5 Crucial IRA Tax Planning Strategies

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Someone once said “It takes a great deal of boldness and a great deal of caution to make a great fortune and when you have got it, it requires ten times as much wit to keep it.” Although exactly who said it is unclear, the message is definitely clear. Many of you have been building your retirement savings for years, even decades. No matter how much you have saved, you definitely don’t want to lose some of it by making an avoidable mistake.
While the market volatility can be a major threat to some retirement plans, Uncle Sam is an unavoidable reality for most of us. And unless you have a Roth IRA, if you take a withdrawal from a Traditional IRA, or comparable tax-deferred account, you are inevitably going to pay taxes. No way to avoid it, but you may be able to minimize the amount of taxes and/or penalties by paying attention to some key areas.
Here are five pointers that may help you avoid penalties and/or reduce your tax liability.
IRA and Roth IRA Income Limitations
If you make improper contributions to your IRA or Roth IRA, penalties can apply. There are no income limits to contribute to a conventional/traditional IRA, but some of the contributions you make to your IRA, thinking they will reduce your taxable liability, might not be allowed and could be disqualified in the future. Taxes and penalties may be assessed in arrears. Specifically, if you are active in a company-sponsored retirement plan, income limits apply to how much of your contribution will be tax-deductible. The deduction starts to phase out if your Modified Adjusted Gross Income (MAGI) is $98,000 for married/joint filing ($61,000 for single) and is entirely phased out if your MAGI is greater than $118,000 for married/joint ($71,000 for single).
If you are married and are not active in a company-sponsored retirement plan, but your spouse is, then the deduction phases out from $184,000 to $194,000 MAGI for your contribution. The rules above apply separately to your spouse’s potential contribution.
RMD Aggregation
If you don’t take the Required Minimum Distribution (RMD) from your tax-deferred plan(s), such as IRA, 401(k), 403(b), etc., which are required in the year in which you turn age 70 ½, you may have to pay a major penalty. You can defer the first year’s distribution to the second year, but then you have to take two RMDs in the second year. Except for the first year, you have to follow the rules every year to avoid the penalty. And the penalty is a stiff one! It’s 50% of the RMD – and you still have to pay the income tax as well. For example, if the RMD is $2,500 and you are in the 25% marginal federal income tax bracket, the penalty would be $1,250 (paid to the IRS), along with the $625 income tax on the full $2,500, leaving you with $625! You definitely want to avoid this penalty.
Here is one of the more common ways to make a mistake in this area. You remember to take the RMD from your primary IRA, but you forget that you have other IRA accounts. In order to fully satisfy the IRS, you have to withdraw the RMD based on ALL of your tax-deferred accounts, including any annuities that you may own in an IRA. Your total RMD for any given tax year is calculated by taking the current value of all of your tax-deferred accounts as of December 31st of the prior year, and dividing it by the government’s uniform life expectancy table, giving you the minimum amount that must be distributed from your tax-deferred accounts. The penalty applies to the amount that you are short. It’s also important to know that you don’t have to take withdrawals from each separate account. Strategically, it might make sense for you to take the entire RMD from one account, or two accounts; it’s up to you. The IRS doesn’t care where it comes from they just require you to take the total RMD each year. Make sure you follow this requirement and avoid the costly penalty!
Inherited IRAs – Spousal Beneficiary
It is common for a spousal beneficiary to roll an inherited IRA into their existing IRA. That’s okay if the surviving spouse is over 59 ½. However, if the spouse is under 59 ½, it is important for that spouse to keep it separate as an inherited IRA in order to preserve the right to withdraw funds without the 10% early withdrawal penalty, which is waived for this type of account. On the other hand, if the spouse beneficiary is over 59 ½, an inherited IRA can be combined with another IRA.
Another key difference for a spousal beneficiary is that they do not have to immediately begin taking an RMD unless the original owner had reached 70 ½ and had started taking the RMD. If the original owner had started taking an RMD, then the spouse has to continue to take the RMD based on the spouse’s life expectancy after the year in which the original owner died.
Inherited IRAs (and Roth IRAs) – Non-Spousal Beneficiary
Non-spousal beneficiaries of any age who want to “stretch” the IRA withdrawals over their life expectancy must start the RMD in the year following the death of the original owner, regardless of whether that owner had reached age 70 ½ or not. They also want to keep an inherited IRA separate in order to preserve the ability to withdraw funds without the 10% early withdrawal penalty. Once they reach age 59 ½, they can combine it with another IRA, though they may want to keep it separate if they are utilizing the “stretch” option.
Note that Roth IRA owners are not required to take an RMD, but non-spouse beneficiaries are required to take an RMD from an inherited Roth IRA (spouses are exempt from this requirement). If they do not, the 50% penalty will apply, even though withdrawals from any Roth IRA are tax-free.
Inherited IRAs – Wrong Beneficiary
This pointer won’t produce any tax savings, but it may keep a tragedy from occurring. Unfortunately, people don’t always pay enough attention to who they have named as beneficiaries. There are many stories following a divorce, death or remarriage where owners forget to update their beneficiaries.
Beneficiaries should be reviewed after every major life event to ensure that the information is properly updated on the account. A basic will does not apply to any tax-deferred account, unless the individual’s estate is the named beneficiary. And this is typically not a recommended strategy as it robs the potential beneficiaries of the opportunity to “stretch” IRA withdrawals over their lifetime.
As you can see, IRAs can have quite an effect upon an individual’s tax situation. IRA accounts continue to grow in popularity, as more and more businesses move away from providing traditional defined pension plans and workers are expected to take on a more significant role in funding their own retirement. Not surprisingly, the rules and regulations surrounding IRAs are very complex and often confusing. The same can also be said to our Tax Code. Thus, if you are seeking some assistance with gaining more clarity about IRAs and the role they can play within your own retirement planning, give me a call and we can talk about doing so.