Avoiding Costly IRA Mistakes

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My column from last week (“Inheriting My Husband’s IRA”) generated several questions. One reader wanted to know if his daughter could inherit his IRA with the same rules that apply to spouses. (Sorry, she can’t.) Another reader, this one from Salzburg, Austria, wondered tongue-in-cheek what the Irish Republican Army had to do with retirement savings. (I assured him we were discussing Individual Retirement Accounts, not terrorist organizations.) As I thought about these and other questions, I decided it would be worthwhile to review three costly mistakes people make in their IRAs and how to avoid them. They are listed in order of increasing severity.

Mistake #1: Failing to take your required minimum distribution (RMD) on time.

When an IRA owner turns 70 ½ years of age, she is required to begin taking required minimum distributions. The distribution for the first year is due by April 1 of the year following the year in which she turns 70 ½. RMDs for subsequent years are due by December 31.

The penalty for missing your RMD deadline is severe: 50% of the missed RMD. However, if you miss an RMD or are late in your payment, all is not lost. Follow these three steps and chances are the IRS will waive the penalty.

1.    Take the RMD.

2.    File IRS Form 5329 “Additional Taxes on Qualified Plans (Including IRAs)”.

3.    Attach a letter to Form 5329 explaining why you missed the RMD deadline, that you have          since taken the RMD, and that you have taken steps to prevent a recurrence of the                      problem. The IRS will usually respond within a few months.

Mistake #2: Prohibited Investments

IRAs are very flexible. They can own just about anything, but they cannot own insurance policies or “collectibles.” If you invest in a prohibited asset in your IRA, your investment will be deemed to be a distribution. You will owe tax (and a possible early withdrawal penalty) on the value of the prohibited investment at the time the investment was made.

Collectibles include works of art, rugs, antiques, metals, gems, stamps, most coins, and any alcoholic beverage. The IRS allows some gold and silver coins minted by the U.S. Treasury or other gold coins of a certain purity standard (at least .995 fine) and certain precious metal bullion. All such holdings must be held by an IRA trustee or custodian to qualify.

Mistake #3: Prohibited Transactions

The most serious mistake you can make in your IRA is to engage in a “prohibited transaction.” A prohibited transaction disqualifies the entire IRA as of the beginning of the year in which the prohibited transaction occurs. In practical terms, this means you will owe tax (and possibly an early withdrawal penalty) on the entire value of your IRA.

A prohibited transaction occurs when IRA assets are used for the personal benefit of the IRA owner, his or her beneficiary or a disqualified person. Disqualified persons include the IRA owner’s fiduciary, spouse, ancestor, lineal descendant or spouse of a lineal descendant. (Note that siblings and spouses of siblings are not considered disqualified persons.)

Prohibited transactions are not uncommon. For example, if your IRA owns rental property and you rent it to your child, parent or the investment advisor for your IRA, you have engaged in a prohibited transaction. If your IRA makes a loan to your wife’s business, you have engaged in a prohibited transaction. Given the huge downside, IRA investors need to be very careful about prohibited transactions.

 

Steven C. MerrellMBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell,   2340 Garden Road Suite 202, Monterey, CA93940 or email them to steve@montereypw.com.