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 Therefore, amounts withdrawn from a traditional IRA are taxed as ordinary income unless the individual has made nondeductible IRA contributions.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:

1. the naming of a designated beneficiary; and
2. 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

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:

1. The trust is a valid trust under state law or would be but for there being no corpus.
2. The trust is irrevocable or becomes irrevocable at the owner's death.
3. The trust beneficiaries who are beneficiaries with respect to the trust interest in the IRA are identifiable from the trust instrument.
4. A copy of the trust instrument is provided to the plan (or other certain requirements are met).
5. All beneficiaries are individuals.
6. 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:

1. Dec. 31 of the year in which the owner would have reached age 70½; or
2. 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:

1. 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.
2. Does the IRA agreement allow a beneficiary to take minimum withdrawals over his or her life expectancy?
3. 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