The IRA Maze: Finding a Way Out
The author breaks
down the IRS rules for individual retirement accounts, highlighting the
basics of traditional IRAs, and provides a checklist of important terms,
rules, concepts, and deadlines regarding traditional IRA distributions.
by Terry L. Campbell
client with a traditional IRA encounters a
maze of Internal Revenue Service (IRS) rules and regulations that
mandate the manner in which an IRA account may be accessed without
penalty, the time by which distributions must commence, how
distributions must be calculated, and the "dos and don'ts" of
beneficiary designations. Failure to abide by the rules results in harsh
penalties and consequences. Clients rely on their attorneys to guide
them through this maze. However, there are traps and pitfalls that can
snare attorneys not familiar with the key provisions.
There are countless articles (or treatises) that
offer an in-depth analysis of the Internal Revenue Code provisions and
rules governing individual retirement accounts (IRAs) and the
requirements for distributions. The articles often are both insightful
and a welcome relief for insomniacs. This article breaks down those IRS
rules and highlights the basics regarding the traditional IRA. A
traditional IRA is any IRA that is not a Roth IRA, a SIMPLE (Savings
Incentive Match Plan for Employees) IRA, or an Education IRA. A Roth IRA
is subject to the rules that apply to a traditional IRA. However, unlike
a traditional IRA, one cannot deduct contributions to a Roth IRA and
qualified distributions are tax-free. A SIMPLE IRA is a plan that small
employers (including self-employed individuals) can set up for the
benefit of employees. Contributions under a SIMPLE IRA plan may be
salary deferrals by an employee and/or contributions by the employer. An
Education IRA is not a retirement arrangement; it is a trust or
custodian account created to pay qualified higher education expenses of
a designated beneficiary.
This article does not review every provision of the traditional IRA,
nor does it provide detailed scrutiny of each provision. Rather, it is
intended to provide a summary or a checklist of important terms, rules,
concepts, and deadlines regarding traditional IRA distributions.
Taxation
Subject to certain limitations, one can take a deduction for
contributions to a traditional IRA. Therefore, amounts withdrawn from a
traditional IRA are taxed as ordinary income unless the individual has
made nondeductible IRA contributions. A nondeductible contribution
typically occurs because an individual participates in an employer
retirement plan and has modified adjusted gross income above certain
levels. When this occurs, the deduction attributed to the contribution
may be reduced or eliminated. The difference between the total permitted
contribution and the total deductible contribution is the nondeductible
contribution. A return of a nondeductible contribution is not taxable;
however, the tax-deferred earnings are taxable. If there are
nondeductible contributions, the taxpayer must file Federal Form 8606
with his or her income tax return to determine how much of the
distribution is taxable.
Age 59½ Rule
Generally, one cannot withdraw assets from an IRA until reaching age
59½ without incurring a 10 percent penalty in addition to ordinary
income tax.1 Disability and death provide
two exceptions to the penalty. Other key exceptions2 are the following:
- Distributions from an unemployed individual's IRA to pay health
insurance premiums.
- Distributions that do not exceed the amount allowable as a section
213 deduction (medical expenses that exceed 7.5 percent of adjusted
gross income) to the employee for amounts paid for medical care. This
exception contains some traps. The plan distribution itself is
includable in gross income, thereby increasing the 7.5 percent
limitation and decreasing the "amount allowable as a deduction."
- Distributions that do not exceed the individual's "qualified higher
education expenses." The distributions must be used to pay for education
furnished to the individual, a spouse, or to a child or grandchild of
either of them.
Room and board are among the covered expenses if the student is
enrolled at least half time. The type of expenses covered include
tuition, fees, books, supplies, and equipment. Eligible institutions
include virtually all accredited public, nonprofit, and proprietary
postsecondary institutions.
- Distributions up to $10,000 used to pay qualified acquisition costs
of a principal residence of a first-time homebuyer who is the IRA owner,
the spouse, or a child, grandchild, or ancestor of the owner or owner's
spouse. "Qualified acquisition costs" are the costs of acquiring,
constructing, or reconstructing a residence, including usual or
reasonable settlement, financing, or other closing costs.3 A "first-time homebuyer" is a person who has had
no "present ownership interest in a principal residence during the
two-year period ending on the date of acquisition" of the residence
being financed by the distribution.4 The
$10,000 amount is a lifetime limit. It applies to the person making the
withdrawal (the IRA owner), not the person buying the home.
Perhaps the most often overlooked exception to the penalty is for a
distribution that is "part of a series of substantially equal periodic
payments (not less frequently than annually) made for the life (or life
expectancy) of the employee or the joint lives (or joint life
expectancies) of such employee and his designated beneficiary."5 There are numerous methods for determining the
size of the equal payments.6 Further, the
payments do not have to actually continue for the participant's entire
life or life expectancy; payments must continue until the participant
reaches age 59½ or until five years have elapsed, whichever occurs
later. Clients can use this exception to 1) access substantial funds to
start a new business, 2) finance early retirement, or 3) fund an annual
exclusion gifting program.
A relatively simple explanation of these exceptions can be found in
IRS Publication 590.
After Age 59½ and Before Age 70½
One can withdraw assets from an IRA after reaching age 59½
without penalty (subject to minimal limitations).
Required Beginning Date
An individual must receive the entire IRA by the required beginning
date or start receiving periodic distributions from the IRA no later
than the required beginning date. The "required beginning date" is April
1 of the year following the year in which the IRA owner reaches age
70½.7 This is not, however, just the
deadline for commencing plan payouts. Two important choices have to be
made by this date:
- the naming of a designated beneficiary; and
- the method for calculating distributions.
If an individual does not take the minimum required distribution by
the required beginning date, the IRS imposes a penalty of 50 percent of
the amount the individual should have withdrawn.8
Beneficiaries
Traditional IRAs: Practice Pointers
1) It is possible to access IRA funds prior to age 59½ without
penalty.
2) There are few restrictions to withdrawals after age 59½ and
before age 70½.
3) It is critical to review with clients the designation of
beneficiaries and selected method for distribution prior to age
70½.
4) Verify that your client's IRA agreement provides for the methods
and choices selected.
5) The Designated Beneficiary Trust offers new solutions for using
IRA assets for the applicable credit amount yet continues income tax
deferral.
Designated beneficiary. A designated beneficiary
(DB) is any individual so designated as beneficiary by the IRA owner to
the IRA trustee or custodian. A DB does not have to be specified by name
as long as the beneficiary is identifiable. If the owner fails to
designate a beneficiary, the IRA agreement itself may provide a default
provision. For example, the agreement might designate as beneficiary the
owner's spouse or children.
Only an individual may be a DB. An owner who names something other
than an individual as beneficiary, such as an estate, is treated as
having no designated beneficiary. If an individual and a nonindividual
are both named as beneficiaries, there is no designated
beneficiary.9 If there is no DB at the
required beginning date, the distribution period is limited to the IRA
owner's life or a period not extending beyond the owner's life
expectancy.10
A trust itself may not be a designated beneficiary. However,
beneficiaries of a trust may be treated as designated beneficiaries if
certain requirements are met:
- The trust is a valid trust under state law or would be but for there
being no corpus.
- The trust is irrevocable or becomes irrevocable at the owner's
death.
- The trust beneficiaries who are beneficiaries with respect to the
trust interest in the IRA are identifiable from the trust
instrument.
- A copy of the trust instrument is provided to the plan (or other
certain requirements are met).
- All beneficiaries are individuals.
- No person has the power to change the beneficiary after the owner's
death.
This trust (referred to as a "Designated Beneficiary Trust") provides
new planning opportunities for clients with a disproportionate amount of
assets in IRA accounts. Prior to the regulations allowing trust
beneficiaries to be treated as designated beneficiaries, it was
difficult, if not impossible, to use the applicable credit amount
because distributing IRA accounts to a trust at death triggered
immediate income taxation. Now, with proper planning, IRA proceeds can
be distributed to a trust at the death of a spouse to use the $675,000
applicable credit amount, and the surviving spouse or other trust
beneficiaries will be subject to income tax only as the required minimum
distributions are made and distributed to them. The Designated
Beneficiary Trust also may be a Qualified Terminable Interest Property
Trust (QTIP Trust). Special care is critical in drafting such a
trust.11
Changing beneficiary. An individual may change the
designated beneficiary on or after the required beginning date. However,
if a new designated beneficiary is named after the distribution period
has been determined with a shorter life expectancy than the individual
being replaced, a new calculation must be made for the withdrawals for
subsequent years using the life expectancy of the new designated
beneficiary. If the new designated beneficiary has a longer life
expectancy than the individual being replaced, a new recalculation
period will not occur.
Lifetime Minimum Required Distributions
Under section
401(a)(9)(C), distributions to an IRA owner must begin by the
required beginning date. The owner needs to withdraw at least a minimum
amount; distributions larger than the required minimum are permitted.
The owner must determine how life expectancy will be calculated and must
choose a calculation method. The minimum required distribution amount is
then calculated by dividing the IRA account balance, valued as of the
previous Dec. 31, by the life expectancy factor.
Life expectancy is determined in the calendar year in which the IRA
owner attains age 70½ from tables in Reg. 1.72-9. The owner may
choose a single or a joint life expectancy. A joint life expectancy will
be longer than a single life expectancy. Therefore, a joint life
expectancy would reduce the minimum required distributions.
Example. Alex has a required beginning date in the year
2000; his spouse is 68 years old. Assume his IRA balance as of Dec. 31,
1999, is $200,000. Consulting the life expectancy tables reveals that
the single life expectancy divisor is 15.3, but a joint life expectancy
divisor is 21.2. If Alex selects single life expectancy, the first
distribution will be $13,071.90 ($200,000 ÷ 15.3). If Alex elects
joint life expectancy with his spouse, the minimum required distribution
will be $9,433.96 ($200,000 ÷ 21.2).
For a designated beneficiary who is not the
owner's spouse, the "minimum distribution incidental benefit" (MDIB)
rule requires that the life expectancy be determined using a
hypothetical individual not more than 10 years younger than the owner as
the owner's designated beneficiary.12
Example. Peter reaches age 70½ in 2000. His designated
beneficiary is his son, David, who is age 35. Even though the actual
joint life expectancy of Peter and David is 47.5 years, the MDIB rule
requires that the divisor be 25.3 years (calculated using an individual
age 71 and a beneficiary age 61). At Peter's death, the MDIB rule
disappears and David may elect to receive the remaining benefits over
the remaining actual joint life expectancy.
An individual must affirmatively make a decision as to how his or her
minimum required distributions will be calculated prior to the
required beginning date or this decision may be made for the individual
by default. Each individual has an opportunity to choose a method for
calculating the minimum required distributions. The three basic
calculation methods are the term-certain or nonrecalculation,
recalculation, and hybrid.
Term-certain. Under term-certain, distributions for
the first year are figured using the account owner's life expectancy (or
that of the account owner and designated beneficiary's joint life
expectancy) from tables in the regulations.13 In each subsequent year, distributions are
calculated by subtracting one from the previously determined life
expectancy. The IRA account balance as of Dec. 31 of the previous year
is divided by the life expectancy multiple to calculate the minimum
required distribution.
Example. A single life expectancy at age 71 is 15.3 years.
In year two, the number used as the divisor would be 14.3, in year three
the number would be 13.3, and so on.
Recalculation. Using recalculation, the life
expectancy tables in the regulations are used each year to redetermine
life expectancy. This will result in smaller minimum required
distributions. Only an IRA owner and a spouse can elect to recalculate
both life expectancies. Using the example of a 71-year-old individual,
the life expectancy starts at 15.3 but in year two the divisor is 14.6,
in year three it is 13.9, and so on. Recalculation occurs on the lives
of both spouses. The advantage of annual recalculation is that the
participant or couple will never outlive the IRA if only the minimum
required distribution is withdrawn each year. The disadvantage is that
in the year following death, the life expectancy of the deceased spouse
is reduced to zero. If both spouses' life expectancies are being
recalculated and both die prematurely (prior to the conclusion of the
life expectancy calculation), all remaining benefits must be distributed
to the beneficiary by the end of the year following the second spouse's
death.
Hybrid. The hybrid method blends the
nonrecalculation and recalculation methods and recalculates only on one
life. For example, one can recalculate the owner's life and use term
certain for the spouse. This may be advisable. If the spouse dies first,
there is still the owner's remaining life term to be used to calculate
distributions. If the owner dies, the life expectancy is zero but the
spouse can roll over the account and start a new calculation process.
There is no sudden acceleration of benefits if both spouses die
prematurely.
Practice Tip: A planning strategy could split an IRA into
several IRA accounts and use different calculation methods for each
different account.
Multiple Accounts
It is common for individuals to have multiple IRA accounts. The
minimum required distribution may be taken from any combination of IRA
accounts as long as the total amount distributed is at least equal to
the minimum required distribution.
Double Distribution Trick
The required minimum distribution for any year after the age 70½
year must be made by Dec. 31 of that later year.
Example. You reach age 70½ on Aug. 19, 1999. For 1999
(your 70½ year) you must receive the required minimum distribution
from your IRA by April 1, 2000. You must receive the required minimum
distribution for 2000 (the first year after your 70½ year) by Dec.
31, 2000. Therefore, if you wait to receive your first distribution by
April 1 of the year following the year in which you reach age 70½,
you actually will have to receive two distributions in calendar year
2000.
Postdeath Distributions/Death Before Age 70½
The general rule provides that if an IRA owner dies before the
required beginning date, the entire interest must be distributed by Dec.
31 of the calendar year that contains the fifth anniversary of the
owner's death.14 There are separate
exceptions to the five year rule for spouse and nonspouse designated
beneficiaries.15
Nonspouse beneficiaries. If the owner dies before
the required beginning date, the remaining account balance may be
distributed to a designated beneficiary over the life expectancy of the
designated beneficiary. The distribution must begin by Dec. 31 of the
year following the owner's death.
Example. Mary died on April 1, 1999 at age 66. Her
designated beneficiary is her 35-year-old son, Ben. Under the exception
to the five year rule, the account balance may be distributed to Ben
over his life expectancy (or a fixed period not greater than his life
expectancy), provided the distributions begin by Dec. 31, 2000.
This designation offers some tremendous planning options. Ben, as a
35-year-old beneficiary, could spread the distributions over a
47-year-life expectancy after his mother's death. Income on the
undistributed account balance could accumulate tax free for far longer
than five years.
Spouse as beneficiary. Two alternatives to the five
year rule are available to the surviving spouse of an IRA owner. The
first alternative allows the spouse to begin receiving distributions at
the later of the following:
- Dec. 31 of the year in which the owner would have reached age
70½; or
- Dec. 31 of the calendar year following the year in which the
decedent died.16
To qualify for this exception, the surviving spouse must be the
designated beneficiary, and the account must be distributed over the
life of the surviving spouse, or for a period not extending beyond that
life expectancy.
The second alternative is provided by Section
408(d)(3), and allows the surviving spouse to treat an inherited IRA
as her or his own and roll it over as such. The surviving spouse is then
treated as the owner of the account for all purposes; this allows the
spouse to use her own required beginning date and to name her own
beneficiaries. Therefore, the surviving spouse would not be required to
begin receiving distributions until April 1 of the year following the
one in which she attains age 70½. This option presents a
significant planning opportunity for younger surviving spouses.
Postdeath Distributions/Death After Age 70½
When an IRA owner dies after age 70½, the life expectancies of
the owner and the designated beneficiary at the required beginning date
determine the distribution period. If the owner had named a designated
beneficiary by the required beginning date, the remaining account
balance must be distributed at least as rapidly as under the method of
distribution being used at the date of death.17 The beneficiary may always elect to receive the
benefits more quickly.
Example. Ted elected to receive distributions from his IRA
over his 16-year life expectancy using term certain, and died
10 years later. The remaining balance in his account may be
distributed to his beneficiary over the remaining six years.
Special Note. Remember that the distributions to a
beneficiary will depend on the method chosen at 70½. For a long
time, it was believed by practitioners that if the life expectancy of a
single owner was being recalculated, the owner's life expectancy for the
year following death was zero and all funds had to be distributed to the
owner's beneficiary by the end of that year. However, IRS Letter Ruling
199951053 explicitly held that a nonspouse beneficiary who was
designated beneficiary prior to the owner's required beginning date
could take distributions after the owner's death over the beneficiary's
life expectancy even though the owner had been taking lifetime
distributions based upon single life recalculation. This ruling provides
an unexpected benefit to the beneficiary. The ruling treats the
beneficiary as if the IRA owner had in fact taken required distributions
over the owner's and the nonspouse beneficiary's joint life
expectancies.
Stretching the IRA
The concept of the "stretch IRA" has become popular as the bull
market roars on and creates unforeseen sizable IRA accounts. An example
of the stretch IRA is demonstrated by an IRA owner designating a child
or a grandchild as beneficiary.
Example. Assume an IRA owner dies at age 69 with $1.3
million in his IRA and he has designated his 35-year-old son as
beneficiary. Assuming the IRA earns 7 percent per year, the son can
withdraw more than $2 million over the next 25 years and still have more
than $3.5 million in the account.
A word of caution directs you to IRA custodians and agreements. This
arrangement and beneficiary form should be cleared in advance with the
IRA custodian.
Not All IRA Agreements are Created Equal
The IRA agreement may specify whether the five year rule or one of
its exceptions applies at the death of an IRA owner. IRA agreements may
not provide for the same flexible options that are provided for by the
Internal Revenue Code and related regulations. This poses a regular
planning dilemma for attorneys.
The following is an important checklist of questions to ask the IRA
custodian:
- Does the IRA custodian let IRA beneficiaries name their own
beneficiaries? Occasionally, an IRA agreement will provide that the IRA
terminates at the first beneficiary's death; therefore, all remaining
funds are immediately distributed and subject to income taxes.
- Does the IRA agreement allow a beneficiary to take minimum
withdrawals over his or her life expectancy?
- Does the IRA agreement permit an IRA beneficiary to create separate
IRAs? For example, for multiple beneficiaries, creation of separate IRAs
will provide more flexibility and slow the timing of taxable
withdrawals.
Terry L. Campbell, Marquette 1979, is a
shareholder with Moertl, Wilkins & Campbell S.C., in Milwaukee. He
practices in lifetime and estate planning.
Conclusion
A basic understanding of the traditional IRA begins with an
understanding of key terms such as "required beginning date,"
"designated beneficiary," and "minimum required distributions." The
required beginning date is the critical deadline for determining the
method used in calculating distributions and for naming a beneficiary.
The nitty gritty details that further explain these provisions can be
found in the cited code provisions and regulations.
The charts
accompanying this article provide a useful resource and
checklist.18 With an understanding of the
basics, the general practitioner can offer guidance and understanding to
his or her clients without getting lost in the maze of IRA rules.
Endnotes
1 I.R.C. §
72(t)(2)(A)(i).
2 I.R.C. § 72(t)
provides other exceptions than those listed in this outline. The outline
concentrates on most commonly used exceptions.
3 I.R.C. §
72(t)(8)(C).
4 I.R.C. §
72(t)(8)(D). If the homebuyer is married, both spouses must meet
this test.
5 I.R.C. §
72(t)(2)(A)(iv).
6 Two very useful software programs
that can help with the necessary calculations are Number Cruncher and
Pension Distributions Calculator by Brentmark.
7 I.R.C. §
401(a)(9)(c).
8 I.R.C. §
4974(a).
9 Proposed Regs. §
1.401(a)(9)-1, Q and A-E-5(a)(1).
10 Proposed Regs. §
1.401(a)(9)-1, Q and A-D-3(a).
11 See Internal Revenue
Ruling 2002-2.
12 Proposed Regs. §
1.401(a)(9)-2, Q and A-4(a)(1).
13 IRS Publication 590 contains
life expectancy tables.
14 Proposed Regs. §
1.401(a)(9)-1, Q and A-C-2.
15 Proposed Regs. §
1.401(a)(9)-1, Q and A-C-3.
16 Proposed Regs. §
1.401(a)(9)-1, Q and A-C-3(b).
17 I.R.C. §
401(a)(9)(B)(i).
18 The charts accompanying this
article are published with the permission of Jack McManemin III, CFP,
© 1998. His originals, which are laminated and in color, provide an
excellent handout for clients.
Wisconsin
Lawyer