Most Americans have made substantial contributions to their 401(k)s, IRAs and other qualified retirement savings plans. The initial tax benefit makes them an attractive proposition. You don’t pay taxes on your contributions and all your gains are tax deferred – but that’s just half the story.
For many who are nearing retirement or already in retirement, their 401(k) and IRA represent the bulk of their retirement savings. When I refer to IRAs I’m referring to: 403(b), 457, TSA, TSP, SEP IRA and SIMPLE IRA that adhere to the same basic IRA distribution rules. Avoiding mistakes can save you a fortune in taxes, penalties, fees and loads.
Not long ago I was meeting with a client (we will call them Jim & Mary) reviewing their financial statements. As I looked over each of their IRA statements I noticed that they had accumulated almost $600k.
At the time Jim and Mary had been retired for almost five years, both professionals in the medical field… they had done pretty well and didn’t need the IRA assets to live on. I could tell that they were feeling pretty good, and proud of themselves for accumulating so much money in these two accounts over their lifetime.
I asked them what their primary goal was for these assets. Without batting an eye, Mary immediately said, “We want to leave this money for our three kids (three grown children and four grandkids)” and Jim backed her up by following with “I think $200k for each kid is a pretty good deal.”
Those two simple statements alone changed the whole dynamics of the conversation and addressing the multiple mistakes that people make concerning the withdrawal and distribution of their government qualified plans.
However, somewhere in the conversation, I stated, you have to realize that this $600k is not all your money. Mary immediately jumped in and said, “What do you mean it’s not ALL our money,” to which I responded, you have a business partner and you entered into a business relationship with Uncle Sam… you haven’t paid a dime in taxes on all this money… in short, if both of you pass away tomorrow, 39.6% (2017) of your money is going to go to the IRS and an additional 12% to the great state of California.
So 50% or $300,000 of their $600k IRA was Uncle Sam’s cut… the additional uninvited beneficiary of their retirement savings plan that Jim & Mary had not taken into account.
Needless to say, Jim & Mary were just hit with a reality check that subconsciously they may have been aware of but never really took into consideration. I find this to be the case more often than not.
Unfortunately the only way out of an IRA is through the IRS. This contract is air tight and they hold all the chips. It’s their field, their bat and their ball and you play by their rules.
The simple fact that the IRA was on Jim & Mary’s letterhead gave them the impression that they owned their IRA, yet nothing could be further from the truth! This is the contract they made with the IRS – save tax on the seed (contributions) and pay tax on the harvest ($600,000.00).
The unfortunate part of this blind contract is that Uncle Sam will dictate when you will pay the tax and how much you will pay. If taxes go up just 10% more in the future due to the national deficit and the unfunded liabilities of Medicare and Social Security… Uncle Sam could very well become your senior partner and primary beneficiary of your IRA. For Jim & Mary it was TAX SHOCK to realize their IRA was a ticking TAX TIME BOMB.
In reviewing their IRA statements a few concerns and mistakes where obvious from the beginning. Jim & Mary where not prepared to take their first Required Minimum Distribution (RMD) starting at age 70½ and were not aware of the IRS 50% tax penalty for missing a mandatory distribution. They had not properly named their designated beneficiaries, nor had they made any arrangements for the benefit of their grandchildren.
Jim & Mary had not made any arrangements that would allow the taxes on their IRA to be spread over three generations to include their grandchildren thus reducing the massive tax burden. Jim & Mary were not aware of the IRS Separate Account Rule for each beneficiary and the deadline of when to establish the Separate Accounts for each of their children. Also, Jim & Mary had not taken the fees and loads on the accounts into consideration.
Wall Street’s appetite for fees and loads tied to mutual funds is a lost opportunity for IRA owners, because all the fees and loads on the account are out of the compounding formula forever.
I asked Jim & Mary if they were aware of IRS Publication 590 or if their stock broker or IRA custodian had made them aware of this important document? They were not. IRS Publication 590 is over 100 pages of the IRS Code that pertains to the proper planning and distribution of IRA assets; it is the IRA rulebook that every astute advisor/planner should be aware of – especially if he or she has clients with qualified accounts.
Please Note: It is not the responsibility of your IRA custodian or your stock broker to inform you of the new IRS distribution rules… in more cases than not, most custodians and stock brokers are not even up to speed on how to best protect and pass on your IRA to your beneficiaries… it’s simply not their business model. Bottom line – it’s your responsibility.
There are 10 important questions that you must ask your IRA custodian to make sure that your IRA does not become an I.O.U. to the IRS. Send me an email and I will get a copy of this out to you.
And the scariest part for Jim & Mary after meeting with me was the fact that their stock broker at XYZ brokerage firm had instructed them to name their revocable living trust as the primary beneficiary of their IRA accounts.
When it comes to IRA distribution planning, special rules apply regarding the use of trusts. Not knowing these rules can have a disastrous outcome for those wishing to take advantage of generational planning as Jim & Mary did. First under IRS regulation 401-(a)(9)-4,A-5 the trust must adhere to four rules to be valid. Unless you know all the IRS rules:
DO NOT NAME YOUR TRUST AS THE PRIMARY BENEFIFCARY OF YOUR IRA, UNLESS YOU KNOW WHAT YOU ARE DOING AND IT’S YOUR ONLY SOLUTION!
The IRS is a minefield of regulations, deadlines and penalties when it comes to your retirement savings…this minefield is not going to go away. The IRA owner’s worst enemy is bad advice offered by the unskilled and untrained financial sales person.
Fortunately the tax code does contains hidden and little known secrets that can help you take control of your retirement plan and pass more on to your family and less to the IRS. You owe it to yourself to get a second opinion from someone who can help you safely navigate this minefield… and remember you cannot get a second opinion from the person who gave you the first.
So, how do you know if the financial person you are working with is properly informed and educated in IRA distribution planning?
TIP: Ask them these two simple and basic questions, “Do you have a copy of IRS Publication 590?” and “What are the three tables used to calculate Required Minimum Distributions?”
There are financial strategies that I shared with Jim & Mary that their stock broker either didn’t know or just neglected to mention in regards to minimizing taxation and distribution planning. One question that I asked Jim & Mary… How would you like to take your mandatory distributions from your IRA and still guarantee to leave more money to your spouse or beneficiaries regardless of interest rates or market fluctuations?
An interesting question which definitely caught their attention.
BOTTOM LINE
If you don’t address the issue of protecting your 401k/IRA distributions from excess taxation now, while you’re still alive, your family will pay the price – or worst they’ll spend the rest of their lives wondering how you could have been so smart to have accumulated so much money only to have been careless or just plain ignorant to have left it to the IRS.
Your retirement savings is your money. Learn to protect it and get the most out of your 401(k), IRA and other qualified retirement plans.
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If you have any questions or you would like additional information please feel free to contact me. As always, I will do my best to help you in any way I can or lead you in the right direction.
