5 things people get wrong about IRAs: Bankruptcy protection limits, inheritances and more

·4 min read

IRAs have been around since 1974. And yet after nearly 50 years, there’s plenty that the 47.9 million households that use IRAs to save for retirement still get wrong about these retirement accounts.

Here’s a look at often overlooked facts about IRAs:

How much can I contribute and is it tax deductible?

Experts say account owners often forget how much they can contribute to an IRA. To be fair, the IRS does on occasion change how much one can contribute to an IRA. For 2021, for instance, the total contributions you make each year to all of your traditional IRAs and Roth IRAs can't be more than $6,000 ($7,000 if you're age 50 or older), or if less, your taxable compensation for the year.

Experts also say account owners also forget whether their contribution is taxdeductible. Yes, the deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds a certain threshold.

Traditional IRA: Known as a traditional individual retirement account, it allows people to direct portions of their pretax income toward investments that can grow tax-deferred.
Traditional IRA: Known as a traditional individual retirement account, it allows people to direct portions of their pretax income toward investments that can grow tax-deferred.

“Often account owners don’t realize that they may be able to contribute to an IRA even if they have a 401(k) depending upon their income,” says Phillis Sax Pilvinis, the founder of PSP & Associates Inc. Retirement Wealth Strategists.

How best to avoid misconceptions about the annual IRA contribution limit? Review those details on the IRS’s website.

What I can invest in?

Sax Pilvinis also notes account owners are not always aware that an IRA is a tax status and not an investment vehicle. But even though it’s not an investment vehicle, account owners can invest in almost anything except life insurance or collectibles such as artwork, antiques, stamps, comic books, most coins, alcoholic beverages and certain other tangible personal property.

When in doubt, check the IRS’s website.

Who inherits my IRA?

You can't just lay out who inherits your IRA in your will. You must specify beneficiaries with the company holding the account. In addition, only surviving spouses get 60 days to roll them over. Everyone else must do a direct transfer.
You can't just lay out who inherits your IRA in your will. You must specify beneficiaries with the company holding the account. In addition, only surviving spouses get 60 days to roll them over. Everyone else must do a direct transfer.

Many account owners mistakenly think their heirs will inherit their IRA by stating those wishes in their will. But that’s not how IRAs are transferred when a person dies. Instead, IRA, as well as 401(k) account owners, need to designate a beneficiary as well as a contingent beneficiary, says Jeannette Bajalia, the president of Petros Financial Group.

“The beneficiary form is, in essence, the will for the IRA,” says Joe DiSalvo, chartered financial consultant, the president of Quest Capital & Risk Management and co-author of "Income for Life: The Retiree's Guide to Creating Income From Savings." “The average person and many brokers do not understand this. Most people cannot put their hands on their beneficiary designation forms, and many are often executed incorrectly.”

What to do? Check the primary and secondary beneficiary designation on all your retirement accounts, and insurance policies and update them as needed.

A tax time bomb waiting to happen

Time was those who inherited an IRA could distribute assets from those accounts over their lifetime. No more. The SECURE Act put the kibosh on what advisers called the “stretch IRA.”

Now, those who inherit an IRA have just 10 years to distribute all the assets in the account. And because of that, says Bajalia, “IRAs are now tax time bombs to their beneficiaries because of the loss of the stretch IRA.”

That’s because distributions are taxable as ordinary income and could push the beneficiary’s income into a higher tax bracket.

Bajalia’s advice: “Be aware of your beneficiary's tax status. It may make sense to spend all your IRAs during your life span and not leave the tax burden to children in higher tax brackets.”

Speaking of tax bombs, owners of IRAs also forget that the assets in those accounts don’t have a cost basis. “One hundred percent of the value is taxed as ordinary income,” said Bajalia. “No losses and no gains.”

Given that, one should plan on the gross value of one’s IRA account not being the after-ordinary income tax value.

No 60-day rollover

Many non-spouse IRA beneficiaries suffer from the misconception that they can do 60-day rollovers of inherited IRAs.

“In actuality, beneficiaries other than spouses can only do direct transfers, which is called ‘trustee-to-trustee transfers,’ ”, says Ian Berger, an IRA analyst with Ed Slott & Co.

If an inherited IRA is paid to a non-spouse, the entire IRA will be taxable to the beneficiary, he notes. “This makes it imperative for advisers to make sure that a client’s IRA custodial agreement allows a non-spouse beneficiary to move assets via a direct transfer,” he explains. “Otherwise, a custodian could hold the inherited IRA assets hostage.”

Complete creditor protection?

Another misconception is that IRAs enjoy complete creditor protection from lawsuit judgments against the IRA owner, says Berger. “Since IRAs are not ERISA (Employee Retirement Income Security Act) plans, they do not receive the iron-clad protection that ERISA plans provide,” he said.

IRAs are shielded from bankruptcy creditors up to a certain dollar amount ($1,362,800 in 2021), and that dollar amount does not include rollovers from company plans, he notes.

"This equates to a complete bankruptcy shield for most IRA owners,” Berger explains. “However, protection from non-bankruptcy judgments depends on state law. Some states provide complete protection, but creditor protection in other states is weaker.”

► Retirement quiz: Can you tell the difference between an IRA and a Roth IRA?

This article originally appeared on USA TODAY: Retirement: 5 things people get wrong about IRAs