Each year, you’re allowed to contribute to an Individual Retirement Arrangement (IRA), commonly known as an Individual Retirement Account. The most common IRA mistakes occur either because you don’t know — or aren’t receiving — the necessary guidance on the complex rules.
Not knowing the difference between a Roth and traditional IRA
The two types of IRAs are the Roth and the traditional IRA. Both accounts receive different tax treatments. Essentially, Roth IRA contributions are made with after-tax money, whereas contributions to a traditional IRA might qualify for a tax deduction for the year the contribution was made.
With a Roth, tax payments are front-loaded so that all distributions during retirement, including interest and earnings, are tax-free. Conversely, a traditional IRA generally gets a tax advantage at the time the contribution is made, but distributions are taxed as ordinary income in retirement.
Note: There is an exception. High earners who are covered by a retirement plan may not qualify for a tax deduction in either category. (See the next section for solutions to this problem).
Moreover, IRS rules call for required minimum distributions from traditional IRAs beginning at age 70 1/2. Failing to take the entire amount required can lead to stiff penalties.
With a Roth IRA, no minimum distributions are required during your lifetime. If you die and leave the Roth to a beneficiary other than your spouse, that person will be required to take distributions based on their own life expectancy if they choose to stretch the tax advantage of the retirement account until the end of their life.
Not understanding your options as a high earner or high contributor
Those who make too much money to contribute to an IRA can still take advantage of the Roth IRA by contributing to a nondeductible IRA and then converting to a Roth. A nondeductible IRA is simply a traditional IRA for which there is no tax deduction, and it is available to almost everyone with wages or self-employment income.
As for high contributors, the IRS limits the amount that may be contributed to a Roth or traditional IRA in any one year. With contribution limits under strict review, putting in more than the allowed amount can trigger hefty penalties — such as 6% on the extra amount.
There are several ways to circumvent this rule. For example, if you contribute more than your taxable income for the year or contribute on behalf of a deceased individual, you can easily remedy this mistake if it is caught before taxes are filed. You can also carry the contribution to another year.
Ignoring important details
All in all, the most important mistake to avoid with IRA rollovers is ignoring small, key details. And unfortunately, paying someone to take care of your financial plans doesn’t make you immune to the problem.
Advisors don’t always act in the most proactive way or have time to check for small mistakes. Administrative transactions, such as transferring a retirement account, require attention to detail. You need to make sure that you and your representative are on the alert to ensure that money gets to the IRA or that the money is moved correctly. If not, rollover mistakes can take several months to correct with the IRS.
Also, attention to deadlines is crucial. Individuals can take money out of their IRAs or take a distribution from their 401(k) when they leave an employer and put it back into a qualified retirement account without tax consequences, as long as they do so within 60 days. As explained above, extensions for rollovers can only occur if the financial institutions or their representatives were to blame. A person can only miss rollover deadlines a maximum of once every 365 days, not once a calendar year. Some people can lose their entire IRA because they did two rollovers in a year and didn’t realize it.
The safest way to counteract this problem is to make a direct transfer from one institution to another. When everything goes smoothly, the money never comes out of a retirement account because the check is written to the receiving institution, not to an individual. In the end, however, the burden is on the account holder to make sure the new account is set up correctly.
Finally, make sure you fill out beneficiary forms properly. While they are a hassle to fill out and most people just focus on getting the account open and taking care of the beneficiaries later, it pays to get the new forms with each newly opened account or transfer. Not having a beneficiary form might not affect you after you die, but it will cost your beneficiaries valuable tax benefits that could go to another person.
Learn more about Carlos on NerdWallet’s Ask an Advisor.