiaries. Additionally, their two unmarried
sons understand tax deferral and there is no need for a trust. Everything is
okay.
Many plan owners don't consider what happens if their beneficiary pre-deceases
them.
Let's say you have two sons, Jack and Tom. Your name them as primary
beneficiaries for the IRA distributions by completing an "IRA Beneficiary
Designation Form" at the bank or securities firm. Jack and Tom each have a son.
Jack's son is Bob. Tom's son is Dan. So you write the grandson's names on the
line of the beneficiary designation form that says "secondary beneficiaries."
If Jack dies before his parents who own the plan assets, they probably think
Jack's share goes to his son, Bob. Wrong.
It goes to Tom, because on the beneficiary designation form, there is no place
to specify how the primary beneficiaries and secondary beneficiaries are
related. There is no place for you to explain your intentions or write "per
stirpes" to clarify intentions with respect to those beneficiaries. Those
beneficiary designation forms with the bank or the securities firm are not
sufficiently detailed to carry out your wishes.
At minimum, you should replace those forms with your own forms, called an "IRA
Asset Will." This can be inexpensively prepared by any attorney. And if the
custodian won't accept it, move your account to another custodian.
IRA Distribution Mistake #4
Failing to use IRA funds for charitable intent
If you want to leave even $1 to charity, do it from your IRA money. You can
specify one or more charities to receive portions of the IRA and the heirs will
thank you. When taxpayers leave heirs a dollar of IRA funds, the heirs will pay,
for example, 35 cents to tax and have 65 cents left to spend. If the estate is
over $2 million, heirs will also pay estate tax on this money and may have only
30 cents left from each dollar. However, when mom and dad leave heirs a dollar
that is non-retirement money, heirs can spend it with no income tax. Therefore,
heirs would much rather have "regular" money and not IRA money.
About the Author:
Gain more knoweldge about managing your IRA from Larry Klein, CPA/PFS, CFP at
http://www.required-minimum-distribution.com and financial advisors can download
an entire library of articles at http://www.ira-distribution.com.
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