Common and Costly IRA Mistakes: Divorce and Death
As if divorce or death weren’t tough enough, Congress and the Internal Revenue Service do not make the rules that apply to Individual Retirement Accounts any easier in either of these times of distress. “You don’t know what you don’t know” can come back to financially bite you, as many financial moves, once made, cannot be reversed.
Divorce. When a married couple splits up, so do their assets in most cases. I was attending a continuing education session at a conference recently where a case study was presented. A dentist and his wife had recently divorced and she was entitled to half of his $1 million IRA. Not realizing his options and the IRA rules, the dentist withdrew $500,000 to give to her. At tax time, he received a 1099-R, which indicates distribution from a retirement account. Unbeknownst to him, taking the money out of the IRA and writing her a check constituted a distribution rather than a transfer. Thus, she received the same $500,000 as she would have had he initiated a direct transfer from his IRA custodian directly to her IRA custodian. However, because he withdrew the money instead, he had to pay ordinary income taxes on the entire $500,000 in the year it was taken out of his IRA, as well as the 10% federal and his state premature distribution penalties since he was under age 59 ½. The $500,000 distribution was added as ordinary income on top of his earned income for the year, bumping him into the highest tax bracket.
Death. It is almost always most beneficial to name your spouse as the primary beneficiary of your retirement accounts. A spousal beneficiary has the option to inherit the retirement account directly as their own, or as a Beneficiary IRA. Which one is optimal for the surviving spouse depends on the ages of the couple upon the IRA owner’s death as well as the surviving spouse’s personal circumstances. The surviving spouse, as beneficiary, may retitle a Beneficiary IRA into their own IRA in the future, however, when an inherited IRA is titled into their own IRA, it may not be retitled to a Beneficiary IRA, so it is best to turn over all stones before making financial moves in this case. If you are a non-spouse beneficiary, specific rules apply to you. Eligible Designated Beneficiaries, as defined by the SECURE ACT of 2019 may have the option to “stretch” the tax deferral of the IRA. Consult with your tax professional to see if you qualify, and for how long. All beneficiaries need to be aware of Required Minimum Distribution rules, especially if the IRA owner had reached his or her Required Beginning Date before passing. Additionally, non-EDB's must empty the IRA account within 10 years. If a trust was named beneficiary, other rules may apply. Overall, be sure you know the distribution rules that apply to you. Failing to take your RMD’s will subject you to a substantial penalty. Furthermore, if a beneficiary to an IRA failed to empty the inherited IRA by the end of the 10th year following the inheritance, the entire account balance becomes subject to the RMD penalty.
Unlike your own IRA, you may not contribute to an inherited IRA. Doing so would also subject you to penalties.
IRAs can be powerful tools preparing for as well as navigating through your retirement. The benefits surrounding IRAs may make the accounts well worth your efforts in building them. If you do not follow the rules along the way though, the mistakes can be costly, adding insult to injury in the events of divorce or death.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
The term "stretch IRA" is a marketing term used to describe an IRA that is set up to extend the period of tax deferred earnings beyond the lifetime of the individual who created the account. The accounts are typically designed to last over multiple generations.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
LouAnn Schulfer of Schulfer & Associates, LLC Wealth Management can be reached at (715) 343-9600 or louann.schulfer@lpl.com. SchulferAndAssociates.com , louannschulfer.com or louann.biz
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