14 Biggest IRA Mistakes
Here are 14 of the biggest IRA mistakes investors commonly make. Do your best to avoid these so you can maximize your IRA’s potential.
1) Contributing Too Little
In our Next Dollar Roadmap on martinmoney.com, we recommend saving anywhere from 15% to 25% of your income in tax-advantaged retirement accounts.
Failing to do so could result in a lackluster retirement.
The maximum allowable contribution to an IRA in 2024 is $7,000 if you’re under 50, and $8,000 if you’re 50 or older.
This amount is set to increase with inflation.
If you just contributed $7,000 annually to an IRA for 30 years, it could be worth $1.44 MM using historical S&P500 index returns of 10.67% annually.
That’s a lot of opportunity you’d be missing out on if you fail to take advantage of the opportunities IRAs present.
2) Contributing Too Much
As we just mentioned, you are only allowed to contribute $7,000 to an IRA in 2024 if you’re under 50 years old and $8,000 if you’re 50 or older.
If you contribute more than this amount, you’ll face potential penalties from the IRS.
Each year an excess contribution is left in an IRA, it is subject to a 6% penalty.
You can avoid the 6% by removing excess contributions before income tax filing deadlines, but you’ll owe income tax and may owe a 10% early withdrawal penalty on the earnings when you back out the transaction.
3) Contributing to Roth Instead
Traditional IRAs allow you to take a tax deduction at the time of contribution and are only taxed when you make withdrawals.
On the other hand, Roth IRA contributions do not receive a tax deduction, but all withdrawals are completely tax-free.
This difference in when taxes are paid creates a unique tax arbitrage opportunity because it allows us to choose when we want to pay tax on our retirement savings.
At the time of your contribution, if your income tax is lower than you expect it to be when you make withdrawals, then a Roth IRA is a smarter choice from a tax-efficiency standpoint.
If you believe your income is higher at the time of contribution, then a Traditional IRA is the way to go.
Being strategic about choosing a Roth or Traditional IRA could save you thousands and thousands of dollars in taxes.
4) Not Knowing Deductible Limits
Traditional IRA contributions are normally eligible for a tax deduction, but the deductible amount is subject to certain limitations based on whether you have access to an employer-sponsored retirement plan.
Here are the deductible limits for IRAs based on income:
You are still eligible to make contributions to an IRA on an After-Tax basis, but there’s really not a good reason to do that unless you’re planning to do a Backdoor Roth IRA.
5) Not Planning for RMDs
Required minimum distributions (RMDs) will force you to begin removing a portion of your Traditional IRA balance each year, beginning at age 73 or 75 (starting in 2033).
You should plan for this as you approach retirement, but especially if you don’t need your RMDs to supplement your income.
The reason is RMDs are designed to force a taxable event from your IRA, which is just another way of saying you’ll be forced to pay income tax you otherwise wouldn’t have had to pay.
There are several ways to limit or avoid RMDs, but the most popular is through Roth conversions. To do this tax efficiently will require some planning, so again, think ahead.
You could also spend down your Traditional IRA balance before you reach RMD age or use Qualified Charitable Distributions to offset your RMDs.
6) Forgetting to Take RMDs
A required minimum distribution wouldn’t be much of a requirement without some penalty for failing to yield to it.
So, the IRS will invoke a 25% penalty every year you fail to remove your RMD from the account.
That is one of the stiffest penalties the IRS levies against retirement account assets.
You have until December 31st of each calendar year to remove your RMD from you IRA.
The good news is you’ll use your IRA balance on December 31st of the prior year to calculate your RMD, so you’ll know how much it is all year long.
7) Early Distribution Penalties
You must be 59.5 years old to make distributions from your IRA. If you make a distribution before that, you’ll owe a 10% penalty in addition to applicable income taxes.
There are a few ways to make early withdrawals without the penalty. We won’t cover them in detail here, but here’s a short list if you’re curious:
- T2T Distributions or Series of Equal Periodic Payments (SEPP)
- Roth Conversion Ladder
- Exceptions like first-time home purchase, educational expenses, medical bills, disability, birth and/or adoption, health insurance costs if unemployed, and qualified reservist distributions (QRDs)
We’ve written a post about how you can access your retirement funds early. I suggest checking it out if you want to learn more.
8) Fumbling a Rollover
There are a lot of good reasons to roll assets from an employer-sponsored retirement plan into a Traditional IRA.
The main one is the amount of control you gain over how the account is invested.
However, if you fumble the rollover process you run the risk of having it characterized as a distribution, forcing you to pay income taxes and early withdrawal penalties on the entire rollover amount.
That’s no bueno.
Spare yourself this misery by doing a direct rollover instead. Using this method, you’ll never handle the funds, so there’s no way for it to be characterized as a distribution.
Just contact both your employer plan and your IRA custodians for instructions on how they’d like the funds to be sent and received.
It’s a bit of work, but no more than you’d have to deal with if you handled the rollover yourself.
Remember, you only get one rollover each year so plan it well.
9) Rolling Company Stock Into IRA (skipping NUA)
As we just mentioned, there are a lot of good reasons to roll assets into an IRA.
However, you could cost yourself a significant tax benefit if you roll stock from your employer into an IRA.
If you roll the company stock into your IRA, you’ll owe income tax on the distribution when you sell it and take the money out of the account.
However, if you roll the shares of stock into a taxable brokerage account instead, you would only owe capital gains tax on the appreciated portion of the stock’s value.
There are some tightly enforced rules about using NUA:
- You have one year to completely distribute your vested balance in your 401(k) plan and you must distribute all assets from any other qualified plans you have with your employer, even if those plans don’t have stock in them.
- You have to make the distribution to your taxable brokerage in actual shares. You cannot sell the stock within the 401(k) first, and then move the funds to the brokerage account.
- You have to either completely separate service from the employer (unless you’re self-employed), be 59.5, be totally disabled, or be dead.
10) Owning Growth and/or Expensive Investments (But no MUNIs!!!)
Using modern portfolio theory, most investors now set up their portfolios with a goal to own a certain ratio of stocks to bonds across all of the account types they have.
The reason is certain assets are more strategically advantageous to own in certain accounts than others.
For example, it makes sense to hold long-term growth assets like stocks in a Roth IRA because all earnings and future withdrawals are completely tax-free.
On the other hand, it’s wiser to own slower-growing investments like bonds in a Traditional IRA because fixed-income assets will provide a risk cushion while also not creating a large tax burden upon withdrawal.
So, when purchasing investments according to your desired asset allocation, begin buying fixed-income assets in a traditional IRA but don’t adapt your strategy just to limit the growth in that account.
Asset allocation first. Asset location second.
Finally, don’t buy municipal bonds in a Traditional IRA. Yields from Muni’s are already tax-exempt, and you can’t double that benefit by putting it in your IRA. Hold muni’s in a taxable account instead.
11) Forgetting the Pro Rata Rule
We touched on the Backdoor Roth IRA earlier but there’s a potential tax aspect we didn’t discuss that we should now highlight.
Conversions of after-tax and tax-deferred IRA dollars to a Roth IRA are subject to tax on a pro-rata basis.
That just means that when you convert money from an after-tax IRA, income tax for that conversion will be calculated in proportion to all of your non-Roth IRA assets.
For example, if you have $20,000 in a Traditional IRA and $5,000 in an after-tax IRA, you would have to pay tax on 80% of any converted amount because 80% of your non-Roth assets are taxable.
This could potentially be a major hurdle for conducting a Backdoor Roth IRA.
One way to avoid this potential tax hiccup is to roll your Traditional IRA into an employer-sponsored plan (assuming they’ll accept it).
This way you reduce the untaxed portion of your IRAs to zero and you won’t owe any tax on future conversions.
12) Fumbling a 72T or SEPP
A 72T distribution or Series of Equal Periodic Payments (SEPP) is a method for making withdrawals from an IRA before you reach age 59.5 without penalty.
There are three methods for calculating the withdrawals and once you begin making them you must continue to do so for five years or until you reach age 59.5, whichever occurs later.
Depending on the method you use, your annual withdrawal amount could vary a bit from year to year.
The problem is your withdrawal must be correct or you could face early withdrawal penalties for the distribution.
Anytime I talk about these I am quick to recommend talking to a tax professional before taking on a 72T distribution. If they keep you from botching the distribution it will be money well spent.
13) Leaving Your IRA to Your Ex
If you haven’t taken a look at the listed beneficiaries on your IRA in a while, this one may inspire you to do so.
There are many unfortunate stories about people who passed away and inadvertently left their IRA to someone they didn’t intend to give it to.
The juiciest stories usually involve an ex-spouse receiving it in lieu of the deceased’s current spouse. Ouch.
How could this happen? By doing nothing.
In this case, the IRA owner simply filled in their beneficiaries when they set up the account and never looked back.
Years passed, family dynamics changed, and fallout ensued.
Of course, this could also happen if you name someone as your account beneficiary before you have kids or get married, or some other event occurs that calls for you to make a change.
For example, my brothers were listed as my IRA beneficiaries before I was married. I’m not sure how close to my wedding I made the correct, but I’m pretty sure I didn’t tarry on this important update.
A good practice is to update your IRA beneficiaries annually.
Remember that your custodian will carry out the directions you give them. They will not yield to your will and final testament no matter what.
So, be sure you get those beneficiaries declared correctly.
14) Not Liquidating an Inherited IRA
Before 2019 if you inherited an IRA you could slowly liquidate the balance based on your remaining life expectancy.
This actually produced a unique tax strategy called a stretch IRA which allowed older folks to bequeath their IRAs to younger generations, effectively giving them a lifetime income stream.
Alas, that was then.
Now, you have just 10 years to completely liquidate an IRA (Roth or Traditional) unless you are the spouse of the original account owner, less than 10 years younger, or his or her minor child.
If you fail to liquidate the account in 10 years or less, you’ll owe a 25% penalty each year until you do.
Conclusion
Any time the IRS gets involved, you can rest assured that things will get complicated. IRAs are no different.
Some of these tax quirks work in our favor, but there are plenty of ways to go awry.
If you think any of these mistakes could potentially trip you up, be sure to learn more to avoid tax headaches down the road.
