As the population ages and more than 4000 people a day are forced to take IRA distributions (they must do so by April 1 after turning 70 and a half), mistakes in taking IRA distributions can add up to billions of dollars. But because most people have never done anything like this before, they make a lot of mistakes. Here are 4 common mistakes to avoid when taking money out of an IRA.
Mistake #1: Giving Out Your IRA
Every IRA owner can name a beneficiary and "stretch" the IRA to get the most tax deferral over the next generation.
Owners of IRAs who know what they're doing think that the following will happen to the assets they don't use during their lifetimes. Say they leave their heirs $500,000 in retirement savings. They think that Junior will take out small amounts each year (as required by the IRS), and at 6%, the account with a 42-year-old beneficiary will bring in $2.5 million over Junior's lifetime (IRA distributions plus ending balance at life expectancy). This is a great idea, but it might never happen.
At least two things can go wrong with the stretch IRA. The first way is because the custodian has rules that don't let IRA payments be made for life. This happens a lot with qualified plans, where the rule may be that "all IRA distributions to beneficiaries must be finished within 5 years." Since no one ever reads the fine print of their qualified plan, they don't know that beneficiaries who are not their spouses will have to take a fast IRA distribution.
The other problem is who will get the money. Even if mom and dad are smart enough to understand tax deferral, that doesn't mean that junior will do the same. As soon as Junior finds out that he can close his IRA, give out all the money, and buy a Ferrari and a Lamborghini at the same time, he does so, pays a lot of money in taxes, and uses the money to have fun.
To stop this, you can put your retirement savings in an IRA trust. With a trust, the parents can decide how the heir gets paid.
Mistake #2: Giving Out Your IRA
My IRA will go to my wife. I only have one son, and when both of us are dead, he can do whatever he wants with the IRA. My problem is easy to explain. Most people choose their spouse or their children as beneficiaries for their IRAs. Even though this seems easy, it can cause trouble. Think about these two situations.
When a plan owner dies and leaves an IRA to a spouse, the spouse's assets go up. When the second spouse dies, if their estate is worth more than $2 million (the limit for estate exemptions in 2006), they have to pay estate tax. By leaving the IRA to the surviving spouse, the person who died didn't need to pay estate taxes because the IRA made the surviving spouse's estate bigger.
So, they give the IRA to their son instead. But, as we've already said, this gives the son full control of the asset. He could take the money out right away and decide to buy a mansion with his wife (who was despised by mom and dad). To make things even worse, let's say that the daughter-in-law files for divorce the next week and gets to keep the mansion as part of the settlement. Mom and dad just used their IRA money to buy a mansion for their awful daughter-in-law. Even after they die, they have trouble with money.
They decide to leave the IRA to their "estate" so that neither of the above things will happen. Many lawyers say that you should never put your retirement plan in your will. Because when someone dies, the IRS wants the money to be given out quickly instead of being spread out over the beneficiaries' lifetimes. Also, the IRA will now be part of the estate and can be claimed by creditors. So, what do rich people do to keep from ending up in one of those three bad situations? They put their IRA in a trust and choose a trustee who has good tax knowledge and common sense, like an accountant, financial advisor, lawyer, etc. The trustee will decide who will get the IRA and how much they will get based on what mom and dad wanted and what the IRS requires as minimum distributions. The trustee will decide how quickly this IRA money, which is more than the minimum amount the IRS requires an IRA to give out each year, is given out. Even more, mom and dad can give very clear instructions. For example, they could say that the despicable spouse couldn't use IRA money to buy a house. Or, if the money is to be used for education, they might say that up to $15,000 a year can be given out. If the money is to be used to start a business, they might say that up to $25,000. These kinds of instructions can go on and on.
#3: Giving Money Out of an IRA
The owner of the IRA has checked with the custodian and found out that non-spouse beneficiaries can receive distributions for life. Also, their two sons who are not married understand tax deferral, so they don't need a trust. Nothing is wrong.
Many people who own plans don't think about what will happen if their beneficiary dies before they do.
Say you have two sons whose names are Jack and Tom. By filling out a "IRA Beneficiary Designation Form" at a bank or securities firm, you can name them as the main people who will get money from your IRA.
Each of Jack and Tom's sons is a boy. Bob is Jack's son. Dan is Tom's son. So, you write the grandson's name on the "secondary beneficiaries" line of the beneficiary designation form.
If Jack dies before his parents, who own the plan assets, they probably think that Jack's share goes to his son, Bob. Wrong.
It goes to Tom because there is no place on the beneficiary designation form to say how the primary beneficiary and secondary beneficiary are related. There is no place for you to explain your intentions or write "per stirpes" to clarify your intentions with those beneficiaries. Those beneficiary designation forms at the bank or securities firm don't have enough information for your wishes to be carried out.
At the very least, you should replace those forms with your own, which is called a "IRA Asset Will." Any lawyer can put this together for a low price. And if the custodian doesn't agree, move your account to someone else.
Mistake 4: Giving Out Your IRA
Not giving money from your IRA to charity
Donate even $1 to charity from your IRA if you want to. You can choose one or more charities to get money from your IRA, and your heirs will be grateful. When a taxpayer leaves a dollar in an IRA to their heirs, for example, the heirs will pay 35 cents in taxes and have 65 cents to spend. If the estate is worth more than $2 million, the heirs will also have to pay estate tax on this money, and each dollar may only be worth 30 cents after this. But if mom and dad leave their kids a dollar that isn't for retirement, the kids can spend it without paying taxes on it. So, heirs would much rather have "normal" money than money from an IRA.
