Retirement planning can be a tricky area to navigate because it involves hundreds of rules, and violating them can result in unnecessary taxes and penalties. Couple this with the fact that the majority of people are unfamiliar with this maze of rules and regulations and it’s not surprising that many retirees have made some costly errors in their golden years.
Knowing where the most common mistakes are made is an important step to avoiding them.
Not having beneficiaries on a retirement plan or IRA is a common blunder. If you are not sure you have beneficiaries on your accounts, you should check this immediately. Overlooking this can cause the account to go through probate where the average cost to heirs can be as high as 6 percent of the account value. It also stops the heirs from taking advantage of the inherited IRA option for non spouse beneficiaries which can be a huge tax saver.
There is a potential tax savings feature called Net Unrealized Appreciation (NUA) that applies to common stock held in an employer sponsored retirement plan, like a 401k. If done correctly, it allows you to withdraw highly appreciated stock from the employer plan and pay capital gains rates on the appreciation while paying ordinary income tax on the basis. If the majority of the stocks value is from appreciation, NUA can be a great tax saver. But it must be done "before"cthe retirement account is rolled over to an IRA.
Indirectly rolling over more than one IRA within a 12 month period is no longer allowed. This iscsometimes called a 60 day rollover, where you take receipt of the proceeds before putting them back into a new IRA. Additional 60 day rollovers will be disallowed, and worse, they'll be fully taxed, and if the IRA owner is under age 59½, they may be subject to a 10 percent early withdrawal penalty. With this new rule, it is now much better to only use trustee-to-trustee transfers which are unlimited, where you never take receipt of the proceeds.
Not paying back a loan from your 401k before rolling it over to an IRA can cause the loan to be treated as a taxable distribution and if you’re under age 59½ it will also trigger a 10 percent early withdrawal penalty.
Watch out for age related penalties; for IRAs you must be age 59 ½ before you can take a distribution without a 10 percent early penalty, unless you have an exception. At age 70½ you must start taking annual required mandatory distributions from your traditional IRA or there is a 50 percent penalty on the missed required distribution!
The first time home buyer exception and the higher education exception allows you to avoid the 10 percent early withdrawal penalty for taking distributions before age 59 1/2. But these exceptions apply only to IRAs, not employer plans. Trying to use these exceptions for an employer plan will trigger the penalty.
A common mistake is not rolling over a company retirement plan to an IRA properly. If the rollover check is made out to the employee instead of the IRA custodian, the IRS requires that 20 percent of the distribution be withheld for taxes. Although the employee will get the money back next year as a refund, if the employee wants to rollover the entire amount he or she must come up with the dollars withheld out of their own pocket. Otherwise they will owe taxes on what's not rolled over and if they are under 59½ a 10 percent penalty will be assessed. Make sure the check is made out to the IRA custodian and you will avoid this small nightmare.
Mistakes can be expensive when it comes to retirement planning. To prevent them it's important to familiarize yourself with the rules or work with a financial planner who is a retirement specialist.
• Mike Piershale, ChFC® is President of Piershale Financial Group. If you have financial questions on this column contact us at Piershale Financial Group, Inc., 407 Congress Parkway, Crystal Lake, IL 60014. You may also email Mike@PiershaleFinancial.com