Five IRA Rollover Mistakes to Avoid

Making a mistake when rolling your 401(k) to an IRA could result in unexpected taxes and possible penalties.
Making a mistake when rolling your 401(k) to an IRA could result in unexpected taxes and possible penalties.

Recent changes in the job market have led to an increase in IRA rollovers, but at the same time, people are making more mistakes when transferring their employer related retirement accounts to an IRA, reports The Wall Street Journal in a recent article, “The Biggest Mistake People Make With IRA Rollovers.” These IRA rollover mistakes may result in additional taxes and penalties.

Done properly, rolling funds from a 401(k) to a traditional IRA offers you more flexibility and control. A company retirement plan may limit you to a half-dozen or so investment choices; but, depending on the IRA custodian, the IRA owner may choose investment options ranging from stocks and bonds to mutual funds, exchange-traded funds, certificates of deposits or annuities.

However, if you are considering rolling over an employer related retirement plan to an IRA, make sure to avoid these common IRA rollover mistakes:

Mistake #1:  Taking a lump-sum distribution of the 401(k) funds instead of moving the funds directly to an IRA custodian. The clock starts ticking when you do what’s called an “indirect rollover.” Miss the 60-day deadline and the amount is considered a distribution, included as gross income and taxable. If you’re younger than 59½, you might also get hit with a 10% early withdrawal penalty.

There is an exception: if you are an employee with highly appreciated stock of the company that you are leaving in your 401(k), it’s considered a “Net Unrealized Appreciation,” or NUA. In this case, you may take the lump-sum distribution and pay taxes at the ordinary income-tax rate, but only on the cost basis, or the adjusted original value, of the stock. The difference between the cost basis and the current market value is the NUA, and you can defer the tax on the difference until you sell the stock.

Mistake #2:  Not realizing when you do an indirect rollover, your workplace plan administrator will usually withhold 20% of your account and send it to the IRS as pre-payment of federal income tax on the distribution. This will happen even if your plan is to immediately transfer the money into an IRA. If too much tax was withheld, you’ll get a refund from the IRS.

Mistake #3:  Rolling over funds from a 401(k) to an IRA before taking a Required Minimum Distribution or RMD. If you’re required to take an RMD for the year that you are receiving the distribution (age 72 and over), neglecting this will result in an excess contribution, which could be subject to a 6% penalty.

Mistake #4:   Rolling funds from a 401(k) to a Roth IRA and neglecting to pay taxes immediately. If you move money from a 401(k) to a Roth IRA, it’s a conversion and taxes are due when you make the transfer. However, if you have some after-tax dollars left in the 401(k), you can make a tax-free distribution of those funds to a Roth IRA.

Mistake #5:  Not knowing the limits when moving funds from one IRA to another, if you do a 60-day rollover. The general rule is this: you are allowed to do only one distribution from an IRA to another IRA within a 12-month period. Make more than one distribution and it’s considered taxable income. Tack on a 10% penalty, if you’re under 59½.

Reference: The Wall Street Journal (Oct. 1, 2021) “The Biggest Mistake People Make With IRA Rollovers”

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What is the right kind of Financial Power of Attorney for You?

A June 2020 Transamerica Center for Retirement Studies survey showed that a mere 28% of retirees have a financial power of attorney (POA)—and many people don’t understand that there are two types of financial powers of attorney that serve different purposes.

MarketWatch recently published an article “Does your estate plan use the right type of Power of Attorney for you?” that says knowing how both types work is crucial in the pandemic, especially in the event that you get sick with coronavirus.

A Durable Financial Power of Attorney can be either “springing” or “immediate.” “Durable” refers to the fact that this Power of Attorney will endure after you have lost mental or physical capacities, whether temporary or permanent. It lists when the powers would be granted to the person of your choosing and the powers end at your death.

An “immediate” Financial Power of Attorney is effective as soon as you sign the document. In contrast, a “springing” POA  means it is only effective when you cannot manage your own financial affairs, usually based upon the written opinion of two physicians.

Therefore, to begin paying your bills, your agent must have written proof of from the physicians, and he or she doesn’t automatically have the authority to ask for them.  When issues, such as doctors’ letters, are required before the agent you chose can serve you, ask your estate planning attorney for guidance.

An obstacle that requires a Durable Financial Power of Attorney can come upon you very fast and possibly include you and your spouse at the same time. For example, you may both become ill, or one could become ill and the other is absorbed in caring for their spouse.

The powers granted by a typical Financial POA are often broad and permit selling and buying assets; managing your debt, car and Social Security payments; filing your tax returns; and caring for any assets not named in a trust you may have, such as your IRA.

If you recover your capacity, your agent must turn everything back over to you when you ask.

Remember that your power of attorney documents are only as good as the people who implement them. You should also make certain anyone named knows that they’ll have the job, if needed. They must know where to find your POA and all other important information.  If you aren’t sure of the type of POA you currently have, it is worth checking as part of an estate plan update.  See our recent article for when it might be time to do that!  https://www.galliganmanning.com/when-to-update-your-estate-plan/ 

Reference: MarketWatch (Oct. 9, 2020) “Does your estate plan use the right type of Power of Attorney for you?”

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Common Mistakes Made on Beneficiary Designations

Assets like life insurance, retirement accounts and annuities are governed by beneficiary designations.
Assets like life insurance, retirement accounts and annuities are governed by beneficiary designations which override your will.

Many accounts and other assets are governed by beneficiary designations. Examples include life insurance, 401(k)s, IRAs, and annuities. These assets rely on contractual provisions with the financial institution to designate who receives the benefits upon the death of the owner.

Kiplinger’s recent article entitled “Beneficiary Designations – The Overlooked Minefield of Estate Planning” describes several mistakes that people make with beneficiary designations and some ideas on how to avoid problems for you and your family members.

Believing that Your Will is More Powerful Than It Really Is. Many people mistakenly think that their will takes precedence over a beneficiary designation form. This is not true. Your will controls the disposition of assets in your “probate” estate. However, the accounts with contractual beneficiary designations aren’t governed by your will because they pass outside of probate. That is why you need to review your beneficiary designations whenever you review your estate plan.

Allowing Accounts to Fall Through the Cracks. Inattention is another thing that can lead to unintended outcomes. A prior employer 401(k) account can be what is known as “orphaned,” which means that the account stays with the former employer and isn’t updated to reflect the account holder’s current situation. It’s not unusual to forget about an account you started at your first job and fail to update the primary beneficiary, which could be a former spouse.

Not Having a Contingency Plan. Another thing people don’t think about is that a beneficiary may predecease them. It is important to name a contingent or secondary beneficiary in the event the first beneficiary is not survivig.

Not Paying Attention to a Per Stirpes Election. If a person names several beneficiaries (such as children) as primary beneficiaries to share equally in the account or life insurance policy at the owner’s death, what happens if one of the beneficiaries is not surviving? Some beneficiary designation forms state that the deceased beneficiary’s share automatically goes to the other surviving beneficiaries. Other beneficiary designation forms give the owner the option to state that the deceased beneficiary’s share should pass to the deceased beneficiary’s children. This is known as a per stirpes election. Many times people are unaware as to which option they have chosen on the beneficiary designation form.

Naming a Minor or Incapacitated Person as a Beneficiary. If a minor or incapacitated person is named as beneficiary, unless the beneficiary designation form allows for the appointment of a custodian or trustee to accept the benefits on behalf of the minor or incapacitated person, a court-appointed guardian may be necessary for the minor or incapaciated person to receive the benefits. Also keep in mind that if an incapaciated person you’ve named as beneficiary is receiving government benefits, distributions from a retirement account, annuity, or life insurance policy, may jeopardize his or her eligiblity to receive the government benefits.

It’s smart to retain copies of all communications when updating beneficiary designations in hard copy or electronically. These copies of correspondence, website submissions and received confirmations from account administrators should be kept with your estate planning documents in a safe location.

Remember that you should review your estate plan and beneficiary designations every few years to make sure that they are coordinated and that they say what your really want.

You may also be interested in https://www.galliganmanning.com/trust-owned-life-insurance-in-your-estate-plan/.

Reference: Kiplinger (March 4, 2020) “Beneficiary Designations – The Overlooked Minefield of Estate Planning”

 

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