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Money-Management Articles >> IRA Distribution Mistakes--How to Blow your Retirement Money
By Larry Klein With the
population aging and over 4000 people a day being forced to take IRA
distributions (such distributions are mandatory by April 1 after reaching
age 70 1/2), mistakes in taking IRA distributions can total in the
billions. Yet, because people have had no prior experience, mistakes are
rampant. Here are 4 common IRA distribution mistakes to avoid.
IRA Distribution Mistake #1
Every IRA owner can name a beneficiary and "stretch" the IRA for maximum
tax deferral over the next generation.
Informed IRA owners believe that the following will occur with retirement
assets they do not use during their lifetime. Say they leave $500,000 of
retirement assets to heirs. They believe junior will make small
withdrawals each year (required by IRS) and at 6%, the account with a
42-year-old beneficiary, will generate $2.5 million during junior's
lifetime (IRA distributions plus ending balance at life expectancy). This
sounds great but it may never happen.
There are at least 2 ways that the stretch IRA can fail. The first way is
because of a custodian with rules that do not permit lifetime IRA
distribution payments. This is particularly common in qualified plans
where the rule may be that "all IRA distributions to beneficiaries are to
be completed within 5 years." Since no one ever reads that fine print for
their qualified plan, they have no idea that a fast IRA distribution will
be forced to non-spouse beneficiaries.
The other problem is the beneficiary. Just because mom and dad have the
good sense to understand tax deferral does not mean that junior will
comply with this wisdom. The minute junior finds out that he can close the
IRA, distribute all the money and buy a Ferrari and Lamborghini at the
same time, he does so, pays a fortune in taxes and blows the money to have
fun.
The way to control this is to have leave retirement assets in an IRA
trust. In a trust, mom and dad can control how the heir gets paid.
IRA Distribution Mistake #2
I am leaving my IRA to my wife. I only have one son and he can do with the
IRA what he wants when we are both gone. My situation is simple. When most
people select beneficiaries for their IRAs, they select their spouse or
their children. As simple as this seems, it can create problems. Consider
these two scenarios.
When a plan owner leaves an IRA account to the spouse, it inflates the
spousal assets. And when the spouse later dies with an estate exceeding $2
million (the estate exemptions limit in 2006), they pay estate tax. By
leaving the IRA to the spouse, the deceased spouse has created unnecessary
estate taxes by making the survivor's estate larger.
So instead, they leave the IRA to the son. But as indicated before, this
leaves the son total control over the asset. He may withdraw the funds
immediately and decide to buy a mansion jointly with his spouse (who was
despised by mom and dad). To complete the misery, let's say that the
following week, the daughter-in-law files for divorce and gets to keep the
mansion in the settlement. Mom and dad just gave the despicable
daughter-in-law a mansion with their IRA money. Even in death they have
money problems.
To avoid the above two scenarios, they decide to leave the IRA to their
"estate." Many attorneys advise that you never leave a retirement plan to
your estate. Because at death, the IRS requires the account to be rapidly
distributed rather than enjoy the potential stretch over the lifetimes of
beneficiaries. Additionally, the IRA will now be a probate asset and
subject to claims of creditors. So what do rich people do to avoid the
three gloomy scenarios above? They leave their IRA in a trust and appoint
a trustee like an accountant, financial advisor, attorney, etc., a person
that has good common sense and tax knowledge. Within the boundaries of
mom's and dad's wishes and IRS-required minimum distributions, the trustee
will determine who among the beneficiaries will get the IRA and how much
they get. The trustee will determine how quickly this IRA money gets
distributed over and above the annual minimum amount of required IRS IRA
distributions. Mom and dad can even give very detailed instructions. For
example, they could dictate no IRA distributions for purchases of homes
with the despicable spouse. Or if the money is to be used for education
they may stipulate that up to $15,000 a year can be distributed, or to
start a business up to $25,000 can be distributed, and they can go on and
on with such instructions.
IRA Distribution Mistake #3
The IRA owner has checked with the custodian and yes, they do allow
lifetime distributions to non-spouse beneficiaries. Additionally, their
two unmarried sons understand tax deferral and there is no need for a
trust. Everything is okay.
Many plan owners don't consider what happens if their beneficiary
pre-deceases them.
Let's say you have two sons, Jack and Tom. Your name them as primary
beneficiaries for the IRA distributions by completing an "IRA Beneficiary
Designation Form" at the bank or securities firm.
Jack and Tom each have a son. Jack's son is Bob. Tom's son is Dan. So you
write the grandson's names on the line of the beneficiary designation form
that says "secondary beneficiaries."
If Jack dies before his parents who own the plan assets, they probably
think Jack's share goes to his son, Bob. Wrong.
It goes to Tom, because on the beneficiary designation form, there is no
place to specify how the primary beneficiaries and secondary beneficiaries
are related. There is no place for you to explain your intentions or write
"per stirpes" to clarify intentions with respect to those beneficiaries.
Those beneficiary designation forms with the bank or the securities firm
are not sufficiently detailed to carry out your wishes.
At minimum, you should replace those forms with your own forms, called an
"IRA Asset Will." This can be inexpensively prepared by any attorney. And
if the custodian won't accept it, move your account to another custodian.
IRA Distribution Mistake #4
Failing to use IRA funds for charitable intent
If you want to leave even $1 to charity, do it from your IRA money. You
can specify one or more charities to receive portions of the IRA and the
heirs will thank you. When taxpayers leave heirs a dollar of IRA funds,
the heirs will pay, for example, 35 cents to tax and have 65 cents left to
spend. If the estate is over $2 million, heirs will also pay estate tax on
this money and may have only 30 cents left from each dollar. However, when
mom and dad leave heirs a dollar that is non-retirement money, heirs can
spend it with no income tax. Therefore, heirs would much rather have
"regular" money and not IRA money.
This article was added on: April 16, 2006.
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