IRAs are complicated retirement vehicles, which is why it’s so easy zone out or get confused by their rules.
Some misconceptions are harmless, while others can lead to serious tax blunders. Don’t feel bad though; even financial advisers get tripped up by the intricate rules of IRAs. Figuring out how the accounts work and what’s allowed could be a full-time job. As a result, the list of things most people don’t know about IRAs could fill a book.
Following are nine common misconceptions about IRAs and our guide to help you sidestep them.
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You invest in an IRA
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It may be a matter of semantics, but saying you’re invested in an IRA is a bit like saying you’re invested in a joint account. An IRA is an account registration, not actually an investment. It’s like the shell that houses a peanut. You don’t eat the shell; you eat the nut. Likewise, you don’t invest in an IRA; the investments are within it.
“IRA is simply a label applied to an account. That label gives it the special tax treatment. Inside the account, you will find the investment or investments,” says certified financial planner Rick Salmeron, founder of Salmeron Financial in Dallas.
Basically, a person can have nearly any type of regular investment in an IRA, whether a CD or stock or mutual fund, and the IRA label indicates how it is treated with regard to tax reporting.
You don’t have to be a financial expert to know that you should be saving money every year for retirement. Some people erroneously believe that every annual contribution requires opening a new account.
“You don’t have to open up a new IRA for every year you make contributions — you can add money to an existing IRA. In fact, people should have as few IRAs as possible in order to facilitate keeping track and managing their investments,” says Brian Frederick, certified financial planner, associate financial planner at Intrinsic Wealth Counsel in Tempe, Arizona.
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The beneficiary form can wait
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The beneficiary form is so simple to fill out but often gets overlooked. Yet, the future of everything you’ve worked for depends on it.
“The beneficiary form determines the ultimate future value of your retirement savings: how soon it will be taxed, how much it will be taxed and who will get it. Will it be subject to probate?” says Ed Slott, founder of Ed Slott and Co., an IRA education company, and author of “Fund Your Future: A Tax-Smart Savings Plan in Your 20s and 30s.”
The tax benefits in IRAs, particularly the Roth, are incredibly valuable. Fill out the beneficiary form properly to ensure that your heirs are able to take full advantage of those valuable benefits, and then explain the benefits to them so that they don’t just cash out the account.
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401(k) plans are better than IRAs
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A workplace retirement plan is indisputably great. The employer often matches a portion of the employee’s contribution, and fees may be lower than those in the open market.
But not all workplace plans are created equal. Some have inflexible rules regarding loans and withdrawals, and may have limited and expensive investment options. The simple fact is that the features of a 401(k) are dependent on the employer.
“The reality is that IRAs tend to offer more freedom, lower costs and simplification,” says certified financial planner Jason Lina, CFA, lead adviser at Resource Planning Group in Atlanta.
“There are no hidden administration fees as with a 401(k), much greater investment flexibility and many options for pre-59 1/2 penalty-free distributions,” he says.
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You must withdraw cash
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Traditional IRAs require investors to take a minimum distribution every year after age 70 1/2. That can be done by taking cash out of the account, which could require selling an investment. But that’s not the only way to take the required minimum distribution, or RMD.
“Most advisers ignore the option to fulfill RMDs using in-kind security transfers rather than moving cash,” says Lina. That means you could move a stock or mutual fund or other type of investment out of the IRA and into a taxable account.
“This has several clear benefits: no transaction costs required to raise cash; no trading required to rebalance the portfolio following the RMD; and it psychologically separates the required distribution for tax purposes from the need to spend the RMD amount,” Lina says.
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A rollover is the best idea
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Moving money from a former employer’s retirement plan to a rollover IRA is often a good idea, but not always. In fact, it can sometimes be against your best interest to do so. But you may not get that message if you go to a big fund company and ask for help.
There are reasons to choose other options. For instance, if you have lots of company stock in your 401(k), you may want to think twice about doing a rollover — particularly if the stock has increased in value.
“There’s a huge tax break: net unrealized appreciation. Even advisers don’t know that much about it. If you do the rollover, it’s off the table — it’s irrevocable. You can’t get the benefit,” says Slott.
“Without getting too into it, the benefit says that if, instead of doing a rollover, you take a lump-sum distribution, the appreciation can come out tax-free (as opposed to taxable in an IRA). Plus, when you sell the stock, you get the capital gains tax rate, which in some cases can be half the tax rate for funds coming out of an IRA,” he says.
Note that the company stock has to be transferred out of the account in-kind, meaning as the stock, not as cash.
Bottom line: Investigate all your options before doing something that can’t be changed.
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You can borrow from your IRA
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IRA owners can’t take loans from the IRA — like they can from a 401(k) account, if the plan allows. Some investors may be tempted to gamble with the once-per-year 60-day rollover provision that allows you to have a check cut from your account and made payable to you when you transfer the account to another custodian. If you deposit the money back into an IRA within 60 days, then you’re fine. Miss the deadline by even a day and you no longer have an IRA. In its place could be a whopper of a tax bill.
A recent IRS rule does loosen this restriction if the oversight is due to something over which the IRA owner has no control, such as a death in the family or a postal error.
But keep this in mind: The best way to transfer money between custodians is with a trustee-to-trustee transfer. That way, the money never leaves the safety of a tax-advantaged account.
“Every time the money is moved, you have to be careful because it’s tax-deferred money. It’s like a hot potato — you move it, (but) you have to be careful,” Slott says.
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The experts will fill you in
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IRAs are complicated beasts, and there is no way to learn all the things you don’t know. Similarly, your bank, broker or IRA custodian may not know what you know, and it’s not the financial institution’s responsibility to educate you.
For instance, if you are unaware that you have only 60 days to put money back into an IRA when transferring accounts, that’s your problem, per the IRS. Plus, a rule change that took effect on Jan. 1, 2015, limits the number of 60-day rollovers to one per year for all of a taxpayer’s IRAs in aggregate. (There is no limit to the number of trustee-to-trustee transfers you can do.)
The 60-day rule is a little tricky if you don’t know about it, and many individuals have no reason to be well-acquainted with the tax laws around retirement accounts. Not all financial professionals are experts, either.
“The average financial adviser is trained to sell investments; they are trained as salesmen. They are not trained on the intricacies of the tax rules,” Slott says.
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Contributing is the hard part
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Squirreling money safely away in a tax-advantaged account is only the first step. Putting the contribution into an investment is the next step. Often, contributions to a brokerage IRA will go into a money market sweep account earning minimal interest.
“Maybe they’re not ready to make that investing decision when they made the contribution decision,” says certified financial planner Maria Bruno, senior investment analyst with Vanguard’s Investment Strategy Group.
If the money isn’t invested fairly soon, investors may lose out on opportunities to let the money grow at a significant rate. The longer they wait, the greater the opportunity cost can be.
Bruno suggests that investors borrow a technique from 401(k) plans and choose a mutual fund to act as a default investment while they decide how they would like to allocate the money over the long term.