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10 Reasons Why IRAs are Different than Other Assets and Why You Should Care

If you are a retiree, chances are that you have accumulated a significant amount of your wealth through some sort of retirement account such as an Individual Retirement Arrangement (IRA), and ever since IRAs were introduced to investors in the 1970s, there has been much confusion surrounding the rules associated with these types of investment vehicles. 

Simply put, IRAs have their own set of rules that must be followed, or investors can find themselves in hot water with the IRS.  Here are the 10 reasons why IRAs are different than other assets and why you should care:

  1. IRAs pass by contract or beneficiary designation not by will.  I review client beneficiary forms regularly and find that they have no designated beneficiary or an incorrect beneficiary.  When I point that out, the client  may say something like “That’s OK, my will lists my beneficiary.”  It is important to understand that the IRA beneficiary designation takes precedence over anything the will says regarding the account.  So if the will contradicts the IRA beneficiary form, the IRA beneficiary designation will supersede.
  1. You must start taking Required Minimum Distributions (RMDs) from your IRA at age 70-1/2.  No other type of investment asset requires this.  Failure to take your RMD in a timely manner may cost you a 50% tax penalty on each dollar that was required to be distributed from the account.  The first distribution must be taken by April 1st of the year following the year you turn age 70-1/2.  In all subsequent years, the deadline is December 31st.
  1. Early withdrawals from an IRA can incur unnecessary tax penalties.  Generally speaking, any distributions taken from an IRA before age 59-1/2 will be subject to a 10% penalty on the amount withdrawn.  There are a few exceptions to this rule, but remember, these accounts are designed for retirement.
  1. Money withdrawn from an IRA is taxed as ordinary income and is paid at your highest marginal tax rate which could be as high as 35% in 2010 and 39.6% in 2011.  Earnings on IRAs do not ever receive the more attractive long term capital gains rate upon withdrawal.  Remember, long term capital gains rates are at 15% right now and are always lower than whatever your current ordinary income tax rate is.
  1. IRAs receive no step up in cost basis when inherited.  For example, normally if you inherit a non-IRA investment account that had an original value of say $50,000 at purchase but is now worth $100,000 at the death of the owner, you as the beneficiary would be able to turn around and sell that asset as if you paid $100,000 for it yourself, resulting in no income taxation to you.  The original “cost basis” would be “stepped up” for you from $50,000 to $100,000.  (NOTE: The repeal of the Federal Estate Tax eliminated that step-up in cost basis for 2010,  but it is expected to come back effective January 1, 2011 as the Federal Estate Tax will be resurrected.
  1. IRA ownership cannot be transferred or held jointly like other property during the account holder’s lifetime, thus the name “Individual Retirement Arrangement.”  Doing so would trigger an immediate end of the tax shelter and cause it to be fully distributed and taxed.  This prohibition also includes transfers to a trust.  I have seen some estate planning attorneys direct their clients to re-title their IRA to the name of a trust.  This is a huge mistake cannot be done without destroying the IRA.
  1. IRAs cannot be borrowed from a 401(k) plan or your home equity without triggering a tax and potential penalty.  However, money can be rolled out of the account once every twelve months and replaced within 60 days without triggering a tax or penalty.
  1. The IRA beneficiary ultimately determines the long-term value of the account.  For example if the beneficiary of your IRA is age 40, he has about a 45 year life expectancy according to IRS tables.  This being the case, the beneficiary would have a few options when receiving the account.  He could simply cash it out and pay all of the taxes or better yet stretch the tax deferral over his life expectancy using a Stretch IRA.  A  Stretch IRA is accomplished by setting up an Inherited IRA in the name of the decedent and for the benefit of the beneficiary.  At that time, the beneficiary is only required to take small distributions over his life expectancy, effectively allowing the remainder of the IRA to grow much larger, and tax deferred, over this long period of time.  Thus is a huge benefit! So the younger the beneficiary, the better this option is.  The third option the beneficiary has is to simply take distributions in amounts somewhere between the minimum required by law and actually cashing it out.
  1. If a trust is named as the beneficiary of an IRA, the trust must be set up specifically by IRS rules that would allow each beneficiary to stretch the tax deferral individually as outlined in item 9 above.  Otherwise the age of the oldest beneficiary is used causing the younger beneficiaries to receive less tax advantage in the stretch.
  1. The bottom line here is that the rules for IRAs are complex and filled with potential tax landmines.  Additionally they require their own estate planning forms, but they must also be integrated with all other estate planning documents and assets.  Otherwise, there may be some unintended consequences to you and your beneficiaries.
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