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Investing Specialists

Avoid These 8 Mistakes With Your IRA

Goofs can crop up during the accumulation phase as well as when you roll over monies and take distributions in retirement.

Funding an IRA may seem like one of the simplest of financial tasks: Pick your provider, send in your money, and choose your investments. Done.

But a look at the Internal Revenue Service publication that details the ins and outs of IRAs--all 114 glorious pages of it--suggests there's more to it. There are two key IRA types that you can choose (Traditional or Roth), as well as two subtypes of Traditional IRAs (deductible and nondeductible), not to mention byzantine rules regarding rollovers, conversions, and recharacterizations. And what about when you begin taking IRA withdrawals in retirement? More kooky rules there, too.

In a previous article I discussed some of the key goofs investors can make when funding their IRAs. That's top-of-mind around tax time, as individuals try to make IRA contributions that will count for the previous year.

But you can also run into problems with an IRA at other times, as well. You may know the obvious IRA mistakes, such as pulling your money out of a Traditional IRA before age 59 1/2, but here are some IRA pitfalls that might be less familiar.

Mistake 1: Not taking full advantage of the tax benefits.
One of the key benefits of any type of IRA--whether Roth or Traditional--is the ability to avoid taxes as your money grows. Hold stocks and bonds in a taxable account and you'll likely receive taxable income and capital gains distributions from your holdings each year. Hold the assets in an IRA, by contrast, and you won't owe any taxes on those payouts, assuming you don't take the money out prior to age 59 1/2. That gives you a golden opportunity to stash high-income-producing securities, such as high-yield bonds and dividend-paying stocks (especially those that produce nonqualified dividends, such as REITs) within the IRA wrapper, while saving more tax-efficient assets, such as broad market equity index funds, in your taxable account.

Mistake 2: Being dogmatic about asset location.
Yet even as it generally makes sense to place income-producing assets within an IRA wrapper, you may also have good reasons to do otherwise. They key consideration is when you expect to need the money. If you're a young accumulator, your IRA should be stock-heavy, and there's no reason to go out of your way to add income producers into the mix. Meanwhile, if you're a 35-year-old holding bonds to fund a remodeling project, you'd of course want to hold them in a taxable account, where you'd face no strictures to withdraw your money before retirement. (You may want to consider municipal bonds in that case.)

Ditto if you're retired and would like to pull some money for living expenses from your taxable account. It doesn't make sense to have all of your bonds residing in your IRA; bonds' relative liquidity might be helpful in your taxable account, too. Finally, it's worth noting that it's often desirable to tap Roth assets toward the back end of retirement--if at all--because their tax-saving features are the greatest so you want to stretch them out as long as you possibly can.

Mistake 3: Not giving due care to IRA beneficiaries.
The importance of beneficiary designations--they actually trump other bequests that you may have laid out in your estate plan--is an underdiscussed topic. Most people, especially young accumulators, fill out the forms without a second thought. Yet naming a beneficiary for an IRA is a surprisingly complicated business. As with any type of beneficiary designation, it's important to keep your IRA beneficiary designations up to date as your life situation changes--marriages, divorces, parents passing away, and so forth. Most people will name their spouses as their IRA beneficiaries; when the account owners die, their spouses can roll the assets into their own IRAs. Meanwhile, naming your estate as a beneficiary of an IRA usually results in forgone tax advantages. This article details some of the key considerations to bear in mind when deciding who should inherit your IRA.

Mistake 4: Triggering a tax bill on a Roth IRA withdrawal.
One of the key benefits of funding a Roth IRA is the ability to take tax- and penalty-free withdrawals in retirement. The Roth is also a great vehicle for accumulators who worry about tying their assets up for a long time, as it's possible to withdraw contributions at any time and for any reason without triggering taxes or a penalty. Things get more complicated, however, when it comes to withdrawing investment earnings, or if your money got into the Roth because you converted it from a Traditional IRA or 401(k). In that case, you risk running afoul of the five-year rules for Roth IRAs, outlined here

Mistake 5: Triggering a tax bill on a rollover.
When it comes to the financial tasks that might crop up on your to-do list during your investment career, an IRA ranks as easy on the degree-of-difficulty scale. But it's still possible to goof up a rollover. One of the key rules to bear in mind if you're rolling over money from a former employer's 401(k) into an IRA is the 60-day rule--that is, you have 60 days to complete the rollover. If you don't complete the rollover within that 60-day window and you're younger than 59 1/2, the amount will be treated as an early distribution and be subject to taxes and a 10% penalty. That's why it's a good idea to have your providers deal with one another on the rollover. That way you never put your hands on the money, and the financial-services providers well know the need to complete the rollover in a timely fashion.

Mistake 6: Letting your brokerage or fund company call the shots on your RMDs.
Investors who are age 70 1/2 know that that's the year in which they must begin taking required minimum distributions from their Traditional IRAs and 401(k)s in accordance with IRA tables. Those RMDs are taxable, which is the key reason I often hear retirees grousing about them. But RMD season also gives you the opportunity to make lemonade by being strategic about the investments from which you pull the distributions. Did your stock holdings shoot up in 2013? If so, it's an ideal time to trim those holdings to restore your asset allocation back to your targets. As long as you take the right amount of RMDs from all accounts of a given type (you can't mix and match RMDs from your 401(k) and IRA, for example), you'll be on the up and up with the IRS. By contrast, if you leave it to your brokerage fund company to decide where to pull the money from, it may not be to your advantage--they'll pull the money in accordance with their default rules, often proportionally from each holding. This article provides more detail on how to make the most out of your RMDs.

Mistake 7: Not appealing a penalty on missed RMDs.
Fail to take the RMD, and you'll be on the hook not just for the taxes, but also a 50% penalty (excise tax) on the amount that you should have taken and did not. That said, there may be legitimate reasons that you (or a loved one) missed the RMD. Perhaps you were ill, for example, or perhaps your parent is in the early stages of dementia and you haven't yet implemented a system to help with financial matters. The first step is to take the required distribution as soon as possible. Then fill out IRS form 5329 in accordance with these instructions, requesting a waiver of the 50% excise tax on missed distributions and providing the reason. Assuming the IRS finds that the missed RMD owes "to reasonable error and you are taking reasonable steps to remedy the shortfall," you should be able to get that penalty waived.

Mistake 8: Spending RMDs you don't need.
In addition to the taxes due on RMDs, many retirees grouse about the distributions because they're taking them over their desired distribution rates. Shortly after they commence, RMDs quickly escalate well above the distribution rates that much research deems safe and up into the range of 6% or 7%. Of course, it's also true that as retirees age, they can arguably take more from their portfolios than they could earlier in their retirement years because their life spans are shorter. Additionally, your IRA may not be your whole retirement kitty; you can forgo distributions from other account types so that your RMDs don't take you over your planned spending rate. But if the RMD requirements are going to take you over your planned distribution rate, you can and should reinvest the money back into your retirement accounts--either a taxable account or a Roth IRA, if you or your spouse have enough earned income to cover the conversion amount.

See More Articles by Christine Benz