Individual retirement accounts (IRAs) allow people to leverage tax benefits while also saving for their future. But the language that regulates retirement savings can sometimes seem equally excessive and complex. This problem is particularly evident come tax time.
IRAs can offer tax deferrals and tax deductions while even lowering tax consequences. However, they can also force unwary savers into paying unexpected taxes and fees at just the worst time if they make a mistake. And with pages and pages of IRS regulations on IRAs, making a mistake can happen to the best of us.
Retirement savers frequently slip up from the contribution or distribution sides of holding an account, which can lead to IRS penalties. Still other mistakes stem from trying to handle unusual or even painful events with financial consequences, like a death or divorce.
The best tool to use against facing additional tax penalties or otherwise leaving potential retirement savings on the table is to learn what the common mistakes are and what can be done to avoid making them. Below, we explore five common IRA tax mistakes
Mistake No. 1: Not Maxing Out Contributions
This happens so commonly that it’s easy to overlook it as a mistake. But if you don’t take advantage of deductible contribution limits each year and maximize how much you’re saving, this can add up in missed retirement savings. Individuals often make this mistake because they don’t know or might even get confused about how to calculate the maximum contribution they can make for the year.
For some accounts, knowing the amount that can be legally contributed and then deducted from taxes each year is fairly straightforward. For 2020, $6,000 is generally the contribution limit for an individual across all Traditional and Roth IRAs.
But this can get trickier depending on factors that range from age through what other accounts an individual contributes to in a particular year. For instance, if you are over 50 years old, the contribution limit for Traditional and Roth IRAs jumps to $7,000. If you have a spouse, they can contribute another $6,000 (or $7,000 if older than 50) to a separate IRA—which can make a world of difference over time. If you stop contributing at $6,000 but are eligible to contribute up to $14,000, the potential savings you’re missing out on quickly adds up.
There are other types of IRAs with different contribution limits. SIMPLE IRAs allow up to $13,500 in annual contributions. SEP IRAs allow the lesser of either 25% of the employee’s compensation or $57,000 in annual contributions.
Roth IRAs can be the trickiest to calculate. Aside from the total contribution limit noted above spanning across both Traditional and Roth IRAs, annual contribution limits for just Roth IRAs vary based on both income and filing status. And so, the modified adjusted gross income for the year is used to calculate the contribution limit specific to a Roth IRA. You can find your individual limit by looking at the IRS Roth contribution table.
A good rule of thumb to maximize your retirement savings is to check in with your account administrator, keep abreast of IRS limits (as they can change from year to year), and plan ahead.
Taking the time to know what limits you face beforehand can go a long way to both maximizing your retirement contributions and easing your tax bill.
Mistake No. 2: Unexpectedly Overcontributing
Just as under-contributing to a plan can be a mistake, so can accidentally overcontributing beyond the annual limits. One common situation where this happens is when people experience an unexpected increase in their income and forget to adjust the percent contributions being taken from their pay.
If you had contributed with the expectation of deducting those contributions on that year’s taxes, you might be in for a rude surprise when you not only can’t, but also end up facing penalties that are assessed until you correct your mistake.
Of course, the best way to avoid this problem is to find out exactly what your annual contribution limits are and make a contribution plan that lets you hit that limit.
But what if you already made the mistake?
If you catch your mistake and remove your excess contribution from your retirement account(s) before the tax deadline—generally April 15, or October 15 if you filed an extension—then your contribution will be taxed as ordinary income. If you are less than 59 ½ years of age, this will unfortunately count as an early withdrawal and you will be faced with a 10% penalty.
An alternative is to count the overcontribution towards the following tax year’s contribution limit. As long as you do this by the tax deadline (including any filing extensions), you will not be charged a penalty. The penalty is typically 6% of the money over your contribution limit, assessed each year until you remove the excess in either of the above two ways. If you’ve made any earnings on this excess, they will need to be removed as well.
Mistake No. 3: Missing Out on Spousal Contributions
Many married couples make this mistake. Even if only one is the sole breadwinner in the partnership, both spouses can often contribute to IRAs.
A second or “Spousal IRA” can be set up in the name of a partner even if they make little or no income as long as they file joint tax returns to the IRS. The individual limits for Traditional and Roth IRAs still stand; so, contributions cannot be made in either spouse’s name in excess of $6,000 as of 2020 ($7,000 for individuals aged 50 or older).
But in this way, a working spouse can contribute to the non-working spouse’s IRA. Contributions are limited to the taxable compensation reported on the couple’s tax returns. If either spouse is covered by another retirement plan at work, additional deduction limits may need to be factored in following the IRS’ rules.
Planning for retirement can be confusing on your own. It can seem even more complicated with a partner. But even if only one of you earns income, both can play a major part in saving for retirement.
The best way to avoid this mistake is to find out if you are eligible for a spousal IRA, and then speak with a tax professional to ensure you follow the latest best practices as you set it up.
Mistake No. 4: Not Leveraging Net Unrealized Appreciation (NUA)
It’s arguably easier to make mistakes on the distribution side of things because the scenarios can quickly get complicated. One such mistake is to overpay taxes on company stock.
Employers often contribute company stock to employees in their company retirement plans. The problems tend to arise when that employee leaves or changes employers and seeks to rollover their 401(k) into another retirement vehicle, such as an IRA.
Distributions are taxed as ordinary income since contributions were made with pre-tax dollars. But gains made on stock held in a 401(k) are often eligible to be taxed at a much lower long-term capital gains rate, not as ordinary income.
The IRS refers to this solution as “net unrealized appreciation,” or NUA. Through a tax break on net unrealized appreciation (NUA), you can lower your tax bill on those gains.
In the event you cash out or roll over a company-sponsored plan, you can take possession of the company stock itself. You’ll have to pay taxes at your ordinary income tax rate on the cost basis of that stock, or in other words the amount it was worth when you received it. But any gains count as NUA, which is taxed at the lower long-term capital gains rate.
If the stock has experienced any significant price fluctuation or if you own a significant amount of stock, the savings using NUA can be quite substantial.
Again, this is another scenario worth discussing with a qualified tax professional.
Mistake No. 5: Not Keeping Beneficiaries Up-to-Date
While highly avoidable, this mistake is very common. If you have a retirement account, be sure to regularly update your beneficiaries and make plans for inheritance.
If the beneficiary listings on a retirement account are out of date, all of the tax benefits so carefully planned out during account selection and set-up could disappear. Turning an IRA over to an estate rather than the beneficiary means the full tax bill comes due immediately. That could cost the inheritor a lot of money in taxes due suddenly.
The sudden tax bill doesn’t need to show up like this. After all, a non-spouse beneficiary has ten years to liquidate an inherited IRA. If everything is current in the account, the tax bill can be dealt with in a much easier way, over time—and potentially costing less.
On the flip side of this mistake, the beneficiary also needs to be aware of what he or she can do to reduce taxes. The options available are different depending on whether the beneficiary is a spouse or not.
For instance, per the IRS a spouse who inherits his or her deceased partner’s IRA can designate themselves as the account owner and take control of the IRA, embrace the role of beneficiary, or rollover those funds into their own account without paying taxes.
A non-spouse beneficiary doesn’t have the luxury of those options, but they do have ten years to deal with the tax bill. A non-spouse beneficiary must begin taking required minimum distributions (RMDs) no later than the end of the year following the death of the original account owner. That beneficiary then has ten years to liquidate the account in full.
This beneficiary rule is new; it was the 2019 SECURE Act capped this time to liquidate for non-spouse beneficiaries at 10 years. Previously, these individuals could “stretch” the withdrawals based on their own life expectancy.
The easiest way to avoid this last mistake is to keep your IRA account information current and have a conversation with your beneficiaries—as well as a qualified tax professional.
The IRS’ rules for IRA taxes can seem complex and overwhelming, but once you start to dig in further it becomes clear that the most common mistakes one can make can also be fairly easy to anticipate and avoid.
The general rule when considering your retirement savings is to check in directly with account administrators, tax professionals, and beneficiaries. The IRS provides a great website with many resources you can read through on your own, so you can find out about contribution limits, tax burdens, and changes from year to year on both. This also helps you ask the best questions about your accounts.
A few minutes here and there thinking about and discussing your retirement accounts can go a long way. These five common mistakes are a great place to start.