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Vol. 73, No. 7, July 2000 |
The IRA Maze:
Finding a Way Out
Estate Planning for a Marital Property Interest in
IRAs
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.
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