Too many people leave money on the table when managing their IRAs. There are a lot of decisions to make, and the wrong choices can result in higher taxes or even penalties.
That's a shame, since IRAs are among the most valuable assets most people own. Resolve this year to review the IRA strategies discussed here and adopt those that will improve the management and after-tax value of your IRA. You probably won't benefit from each of these strategies, but you should consider them and decide which could benefit you.
Required distributions. The IRS has been lax in enforcing the rules for required minimum distributions after age 70, and people make a lot of mistakes with their RMDs, according to recent IRS studies. So, the IRS is stepping up its enforcement. We can't cover the details of RMDs here, but I have in past, and those discussions are in the members' section of our web site. Review the rules and your options carefully to be sure you are avoiding penalties and minimizing taxes.
Don't forget catch-up contributions. When you're still working and making contributions and are age 50 or older, you can contribute an additional $1,000 to an IRA for 2014 and 2015, and an additional $6,000 to a 401(k) in 2015. In 2015 and 2014, the maximum IRA contribution for those 50 and over is $6,500, instead of $5,500. The limit applies to both traditional and Roth IRAs. You can contribute it all to one type or split it between both types of IRAs. You have until you file your income tax return or 2014 to make a 2014 contribution, or until April 15, 2015, whichever is later.
Consider spousal contributions. Generally IRA contributions can be made only to the extent you have earned income from a job or business. There's an exception for married couples when one spouse has little or no earned income. When they file a joint return, contributions to separate IRAs for each spouse can be made up to the maximum, as long as one spouse has at least that much earned income. That means when each spouse is age 50 or older, they can contribute $6,500 for each spouse for a total of $13,000, even when only one spouse has a paid job.
Review your beneficiaries. Perhaps the most common mistake with IRAs is to name the wrong beneficiaries or fail to keep beneficiary designations up to date. There are some interesting court cases in which ex-spouses and other unexpected beneficiaries inherited IRAs because the beneficiary form wasn't updated.
Another mistake is to name the estate, trust, or another beneficiary that under the law requires the IRA to be distributed quickly, preventing stretching out the IRA and causing early tax bills.
What's in your will doesn't have anything to do with who receives your IRA. Be sure to review your beneficiary forms every year or two and any time there is a change in your family. Discuss with your estate planner the effects of choosing different beneficiaries.
Practice tax diversification. Different types of accounts have different tax rules now, but those rules could change. Tax rates also could change. You shouldn't try to predict these changes or structure your finances based on what is most advantageous to you today.
It's safer over the long term to have different types of accounts so you won't be burned completely in any scenario. Spread your investments among taxable accounts, traditional IRAs and 401(k)s, and Roth IRAs and 401(k)s. You might even want to put some money in an annuity if that's appropriate for you.
Consider a conversion. Every year, consider whether it makes sense to convert all or part of a traditional IRA into a Roth IRA. This is another topic we can't discuss in-depth here but have in the past. Whether conversion is a good idea for you depends on factors such as the expected rate of return, the difference between your current tax rate and future tax rates, the source of the cash to pay the taxes, whether future required minimum distributions would exceed your spending needs, and more.
Keep in mind that a Roth IRA avoids RMDs and helps you avoid stealth taxes and higher Medicare premiums in the future. It also gives you better control over when taxes are paid.
It could be that most years an IRA conversion doesn't make sense for you. Yet, one year you might have an unexpected opportunity to make a conversion at low cost when you have a sharp drop in income or a large offsetting deduction. That's why you should review the decision at least every year. You don't want to miss an opportunity to create a stream of tax-free income.
Consider the back-door Roth. Higher-income people can't contribute to Roth IRAs because the tax law doesn't allow them to. Instead, they can make nondeductible contributions to a traditional IRA, and then convert that to a Roth IRA. There shouldn't be any taxes on the conversions, and they'll have Roth IRAs. This can be done every year. But be careful if you already have a traditional IRA with deductible contributions. Then part of your conversion might be taxed.
Another strategy is to make after-tax contributions to a 401(k) if your plan allows them, and roll them directly to a Roth IRA when you roll over the rest of the 401(k) to a traditional IRA. The IRS recently revised its rules to make clear that this strategy works.
Own the right assets in the right accounts. You pay a price for the tax benefits of the traditional IRA, a price you can think of as a mortgage on the IRA. When money other than nondeductible contributions is withdrawn from the traditional IRA, it is taxed as ordinary income. That means tax-advantaged long-term capital gains and dividends are converted to higher-taxed ordinary income.
You can minimize these negative effects by having each type of account own the right assets for it when possible. My research, which has since been backed by other research, reveals that assets paying ordinary income are best held in IRAs, either a traditional or Roth. These investments include high-yield bonds, real estate investment trusts, and investment grade bonds. Also, when stocks, mutual funds, and other investments are likely to be owned for less than one year and generate short-term capital gains, they are best owned through a traditional or Roth IRA. Investments that generate long-term capital gains, such as stocks and mutual funds held for more than one year, should be owned in taxable accounts, as should investments that earn qualified dividends.
When possible, it is best to own your highest-returning assets in a Roth IRA.
You also might own nontraditional investment assets, such as real estate, small business interests, gold, and master limited partnerships. There could be taxes when these investments are owned by IRAs, and some assets are prohibited to IRAs. Be sure you know the tax rules for investing IRAs before you buy nontraditional assets. You can find details in my report, IRA Investment Guide, available through the Bob's Library tab on the Retirement Watch web site.
Owning assets in the right accounts increases after-tax wealth for you and your family. Of course, you don't want to let the tax law dictate your portfolio allocation. For example, if you don't have enough money in taxable accounts to fully fund your desired stock allocation, buy some of the stocks through an IRA. Asset allocation comes first, and tax strategies second.
Spend accounts in the right order. The order in which you draw down your different accounts affects how long your nest egg lasts, primarily because of taxes. As a general rule, it's best to spend taxable accounts first, traditional IRAs and other tax-deferred accounts next, and Roth IRAs last. Spending in this order can make your wealth last a few years longer.
Consolidate or split? I'm a big advocate of simplifying your finances, and that often means consolidating your finances at one financial institution and in as few accounts as possible. Many people have multiple IRAs, and simplifying means rolling them over into one IRA when practical.
There are exceptions to every rule. Suppose you have multiple heirs and expect an IRA to be a significant legacy for them. You could name all the heirs as joint beneficiaries of one IRA and let them decide what to do with the account after they inherit. That could become messy. An alternative is to split the IRA into different IRAs now and name a different person as the primary beneficiary of each. If the heirs aren't likely to agree on how to manage an IRA, you might want to split the IRA now.
Consider charity. When you're going to leave part of your estate to charity, the most tax efficient way to do that might be to name the charity as a beneficiary of an IRA. When individuals receive distributions from an inherited IRA, they must pay income taxes on the distributions just as the owner would have. The beneficiary receives only the after-tax value of the IRA. But individuals can receive most other types of assets from an estate free of income and capital gains taxes. A charity, on the other hand, doesn't pay taxes on IRA distributions it receives as a beneficiary. The charity receives the full benefit of its share of the IRA. It's more tax efficient to make a charitable bequest through an IRA when you can.
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