Mistake-Free IRA Investing

By Dean Hedeker, Hedeker Wealth Management

Make no mistake: An Individual Retirement Account (IRA) is not the straightforward, elementary savings instrument that many would have you believe. Because of the complicated tax laws surrounding distributions from IRAs, you need to avoid four common mistakes to preserve what is likely the biggest part of your estate.

Mistake No. 1: Not Using a Trust as an IRA Beneficiary

When Ruth Heffron named her daughter Heidi as beneficiary of her $300,000 IRA, little did she realize that she was setting into motion a chain of events that would ultimately result in the loss of her entire IRA. Unbelievable? Yes, but it happened in a case which was decided last April by the U.S. Court of Appeals, Seventh Circuit.

In August of 2000, Heffron established an IRA and named her only child, Heidi Heffron-Clark, as the sole beneficiary. On September 19, 2001, Ruth Heffron died. Two months later, Heidi presented the death certificate to the IRA custodian and established an Inherited IRA for her own benefit. On October 28, 2010, Heidi filed for bankruptcy, during which the Inherited IRA had a value of $293,338.

A key question before the court was whether the inherited IRA was an exempt asset. If it was exempt, Heidi would be able to keep the IRA. If it wasn’t, the creditors would get it. In May 2011, the court ruled the IRA was not exempt, and thus the creditors were free to grab it. Heidi appealed to U.S. District Court and in January 2012, the judge ruled in her favor. 

But the tug of war continued, the case went to the U.S. Court of Appeals and two-and-a-half years after trying to claim the IRA, the Court ruled that Heidi’s Inherited IRA was not exempt,  not protected, and Heidi was out of luck.

Had Ruth made a properly drafted Trust the beneficiary of her IRA, this result would most likely not have happened. The trust would have served as the wall between the Inherited IRA and Heidi, and afforded her a degree of asset protection that Heidi simply didn’t have.

Lesson: Trusts can be very flexible and provide the asset protection that people need.

Mistake No. 2: Failure to Determine Permanent Tax Rate

Thanks to recent tax legislation, there now are more tax brackets than ever before – seven different brackets ranging from 10% to 39.6%. When you add “stealth taxes” together with the Illinois income tax, your bracket can hit 49.6%. At the age of 70½, IRA distributions must begin.

With all of this complexity, multiyear tax projections are a must. One-year projections just aren’t good enough; projecting five years out ensures there are no income spikes resulting in a substantial tax bill. Also, it is important that in the low-income years, investors can use instruments such as Roth IRA conversions and itemized deduction planning to shift income from high-income years to low income years.

Lesson: Devise a plan to stay in the same tax bracket for the duration of the retiree’s life.

Mistake No. 3: Automatic IRA Rollover

Losing a loved one is distressing. It’s also tough paying a tax penalty from the bad financial advice given following the death of a young spouse.

At age 55, Al suffered a heart attack and died. He was survived by his 40-year old wife Lori.  Lori rolled over Al’s entire $300,000 401(k) retirement account balance into her own IRA -- a big mistake.

She later needed money, but since she was younger than 59½, she faced a 10 percent early- withdrawal penalty to withdraw the funds, on top of the tax due. Had she set up an inherited IRA, she would have avoided the 10 percent penalty on early withdrawals. She could have rolled over a portion of the $300,000 account balance and placed the remainder in an inherited IRA.

Lesson: Bring in a competent professional before automatically rolling over an IRA following the death of a spouse.

Mistake No. 4: Failure to Name a Beneficiary on an IRA

This one is bizarre! Susan established an IRA for herself and when her husband died, she rolled over his entire $500,000 IRA into her own.  In completing the forms, she mistakenly named herself as the beneficiary of her IRA.

When she died, there was no IRA beneficiary, so the probate court took up the case. In Illinois, probate court can drag on for a year. Worse yet was the tax disaster that resulted – the tax on the $500,000 was due immediately.

Naming a beneficiary would have avoided the immediate tax bite, as the beneficiaries would have been able to spread out the tax over their lifetimes.

Lesson: Visit your financial institution every year, and review the beneficiary of record on all IRA accounts.

Dean Hedeker, owner and principal of Hedeker Wealth Management Group in Lincolnshire, has more than 30 years of experience in estate and financial planning and wealth management. He is an attorney and certified public accountant who can be reached at info@cutyourtax.com.