These Costly IRA Mistakes Can Crush Retirement Savers 

With great power comes great responsibility. 

Individual retirement accounts are a powerful wealth accumulation vehicle, with Americans now owning $19 trillion in such assets, per the Investment Company Institute. But what can’t be denied is the complexity that comes with spending down those accounts in retirement, and income taxes are just the beginning. Factor in required minimum distributions, early withdrawal penalties and the potential for some mistakes to entirely undo the accounts’ tax-exempt status, and it’s a lot for clients to manage. Advisors simply must be well-versed in the rules to effectively serve their clients, according to Denise “the IRA Whisperer” Appleby, founder and CEO of Appleby Retirement Consulting. Those who aren’t could risk serious conflict with the IRS. 

“I advocate for screening incoming clients for serious unchecked IRA mistakes, because they’re out there,” Appleby said. “It can be a huge headache to address them, to the point that you probably don’t want these people as clients.”

Caught Out 

One common misstep occurs when IRA owners make early withdrawals. Many advisors are aware of the 10% early withdrawal penalty assessed on top of normal income taxes. They overlook, however, how the actual payment of the penalty happens, as many assume the IRA custodian sends the required amount directly to the IRS, Appleby said. 

IRA custodians do not automatically calculate, deduct or send the 10% early withdrawal penalty to the IRS on your clients’ behalf, she warned. The custodian may automatically withhold a flat percentage (typically 10% to 20%) to cover income taxes. This goes toward the individual’s overall tax burden, however, not the specific 10% penalty. Instead, the custodian reports the total distributed amount to the IRS (and to the taxpayer) using IRS Form 1099-R. 

“The IRA owner gets real sticker-shock from this added payment during tax season,” Appleby said. “They are often in a tough spot, because they probably took an early withdrawal because they needed liquid funds in the first place.” In fact, Appleby has seen some people resort to tapping home equity to settle unexpected tax burdens tied to early IRA withdrawal penalties. Other traps include: 

• Individuals are limited to one indirect IRA rollover per 12-month period, though unlimited custodian-to-custodian rollovers are permitted. 
• Clients cannot directly convert a required minimum distribution into a Roth IRA.

Don’t Jump the Gun. The IRA rules are nothing if not strict, and even a single day can make a difference in some cases. “Many people are out there waiting eagerly for age 59.5, when they can make penalty-free withdrawals,” Appleby said. “Be careful, because withdrawals made even one day early can be subject to the penalty.”

Another area for serious diligence is around Roth conversions. By IRS rules, the client’s total yearly RMDs must be fully withdrawn from their traditional accounts before they can perform any Roth conversions. Furthermore, the RMD money itself cannot be used to fund the conversion.