Planning for Individual Retirement Accounts

alan-cohn

By Alan B. Cohn, Esq.

Over the years I have been practicing, I have seen a geometric increase in the use of Individual Retirement Accounts (“IRAs”) because of their ability to provide tax-deferred growth on assets. Contributing to such vehicles is quite easy.  However, planning for distributions and beneficiary designations on death are much more difficult.  In many cases, because there has been a decrease in the value of real estate (principally, the value of the homestead) the IRA has become the largest asset on a typical client’s balance sheet.

Distribution Planning

Even people who are not tax planners understand that distributions from IRAs are includable in gross income and are taxed at ordinary income tax rates.  They also understand that if the same asset is held outside of an IRA, then the proceeds on sale might have been taxed at capital gains rates.  Understanding some of the basic distribution rules is important to all clients since there are penalties imposed on insufficient or early distributions.

Distributions taken before a participant turns 59 ½ are subject to a 10% early withdrawal penalty, in addition to the normal income tax which is imposed on the distribution.  There are exceptions to this rule for medical treatment, students financing their higher education, first-time homebuyers, and disability and annuity payments.  After the participant turns 70 ½, there are penalties for not taking IRA distributions in a timely manner.  The smallest distribution a participant is allowed to take after age 70 ½ is called a required minimum distribution (“RMD”).  If the RMD is not made, then a penalty equal to 50% of the undistributed portion is imposed.  The amount of the RMD is determined each year by dividing the value of the IRA (valued as of the previous December 31st) by the remaining life expectancy of the participant.  There are life expectancy tables used for this purpose (Internal Revenue Service Publication 590).  All a participant needs to do is review the life expectancy table each year and take the value of the account and divide it by that life expectancy to arrive at the RMD.

There is an alternate way of calculating the RMD by using the joint and last survivor table provided in Publication 590.  It can be used if the participant’s spouse is both the sole designated beneficiary and more than ten years younger than the participant.  This will result in a smaller RMD, and thus result in a stretching out of the distribution over a longer period of time.

Under normal rules, the RMD must be taken by April 1st of the year following the year in which a person turns 70 ½.  However, the first RMD can be taken as early as January 1st of the year in which the participant turns 70 ½.  Each remaining RMD must be taken no later than December 31st of the following years.  Even though the first RMD distribution can be delayed until April 1st of the year following the year in which the participant turns 70 ½, this will result in two RMDs in that same year (i.e. April 1st and December 31st).  Therefore, two years of income will be bunched into one year, which could place the participant in a higher tax bracket.  Therefore, even though the first RMD does not need to be taken in the year in which a participant attains the age of 70 ½, it might be advisable to do so in order to avoid two years of income being reported in one year.

If additional distributions are made (after age 59 ½ there is no limit on the maximum distribution), it does not have a major effect on reducing your RMDs in future years.  This is because the factor in Publication 590 does not change; only the principal value of the account is slightly reduced.  Therefore, taking additional distributions only makes sense if the participant has losses that will absorb the additional income.  If the participant has losses, then taking additional distributions would be advisable.

If a participant has multiple IRAs, there is no requirement to take a pro rata distribution from each IRA as long as the total amount that was withdrawn by the participant is equal to the total RMD.  The participant can choose from which IRA he or she desires to withdraw the RMD.  Therefore, the participant can make a decision to take a distribution from an IRA that is not performing rather than force a liquidation of assets from an IRA that is performing well.

Beneficiary Designation

As an estate planner, I spend a great deal of time explaining beneficiary designation planning on IRAs to clients.  Providing clients with the optimal options for an IRA is essential.  First, one must make sure that the beneficiary named qualifies as a “designated beneficiary” as defined in the Internal Revenue Code.  To be a designated beneficiary, the individual must be named as a beneficiary in the IRA documents at the time of the participant’s death, and said designated beneficiary must still be alive on September 30th of the year following the year of the participant’s date of death.  That date is known as the determination date.  Generally, individuals qualify as designated beneficiaries although there are some exceptions for certain trusts which name an individual as a beneficiary and would therefore qualify as a beneficiary for purposes of this rule.

Planners need to obtain beneficiary designation forms so that they are signed at the time the wills, living trusts and ancillary documents are executed.  Some attorneys might take care of sending the forms to the plan custodian themselves, while others might give the completed forms to the client to send in.  Whichever method is used, one of the aforementioned options should be on the planner’s “to do” list.

In many cases, there are multiple designated beneficiaries.  More planning options are open to IRAs that contain single beneficiary designations.  At death, all beneficiary designation forms need to be reviewed.  In many cases, certain beneficiaries can disclaim their interest, if desirable.  Having beneficiaries with different ages or non-individual beneficiaries can create tax issues.  The best way to avoid this problem is to have multiple IRAs, each with a single designated beneficiary.  RMDs are determined based on the life expectancy of the oldest beneficiary, which is a crucial rule to understand when there are beneficiaries of different generations or there is a significant difference in the ages of children (i.e. second marriages).

The general rule is if an IRA owner passes away before attaining the age of 70 ½, then all IRA assets must be distributed before the December 31st five years after the year of the IRA owner’s death.  In applying this five-year rule, there is no requirement that a distribution should be taken pro rata; therefore, there is some planning involved.  As an example, a distribution can be taken in the fifth year if, for some reason, the beneficiary believes there might be some deductions available in that year.  If the decedent participant has attained the age of 70 ½ at the time of his or her death, then the beneficiary must take the RMD that the plan participant did not take before death.  The first RMD of the beneficiary must use the plan participant’s remaining life expectancy in the year of their death.  In all succeeding years, the beneficiary will reduce the life expectancy factor contained in Publication 590 for the year of death by one year to determine the RMD.  This is the case, whether or not the beneficiary qualifies as a designated beneficiary.

If the beneficiary of the IRA does qualify as a designated beneficiary, then the designated beneficiary has a better option where he or she can take distributions based upon their own life expectancy, whether or not the decedent attained age 70 ½.  This option is usually chosen for IRA beneficiaries who are designated beneficiaries because it is not dependent upon whether the decedent attained age 70 ½ and usually results in a longer pay out.  In this case, the single life table is used to determine the beneficiary’s remaining life expectancy in the year the first RMD distribution is received.  In subsequent years, the designated beneficiary would reduce the life expectancy by one year to determine their new life expectancy.  The designated beneficiary must begin taking distributions by December 31st of the year following the year of the participant’s death.  A designated beneficiary is not considered an owner of the IRA, so contributions cannot be made to the IRA, nor can they name other parties as designated beneficiaries.

The disclaimer rules for IRAs are similar to all other disclaimer rules (i.e. they must made within nine months of the death of the participant).  In this case, it is very important to look at the contingent or successor beneficiary since a disclaimer will result in that person receiving the benefits.  No disclaimer should be made without being certain of the contingent beneficiary on the documents.  Also, make sure that the contingent beneficiary is a “designated beneficiary,” as defined in the Internal Revenue Code.

If a participant’s beneficiary is their surviving spouse, then there are a myriad of other options that are available.  For example, the surviving spouse can:

  • Take distributions based on the decedent’s RMD. This option is only available if the decedent did not attain the age of 70 ½ at the time of their death.  This allows the surviving spouse to take exactly the amount the decedent would have taken had they not died, which means the same rules apply, such as the first distribution can be delayed until April 1st of the year following the year of the decedent’s death, and with the second distribution being made on December 31st of that same year (see the bunching of income discussion above.).
  • Rollover the assets into a spousal rollover IRA. This would allow the surviving spouse to become the owner of the IRA and retitle the IRA as a rollover IRA, or roll it over into an IRA that the surviving spouse already owns or a new rollover IRA.  The surviving spouse has the option of naming their own beneficiaries and taking distributions on their own RMD schedule.  However, in this case, the surviving spouse must follow all the requirements and is subject to all the penalties on distributions either before age 59 ½ or after age 70 ½.  In cases where the surviving spouse is older than the decedent, this may not be the best option even though it is the option most commonly utilized.  There is no deadline for making a spousal rollover if the assets stay in the same IRA; however, if a distribution is made to the surviving spouse, than that spouse has 60 days to make the qualified rollover to avoid the taxation of the IRA monies as a distribution.  This is an easy mistake to make, so it is strongly recommended that the surviving spouse rollover the assets within the same institution, or hold in a trust and then have the trustee transfer those assets to avoid falling into this mistake.
  • Convert the IRA into a Roth IRA. In Roth IRAs, there are no mandatory distributions required; however, the surviving spouse will pay taxes on the amount converted.

Planning for distributions and beneficiary designations can seem confusing and complex. Therefore, knowing all the IRA distribution requirements during life and designated beneficiary requirements at death and working closely with an experienced estate planning attorney can be major advantages that help avoid costly mistakes.

Alan B. Cohn, Esq. is a shareholder at Greenspoon Marder, where he concentrates his practice in the areas of Tax; Estate Planning & Probate; Guardianship; and Business & Corporate law. Mr. Cohn is Board Certified by the Florida Bar in the areas of Wills, Trusts & Estates. He can be reached at alan.cohn@gmlaw.com or 954-491-1120. For more information, visit www.gmlaw.com.