Three IRA Mishaps That Can Cost a Bundle
Karen Hube
11/06/07 - 12:05 PM EST
Your IRA assets -- and your parents' -- may be at risk, and not due to big dips in the stock market or lousy investment choices. There's something else to worry about: bad advice and mistakes by bankers, brokers or financial advisers who handle or advise on transactions in individual retirement accounts.
"There is a big gap in knowledge about IRA rules, and it is the individual investor who suffers because of it," says Michael Nelson, an IRA adviser based in Baxter, Minn.
IRA mishaps can cost investors a bundle, both in terms of taxes and the loss of years of tax-deferred growth.
Here are some of the most common mistakes investors suffer at the hands of professionals who should know better:
Undoing Your IRA
If you have more than one IRA, nothing should be more run-of-the-mill than moving assets from one to another to consolidate accounts. But some banks or brokerages inadvertently cash out investors' accounts in the process, Nelson says.
"Investors end up with a tax bill for their entire account, and the IRA they thought they had is now just a regular bank account," he says.
The problem occurs when one institution -- either the custodian that is trying to move assets out or the institution receiving the assets -- calls the transaction a "rollover" instead of a "transfer," Nelson says. "They simply check the wrong box on the form because they don't know the difference."
A transfer is not reported to the IRS. A rollover is reported as a payout to an individual. When this error occurs, the investor must pay the tax bill and forgo future tax-deferred earnings on the assets. It's possible to have an IRA reinstated and the taxes refunded by appealing to the Internal Revenue Service, but the process is bureaucratic and time-consuming.
Blowing an Inherited IRA
Thanks to new rules that went into effect in 2003, you can stretch an inherited IRA over your lifetime as long as you were named its beneficiary. But many advisers are unaware of the new law.
It used to be that an inherited IRA had to be cashed out by the end of the fifth year after the death of its original owner. Now, however, heirs can keep an inherited IRA for their lifetimes as long as they take minimum distributions each year and properly rename the account as an inherited IRA.
What's the difference? If you inherit a $500,000 IRA at age 50 and cash it out, you would pocket $325,000 after paying Uncle Sam at the 35% income tax rate. But, says Alan Augulis, a Warren Township, N.J., estate planner, if you keep the IRA intact, take minimum distributions each year and earn 8% on the money, you could have pocketed well over $2 million by age 84.
Michael Reilly, a financial planner in Avon, Conn., who gives seminars on IRAs, recently heard from a distraught investor who had cashed out an inherited IRA over two years on advice from both a broker and accountant. Once he realized the mistake, it was too late. Unlike IRA transfers that are misreported as being cashed out, IRA cashouts made as the result of bad advice cannot be reversed.
Another common error: Investors are advised to simply roll an inherited IRA into their own IRA. "I see this all the time -- but if someone does that, the inherited assets will be considered cashed out and will be fully taxable," says Ed Slott, an IRA adviser and consultant in Rockville Centre, N.Y.
Overlooking Valuable Deductions
Typically, the adviser who deals with taxes on an estate is different from a beneficiary's adviser. As a result, a big potential benefit to IRA beneficiaries often gets lost in the shuffle.
When federal estate taxes are paid on IRA assets, the beneficiary of the IRA is allowed to take a tax deduction on withdrawals. Called an Income With Respect of a Decedent Deduction, or IRD, its value is based on how much of the estate tax paid is attributable to the IRA assets.
Ruining IRA Potential for Heirs
Investors who aren't sure whom to name as their IRA beneficiary are often advised to simply name their estate. That way, the IRA assets will simply be divvied up according to your will, right?
True, but then the beneficiaries miss the opportunity to stretch the IRA over their lifetimes. An IRA left to an estate, rather than beneficiaries, must be cashed out within five years of the original owner's death.
