Did you know when you leave your employer if you plan to rollover your company retirement account to an IRA—but don't fill out the paperwork correctly—you could end up paying unwarranted taxes? (With properly done rollovers no taxes are due.)
1. Doing an IRA Rollover the Wrong Way
Example: You have $200,000 in a 401(k)—you retire and take it as distribution— but you don’t fill out the paperwork correctly. Your company withholds $40,000 in taxes from your funds (20 percent of the distribution amount). You deposit the net $160,000 it into an IRA within 60 days as an IRA rollover. But now you have to come up with an additional $40,000 to deposit into this IRA in order for the entire $200,000 to count as a rollover.
What if this happens and you don’t have the $40,000 lying around to put back into the IRA to make up for the tax withholding that has now been sent to the IRS? Well, that $40,000 of withheld taxes is then considered a taxable distribution from your account, and you have to pay taxes on it—even if you meant for it all to be an IRA rollover. (At a 25 percent tax rate that is $10,000 in taxes for the year that could have been avoided.)
If you are under 59 1/2 years old and this happens to you, you will have to pay an extra 10 percent penalty tax too. Yikes!
How do you avoid this big tax mistake? When you leave an employer you must rollover your funds correctly.
2. Not Knowing About RMD's (Required Minimum Distributions)
"How the heck were we supposed to know that you have to withdraw certain amounts out of your IRA?", said one retired couple facing a hefty penalty tax.
It's true. Once you reach age 70 ½, if you have money in traditional IRAs—or other formal retirement plans like 401(k)s or 403(b)s—then you are required to take distributions. The amount you must withdraw is determined by a formula based on your age and your account balance on Dec 31st of the prior year.
As you get older, for every year you age you are required to withdraw a higher percentage of the remaining balance than what you had to withdraw the year before.
If you don’t take out the required amount? You can owe a penalty tax of up to 50 percent of the amount you were supposed to take!
Required distributions can also apply to inherited IRAs and inherited Roth IRAs even if you are under age 70 1/2.
3. Not Withholding Tax on Pensions and Social Security
“What? I owe how much in taxes?” This is not what you want to be saying in retirement.
Most forms of retirement income are taxable. For example, pension income is taxable income, and your Social Security income may be subject to taxation too! In addition, you'll report interest, dividends and capital gains on any non-retirement accounts.
When you retire, if you don’t have the right amount in taxes withheld from your pension or Social Security income you may be in for a big surprise when you file your taxes. You’ll need to do a tax projection to estimate your taxable income and your tax rate, and make sure you have the right amounts withheld.
4. Doing No Tax Planning BEFORE Retirement
“I could have converted $20,000 from my IRA to a Roth IRA and paid NO tax. But I didn’t find out in time.” This happens a lot. It can be avoided with smart planning.
Tax planning does you no good once the year is over. Low income years can particularly useful and you should use them to your advantage. Losing a job or otherwise having less income is never good—but it may present a tax planning opportunity.
If you have a year with high deductions, such as the mortgage interest deduction and health-related expenses—and low income that year—you may be able to use it to your advantage by converting some of your IRA to a Roth IRA and pay little-to-no tax.
This can save you thousands of dollars—but it doesn’t happen unless you do your tax planning before the year ends. Tax planning can help your nest egg last longer.
5. Not Taking Advantage of IRAs
Many people think you can't fund IRA's if you have a retirement plan at work. That may or may not be true, depending on your income. You may eligible to make an IRA contribution and not even know it. Or, perhaps you can make a contribution on behalf of a non-working spouse. Yes, this is possible.
Learn the IRA rules—and each year see if you are eligible to make an IRA, non-deductible IRA, or Roth IRA contribution.
You should also find out if your company retirement plan offers the ability to make Roth contributions (it is called a Designated Roth account through your 401(k) plan).
Roth contributions go in after-tax, so they don’t reduce your current year’s taxable income, but when you use the money from a Roth in retirement, distributions come out tax-free.
In addition, Roth IRA withdrawals are not included in the formula that determines how much of your Social Security income will be taxable.
6. Not Strategically Choosing How and When to Withdraw Income
Speaking of taxes on Social Security, one of the biggest tax mistakes retirees make is taking Social Security early while waiting to withdraw from IRAs and other retirement accounts until they are required to.
Why is this a tax mistake? Using your retirement money in the wrong order can mean paying thousands more in taxes each year than you would have to pay if you had rearranged things based on the strategy that would get you the most after-tax income.
This is especially true if you have no pension and most of your retirement income will come from Social Security and IRA money. An experienced retirement planner can help with this kind of planning—and it can result in more after-tax retirement income for you.