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 Therefore, amounts withdrawn from a traditional IRA are taxed as ordinary income unless the individual has made nondeductible IRA contributions.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

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