Six 'Traps' to Avoid with Your Retirement Accounts
For most working Americans, retirement accounts provide an important safeguard for the future. Making annual contributions to an Individual Retirement Account (IRA) or employers 401(k) plan during the working years can significantly reduce your taxable income an immediate financial benefit. Your nest egg grows more quickly because those taxes are deferred. And when you finally withdraw those funds in your retirement years, your tax bracket is likely to be lower.
However, the Internal Revenue Service (IRS) has very strict rules governing these retirement accounts. And in todays turbulent financial markets, its all too easy to make a serious mistake that will cost you money. For instance, if you withdraw funds from a retirement account before age 59.5, youll probably pay a 10 percent penalty as well as the income tax.
Here are six suggestions for avoiding the most common traps:
Dont let your bank or other plan custodian give you a credit card or checking account tied to your retirement funds. While its a convenient way to make withdrawals, you could wind up withdrawing excessive amounts that could not be paid back, causing potential future problems. And dont lose sight of the tax consequences: withdrawals taken from these funds will count as personal income.
Dont take out a loan from your IRA or 401k plan. Many Floridians today are looking for funds for overdue mortgage payments or other immediate debts. But any loan from an IRA must be paid back in full in 60 days. If you have a loan from your 401k and you lose your job, it must be paid back immediately. Otherwise its considered taxable income. Youll also have to pay the 10 percent penalty if youre younger than 59.5 in either case
Be sure your IRA accounts that are held at any bank are insured. The Federal Deposit Insurance Corporation (FDIC) currently covers up to $250,000 in retirement accounts at any one bank. But if your IRA has grown to $300,000, the extra $50,000 is at risk. Fortunately, you can move some of your IRA assets to another bank to be sure the total amount is protected.
Be very careful when transferring or rolling over your IRA funds to avoid tax penalties. The IRS will only allow you to move the funds in a rollover transaction from one custodian to another just once in any 12-month period. The better method is a direct trustee to trustee transfer (the capital passes directly from one custodian to the other without being received by the account owner), as there are no imitations for transfers. In any rollover, set up the new IRA first, then ask your current bank to transfer the money directly rather than writing a check in your name for you to deposit.
Name your beneficiaries directly. Designating your spouse or children as beneficiaries of your IRA provides greater flexibility in inheritance funds, allowing them to minimize tax consequences. Therefore, its usually a better choice than naming a living trust as the beneficiary. Remember that someone eventually will have to pay the taxes and its usually better to spread out those tax payments over time. If a living trust is the beneficiary this option is lost.
Diversify your investments. Dont let the volatility on Wall Street lead you to putting all your IRA funds into safe investments like certificates of deposit (CDs), Treasury bills or other fixed-income investments that will not keep up with inflation. To avoid losing your purchasing power in the future, you need to maintain a diverse investment portfolio that may include stocks, real estate and other types of assets. Thats a good way to reduce both short- and long-term risks.