Inherited IRA Problems

Problems often begin after the IRA owner dies, as these readers can attest.

 04/13/2012

by Natalie Choate

Question: Father died in 2008 leaving his IRA to son, who is age 50. Son began taking a life expectancy payout from the inherited IRA. Now mother has died in 2012, and she also left her IRA to son. Since both accounts have the same beneficiary, and son is going to take a life expectancy payout from both accounts, can he combine them? It would be much easier for him to have only one inherited IRA and take only one annual minimum distribution than juggle two inherited IRAs and make two annual minimum distribution calculations.

Answer: Unfortunately, he can't do it. The IRS has decreed that, for minimum distribution and income tax purposes, an IRA inherited from one individual cannot be combined with an IRA inherited from a different individual--even if it's the same beneficiary who now owns both accounts.

Though this answer seems illogical, remember that even though the same beneficiary inherited both accounts, his Applicable Distribution Period (life expectancy) is actually different for the two accounts. Once you inherit an IRA, your life expectancy for that inherited account becomes "carved in stone": It is determined based on your age in the year after the year of the participant's death, then it decreases by one full year each year. Meanwhile, however, your "real" life expectancy does not go down by one each year. Your real life expectancy keeps extending outward the longer you live--until you inherit another account, at which time your life expectancy, as a beneficiary, becomes frozen for the new account.

Son, the beneficiary, was born in 1950. Father died in 2008, so Son's first Distribution Year for the IRA inherited from Father was 2009, the year Son turned age 59. According to the IRS' Single Life Expectancy Table, Son's life expectancy for Father's IRA was 26.1 years in 2009, 25.1 in 2010, 24.1 in 2011, and 23.1 in 2012. Son's "divisor" (life expectancy or Applicable Distribution Period) for Father's IRA for the year 2013 will be 22.1.

Mother died in 2012. Son's first distribution year for Mother's IRA will be 2013, the year Son turns age 63, so Son's life expectancy (Applicable Distribution Period or divisor) for that account in 2013 will be 22.7, not 22.1!

(By the way, this business of a fixed or frozen life expectancy does not apply to the surviving spouse. A spouse who inherits benefits from her deceased spouse has two options that are not available to other beneficiaries. She can take a life expectancy payout with her life expectancy being recalculated (extended) every year, or she can roll the whole thing over to her own IRA and stop taking distributions as beneficiary altogether.)

If you don't like my answer, you can apply for an IRS ruling that it would be all right to combine the two accounts as long as Son uses the shorter Applicable Distribution Period for both accounts. The IRS has never commented on that specific approach. But I assume that applying for an IRS ruling (with attendant delay and expense) would be even more inconvenient than maintaining two separate IRAs with different distribution periods for the next 22 years, especially since there's no way to predict whether the IRS will go along with you.

If you do not obtain an advance IRS ruling blessing the merger, the risk of combining the two inherited IRAs is that one or both accounts might be disqualified (treated as distributed), so I would not recommend that you do this.

Question: Shortly before his death at age 89, Father moved his IRA from Bank X to Bank Y. The old account at Bank X had named Mother (his wife of more than 60 years) as sole beneficiary. He filled out the forms to open the new IRA at Bank Y, including naming Mother as beneficiary, but unfortunately he signed the form in the wrong place (he signed on the "spouse" line instead of the "participant" line). A clerk at Bank Y had him sign a whole new account opening form (prepared by the clerk), but neglected to complete the beneficiary designation part of the form. Nobody noticed this mistake; in the meantime, Father told everyone "My IRA goes to Mother," and the estate planning lawyer prepared a flow chart showing the IRA going to Mother. Now Father has died, the mistake has come to light, and Bank Y says they must pay the benefits to Father's estate as default beneficiary! Is there anything we can do to fix this?

Answer: There are three possible courses of action I can see:

1. In some cases if the IRA provider admits it made a mistake, it will correct the mistake. For example, if the IRA provider clearly was supposed to put "spouse" as the beneficiary and failed to do so, or changed the beneficiary designation without the participant's knowledge, they ought to fix the mistake and recognize that the spouse is the beneficiary.

2. Sometimes it's not clear exactly who made the mistake--the IRA provider, the participant himself, or the participant's estate planning attorney--but it is clear that the participant intended to name his spouse as beneficiary and thought he had done so. In that case, a state court might be willing to "reform" the beneficiary designation to say what it was supposed to say and what the decedent thought it said. This type of reformation would be binding on the IRA provider and even the IRS would probably accept it if there are bona fide grounds for "reformation." They did accept such a state court post-death reformation of a beneficiary designation form in similar circumstances in IRS Private Letter Rulings 200616039 and 200616040.

However, since those 2006 rulings were published, the IRS has become hostile to post-death reformations. The policy change came about because it appeared that some survivors would misuse reformation: Instead of using reformation to correct a paperwork error, some people tried to use it to design an entirely new, better estate plan. So this approach is not certain of IRS success, and it would be expensive, too.

3. Finally, if the spouse is the sole beneficiary of Father's estate, and the benefits are paid to the estate, she can roll over the benefits through the estate to her own IRA. This conclusion is based on a long line of IRS rulings establishing the principle that a surviving spouse can roll over, to her own IRA, benefits that pass to her as beneficiary of an estate or trust, provided certain conditions are met. In fact, you can even bypass the necessity of expensive and time-consuming probate proceedings by having a direct trustee-to-trustee transfer from Father's IRA to Mother's IRA, a procedure blessed by the IRS in a similar situation in Private Letter Ruling 201211034 (12/22/2011). See also the similar IRS Private Letter Ruling 200950058. The key to success with this approach is to find an IRA provider who will allow the IRA-to-IRA transfer without requiring an IRS ruling--perhaps an IRA provider willing to rely on a legal opinion (plus an attorney willing to provide the opinion).

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.

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'SOSEPP' Problems

The "series of substantially equal periodic payments" exception to the 10% premature IRA distribution penalty is a tricky one.

Natalie Choate, 02/10/2012

Taking an IRA or plan distribution prior to age 59½ normally results in a 10% penalty--in addition to the income tax on the distribution. There are more than a dozen exceptions to the penalty, but they are tough to qualify for. One that every IRA owner can use (but that can be difficult to stick to) is the "series of substantially equal periodic payments," or "SOSEPP." The series of payments are sometimes called "72(t)" payments, but that's a misnomer. § 72(t) of the Internal Revenue Code is the section that imposes the 10% penalty. The SOSEPP exception is actually found in § 72(t)(2)(A)(iv).

This reader has a SOSEPP problem:

Question: "Herbie" lost his job in 2010. He needed to start taking distributions from his IRA to pay living expenses, so he set up a "series of substantially equal periodic payments." Working with his accountant, we figured out, using the IRS' permitted payment methods, that Herbie's IRA would support a SOSEPP of $3,600 a month. At $3,600 a month, based on the IRS's prescribed interest rates and mortality assumptions, the IRA would theoretically run out of money at the end of Herbie's life expectancy.

However, of course, under the SOSEPP rules, he would not actually have to keep taking the monthly payments for his entire lifetime. He would only have to take the distributions until the later of the date he reached age 59½ or five years after the beginning of the SOSEPP. After that point is reached, he could discontinue the series payments, or take more or less than $3,600 a month, without worrying about the penalty.

Unfortunately in December 2011 he needed extra money and took an extra $20,000 out of the IRA. He realizes this has "busted the SOSEPP," and he now owes the IRS the 10% penalty (plus interest) on all the payments he has taken. Since he's been taking the payments for 18 months, that's $6,480 of penalty on the SOSEPP payments (18 months times $3,600 times 10%) plus a $2,000 penalty on the extra $20,000 payment taken in December 2011 (total penalty = $8,480).

He will reach age 59½ in September 2012. He proposes to start a new "SOSEPP" right now, in early 2012, because he still needs monthly income. Does that make sense?

Answer: The "series of substantially equal periodic payments" (SOSEPP) exception to the 10% premature distributions penalty is tricky, as Herbie has discovered. At first it seems simple: Using the IRS-blessed payment methods, interest rates, and mortality assumptions, you set up a series of monthly (or quarterly, or annual) payments that theoretically (if continued exactly until the end of your life expectancy) would reduce the IRA to zero. Then you just keep taking those payments regularly like clockwork, until you pass the magic "home-free" date, which is the later of (1) the date you reach age 59½ or (2) the fifth anniversary of the beginning of your SOSEPP. After that, you can stop the payments, or take larger or smaller payments, or do whatever you want, with no more worries about the 10% penalty.

So what's the problem? The problem is that any "modification" of your "series" before that magic home-free date has the effect of killing the entire "SOSEPP." You simply lose your qualification for the exception--retroactively to its beginning! So, for example, someone who faithfully took a series of equal payments every month beginning at age 25, but somehow "modified" his SOSEPP at age 58, would owe the 10% penalty retroactively on all payments he had received since age 25! If that seems absurd, well, I agree: It is absurd. But that's what the rules say.

A "modification" means you take more or less than you are supposed to take under the series schedule. It can be something as small as taking a few too many dollars in one payment, or skipping a payment. Although the IRS tends to be forgiving in the case of very small mistakes--especially if they are caused by a financial institution or clerical error and quickly remedied--it may require a private letter ruling to confirm this.

Because of the draconian punishment for modifying a SOSEPP, the best advice is to only use a SOSEPP after careful consideration and with ongoing competent monitoring. Also, try to keep another IRA "in reserve" (i.e., a separate IRA that is not involved in the SOSEPP), so the participant will have a "safety valve"--another account he can tap for any special extra payments needed, or even to start a second SOSEPP. Unfortunately, for many people who need SOSEPPs, like Herbie, the financial need dictates that all of their IRAs must be dedicated to supporting the SOSEPP payments, so there is no reserve account or rainy day fund to cover emergencies. So Herbie had to "bust" his SOSEPP.

Now Herbie wants to know how he can best get money to live on in 2012. Since Herbie will turn 59½ later this year, and does not qualify for any penalty exception other than potentially the SOSEPP exception, here are his choices going forward:

Option 1: Take no distributions from his IRA until he reaches age 59½ in September 2012. Under this option he will owe no 10% penalty. This is the ideal option if he can manage it.

Option 2: Take distributions as needed from the IRA in early 2012, without starting a new SOSEPP, and pay the 10% penalty on each distribution taken before reaching age 59½.

Option 3: Working with his accountant, design a new series of substantially equal payments that starts right now, based on his current IRA balance and age, and the current IRS interest rates and mortality assumptions. Then he can either:

A. Continue the new SOSEPP for five years and owe no penalty; or
B. Abort the SOSEPP sometime before the five years are up and owe the penalty on any distributions taken between now and the date in September 2012 when he reaches age 59½.

Note that the results are exactly the same under Options 2 and 3-B. Thus if he really thinks he might keep the new SOSEPP going for five years, he has nothing to lose by starting a new SOSEPP in 2012 except the costs of professional advice in designing the series. But if he doesn't really think he will keep it going for five years, he might as well bite the bullet and just choose Option 2 and save the accounting fees. Or better yet, use Option 1!

Natalie Choate practices law in Boston. Her books are repeatedly the go-to source for retirement planning.

The views expressed are the author's.

Estate Planning with Roth IRAs

As Roth usage increases, so do questions about best estate-planning practices for these accounts.

Natalie Choate, 11/11/2011

Since the "income cap" was lifted on Roth conversions in 2010, more and more clients have Roth IRAs. It's time to consider where those assets should be placed in the estate plan.

Question: I read in a financial publication that giving away a Roth IRA is "a good planning idea." Several other articles are out there about this strategy. Does it really work?
Answer: No. You cannot give away a Roth IRA. Or rather, you can do so, but giving it away would cause it to cease to be an IRA. The gift-transfer would be treated as a complete distribution of the account to the donor, followed by a gift of the proceeds to the transferee. The deemed distribution might be tax-free (if the donor meets the requirements for a "qualified distribution"), but there will be no further tax-free accumulation because the Roth ceases to exist.

A "Roth gift" strategy that does work is for a donor (typically the parent of a teenager) to open a Roth IRA for the donee (the teenager). Example: Teenager earns $5,000 in a summer job. Teenager therefore has compensation income, and if his income is low enough, he is entitled to contribute to a Roth IRA. The parent and teen can open the account together in the teen's name and the parent contributes $5,000 to it.
Both of these strategies are discussed in ¶ 5.8.06(C), "Gifts with Roth IRAs," of my book Life and Death Planning for Retirement Benefits (7th ed. 2011).

Question: "Duncan" wants to leave some of his assets to charity, some to his wife, and some to his children. He has some assets in a traditional retirement plan, some in a Roth plan, and some in outside (nonretirement) investments. Which asset should he leave to which beneficiary?

Answer: With a traditional IRA, all three of Duncan's proposed beneficiaries are considered "tax-favored" choices for income tax purposes: Children (or other young people) because of their long life expectancies (facilitating a long tax-deferred "stretch" payout), the spouse (because she can roll over to her own IRA), and charity because it is income tax-exempt. In Duncan's case, leaving the traditional plan to charity is very appealing, since the charity (unlike the wife and children) can receive these retirement plan benefits income tax-free.

With the Roth plan, the picture changes slightly. Charity is not an income tax-favored choice of beneficiary for a Roth plan. Because distributions from a Roth plan are generally income tax-free anyway, there is no advantage to leaving this asset to an income tax-exempt entity. Thus, Duncan should leave the Roth plan either to his spouse or to the children.

If federal estate taxes are a concern, there is a strong argument against making the traditional IRA payable to the children. By inheriting the traditional IRA, they would be inheriting an asset that has a built-in income tax "debt." Duncan does not get a marital or charitable deduction for leaving assets to his children; the only estate tax "shelter" there is for bequests to his children is the federal estate tax exemption. Part of that exemption is "wasted" if the children inherit an asset that they then have to pay income tax on--part of the "exempt" amount goes to the IRS. So the children should inherit either the Roth plan or the nonretirement assets; either way, they will owe no income tax on their inheritance.

We have figured out that the charity should inherit the traditional retirement, and the children should not inherit it; that leaves the Roth plan and the nonretirement assets to be divided somehow between the spouse and the children. The question is, what is the best income tax scenario for the Roth plan?
If a Roth IRA is left to the children, they can stretch it out via annual tax-free distributions over their life expectancies. That's a pretty darn good scenario.

But if the Roth plan is left to the surviving spouse, she can get an even better scenario: She can roll the inherited Roth plan over to her own Roth IRA (only the surviving spouse has this right). Then she will be able to stretch out the tax-free distributions much longer than the children possibly could: She does not have to take any minimum required distributions at all from the rollover Roth IRA during her lifetime. After her death it can be left to the children for gradual tax-free distributions over their life expectancy.

Duncan's choice is made: Leave the traditional retirement plan to the income tax-exempt charity, the Roth plan to the wife for her to roll over and keep accumulating tax-free, and the nonretirement assets to the children.

Resources: For all details regarding Roth retirement plans, including who is eligible to contribute (and how much), income tax treatment of Roth distributions, and minimum distribution requirements for Roths, see Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011).

The views expressed are the author’s.

Ask the IRA Gurus

 

By Natalie Choate

September 2011

Sometimes I get an IRA question to which I don't know the answer. That's when I turn to my nationwide circle of IRA experts. I call them the "IRA gurus." With their astounding collective experience and knowledge, they can often help. So keep those questions coming!

Question: Our client's father, "Homer," is in his 90s. Since he was 70 1/2, he had his IRA minimum distributions sent to him by monthly automatic transfer into his bank account. This had been arranged for him each year by his IRA provider. Last year, he moved closer to his son's (our client's) home because of some serious health problems and in the process moved his IRA to a different provider.

However, he neglected to reinstate the automatic sending of the required distributions. His health issues contributed to a declining ability to manage his affairs. As a result, he failed to take the required distributions for the year 2010. Homer's son helped him with his 2010 tax return, and had him file "Form 5329" as part of the return, reporting the missed distribution and requesting a waiver of the 50% penalty. Now, the IRS has just sent him a notice that the penalty is due--with no mention of the waiver request. Is there anything Homer can do at this point to avoid that penalty?

Answer: I don't have experience with this situation so I turned to my IRA gurus. These enormously knowledgeable and productive people manage to not only speak and write about retirement benefits, they also actively consult with, advise, and/or represent clients who have retirement benefit issues with the IRS. They had plenty of practical suggestions for Homer.

Barry Picker of Brooklyn, N.Y., author of Barry Picker's Guide to Retirement Distribution Planning, speaks nationally and actively practices in the retirement benefits tax area. He says, "The IRS response sounds like a computer-generated notice caused by the filing of the 5329. I've had this before. Don't pay; respond with a letter to the address on the notice explaining the situation and requesting the waiver. Chances are good you'll succeed."

Bob Keebler, CPA, of Green Bay, Wis., nationally known speaker and author of multiple publications dealing with the tax treatment of IRAs and Roth IRAs, heads his own accounting firm that specializes in helping individuals solve their IRA versus IRS problems. Bob has drafted more than150 successful IRS private-letter ruling requests in the retirement benefits area. He was succinct: "I agree with Barry!"

Denise Appleby, author of the invaluable Appleby IRA Quick Reference Guides, reminds the questioner that, "It's not enough to explain why you missed taking the minimum required distribution. You also must 'take steps to remedy the shortfall,' meaning that Homer must take the 2010 distribution now, in 2011, before asking the IRS to waive the penalty. Both steps are required before the IRS will consider granting a waiver." PAGEBREAK  

Ed Slott, publisher of the terrific Ed Slott's IRA Advisor newsletter, who trains financial advisors how to use retirement benefits expertise to expand their practices, agreed with all of the above: "I would have originally advised him to take the missed 2010 distribution immediately and file the 5329 not only asking for the waiver of the penalty, but also showing that he made up the missed distribution--that he took immediate corrective action upon discovering the error.

"Also state the reason for the oversight, which in this case is logical and, I believe, would warrant a waiver of the penalty. But now he has an IRS notice which must be answered. I would respond that the missed distribution was made up, state the reason for the honest oversight, ask for the penalty to be abated, and it should be abated. In addition, mention that before this, he had a perfect track record of never missing a required distribution because they were withdrawn automatically. Once IRS puts this all together, the penalty should be waived and he should be fine. However, it might take a few letters to get this resolved."

Steve Trytten, an estate-planning lawyer in Pasadena, Calif., with special expertise in retirement benefits (and my co-panelist on an upcoming "Retirement Benefits Myth-Busters" seminar), wonders whether the IRS rejection "is not a denial of the penalty waiver but instead an erroneous action based on older form instructions. The instructions to Form 5329 used to require full payment before a waiver could be considered. Several years ago, the instructions were revised to delete this requirement. Perhaps the next step is to resubmit the 5329 along with a copy of the current instructions and renew the request for waiver of penalty."

Seymour "Sy" Goldberg, a well-known speaker and author on the tax treatment of retirement benefits, also tangles regularly with the IRS on behalf of clients. His stated, "The approach I use with respect to a penalty case in general is to respond to the IRS computer-generated penalty notice several times, and if that does not resolve the penalty issue, then I request an appeal to the local IRS Appeals Office. Based on the facts of this case, the penalty should be waived at either the IRS Service Center or the IRS Appeals Office."

Mike Jones, of Monterey, Calif., speaker, writer, and practitioner, and chair of the editorial advisory board for retirement benefits for Trusts and Estates magazine, concurs that if all else fails, Homer can "Exercise the right to go to IRS appeals with this. If that doesn't work, a suit for abuse of discretion could be needed; such suits are authorized by statute. Given the taxpayer's long history of compliance, it could be an abuse of the IRS' discretion not to waive the penalty."

I am a big fan of my IRA gurus. If they don't know the answer, there is no answer!

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed are the author's.

Debunking IRA Urban Legends

Investors in IRAs often need a reality check when it comes to these common misconceptions.

by Natalie Choate

It's time to drive a stake through the heart of some widely held but very mistaken beliefs about planning for retirement benefits.

The Myth: By leaving your IRA to a perpetual or "dynasty" trust that also qualifies as a "see-through trust" under the Internal Revenue Service's minimum distribution trust rules, you can obtain a perpetual stretch-out for your IRA, or (even better) a perpetual tax-free family investment pool with a Roth IRA.

The Reality: It's true that certain states now permit clients to establish perpetual or 1,000-year trusts. But leaving your IRA or Roth IRA to such a trust in no way lengthens the maximum payout period permitted under the Tax Code's minimum distribution rules--even if the trust does manage to qualify as a "see-through trust" under the IRS' "minimum distribution trust rules." The minimum distribution rules require that all benefits be distributed, beginning the year after the participant's death, in annual installments over the life expectancy of the designated beneficiary. The longest payout period possible under that rule is about 81 years (the life expectancy of a one-year-old beneficiary). So if the perpetual trust qualifies as a see-through, and the oldest beneficiary of the trust is a newborn baby, the payout period for the benefits will be about 81 years. The trust can last forever, but the IRA (or Roth IRA) payable to that trust cannot last beyond the life expectancy of the oldest trust beneficiary.

The Myth: We can get a perpetual stretch-out of our IRA death benefits by leaving them to an individual (say the participant's child), who at his later death leaves the account to a next-generation beneficiary (say the participant's grandchild), who at his later death leaves the account to the next younger generation (the participant's great-grandchild), and so on.

The Reality: Well, it's true that the original beneficiary can name a successor beneficiary for the account, and thus pass it on to, say, the original beneficiary's own child. And it's even true that each successor beneficiary can leave what's left of the account on such beneficiary's death to still another successor beneficiary. But no matter how many successor beneficiaries there are, the account will still have to be distributed over the life expectancy of the FIRST beneficiary--he is the original "designated beneficiary," and his life expectancy is the payout period for the inherited IRA regardless of whether he survives for that entire life expectancy or dies prematurely and passes the account on to a successor beneficiary. So you can see it is unlikely that the account will even exist past the life expectancy of the first beneficiary (because he will probably survive to his life expectancy and therefore he will withdraw 100% of the account). It is extremely unlikely that the account will exist for multiple generations--that would require that each successive generation of beneficiaries dies within the life expectancy of the original beneficiary.

The Myth: The client can leave his retirement accounts to a "conduit see-through" trust for the benefit of his surviving spouse. During the surviving spouse's overlife, the applicable distribution period will be the surviving spouse's life expectancy. When the spouse ultimately later dies, the remaining benefits can be paid to the children over the life expectancy of the oldest child.

The Reality: No they can't. When retirement benefits are paid to a trust, if the trust qualifies as a see-through trust, the applicable distribution period is the life expectancy of the oldest trust beneficiary (the surviving spouse in this example). Even if the trust is the special type of see-through trust known as a "conduit" trust, there is no way for the trust to "flip" over to using the children's life expectancies as the applicable distribution period for benefits remaining in the plan at the surviving spouse's later death. By the way, it's very unlikely there will even be anything left in the retirement plan at that point--that would happen only if the spouse did not survive for her entire life expectancy.

If you want the payout period to "flip" to the children's life expectancy at the death of the surviving spouse, there's only one way to get that result: Leave the retirement benefits outright to the surviving spouse, and she rolls them over to her own IRA. By doing that you eliminate the requirement of distributing the benefits over the spouse's life expectancy (instead, she can defer all distributions until she reaches age 70 1/2, then withdraw using the Uniform Lifetime Table, which is much more favorable than a payout over her single life expectancy). At her death, she can leave the remaining balance of the rollover IRA to the children as her designated beneficiaries. As designated beneficiaries, they will qualify for a payout over their life expectancies.

All of these myths arise out of forgetting the basic bedrock principle of the minimum distribution rules: The retirement plan account cannot stay in existence longer than the life expectancy of the original owner (the participant) and his or her designated beneficiary. The money doesn't all have to be spent; the participant and beneficiary can save and invest the distributions they receive (after paying taxes on them, of course, in the case of non-Roth accounts). But at the end of that Code-mandated payout period, all of the money must be out of the plan.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.

Rollover IRAs Offer a Wide Range of Benefits

IRA assets can generally be divided among multiple beneficiaries in an estate plan.

As compared with employer-sponsored retirement accounts, a rollover IRA can provide you with the broadest range of investment choices and the greatest flexibility for distribution planning. Also, a rollover IRA can typically be operated with fewer restrictions. This brief overview highlights some of the key benefits of a rollover IRA compared with an employer-sponsored plan.

• More control: As the IRA account owner, you make the key decisions that affect management and administrative costs, overall level of service, investment direction, and asset allocation. You can develop the precise mixture of investments that best reflects your own personal risk tolerance, investment philosophy, and financial goals. You can create IRAs that access the investment expertise of any available fund complex, and can hire and fire your investment managers by buying or selling their funds. You also control account administration through your choice of IRA custodians.
• More flexibility: IRAs can be more useful in estate planning than employer-sponsored plans. IRA assets can generally be divided among multiple beneficiaries in an estate plan. Each of those beneficiaries can make use of planning structures such as the Stretch IRA concept to maintain tax-advantaged investment management during their lifetimes. Beneficiary distributions from employer-sponsored plans, in contrast, are generally taken in lump sums as cash payments. Also, except in states with explicit community property laws, IRA account holders have sole control over their beneficiary designations.

Efficient Rollovers Require Careful Planning
One common goal of planning for a lump-sum distribution is averting unnecessary tax withholding. Under federal tax rules, any lump-sum distribution that is not transferred directly from one retirement account to another is subject to a special withholding of 20%. This withholding will apply as long as the employer's check is made out to you -- even if you plan to place equivalent cash in an IRA immediately. To avert the withholding, you must first create your rollover IRA, and then request that your employer transfer your assets directly to the custodian of that IRA.

Keep in mind that the 20% withholding is not your ultimate tax liability. If you spend the lump-sum distribution rather than reinvest it in another tax-qualified retirement account, you'll have to declare the full value of the lump sum as income and pay the full tax at filing time. In addition, the IRS generally imposes a 10% penalty tax on withdrawals taken before age 59 1/2.

Also, if you plan to roll over the entire sum, but have the check made out to you rather than your new IRA custodian, your employer will be required to withhold the 20%. In that event, you can get the 20% refunded if you complete the rollover within 60 days. You must deposit the full amount of your distribution in your new IRA, making up the withheld 20% out of other resources. When you file your tax return for the year, you can then include a request for refund of the lump-sum withholding.

If you have after-tax contributions in your employer plan, you may opt to withdraw them without penalty when you roll over your assets. However, if you wish to leave those funds in your retirement account in order to continue tax deferral, you can include them in your rollover. When you begin regular distributions from your IRA, a prorated portion will be deemed nontaxable to reimburse you for the after-tax contributions.

Potential Downsides of IRA Rollovers

While there are many advantages to consolidated IRA rollovers, there are some potential drawbacks to keep in mind. Assets greater than $1 million in an IRA may be taken to satisfy your debts in certain personal bankruptcy scenarios. Assets in an employer-sponsored plan cannot be readily taken in many circumstances. Also, you must begin taking distributions from an IRA by April 1 of the year after you reach 70 1/2 whether or not you continue working, but employer-sponsored plans do not require distributions if you continue working past that age.

Remember, the laws governing retirement assets and taxation are complex. In addition, there are many exceptions and limitations that may apply to your situation. Therefore, you should obtain qualified professional advice before taking any action.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

 This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by James P Ellman, ChFC and Barry Mendelson, CFP, local members of FPA.

Resolving Excess IRA Contributions

Options for fixing excess traditional IRA contributions (and reducing the penalties) for 2010 and 2011

by Natalie Choate 07-08-11 |

Question: We have a new client, "Bill." He is single (his wife died in 2008). He reached age 70½ in 2009 and retired at the end of 2010. In each of the years 2009-2010, he earned compensation income (wages) of $50,000 and his total income was $80,000. He will have zero compensation income in 2011. In each of the years 2009-2011, in January, he contributed $6,000 to a traditional IRA. This was outside of his employment, i.e., these contributions were not made to a "SEP-IRA." He has never taken any deduction for these contributions. However, it appears to us that he was not entitled to make these traditional IRA contributions. Do you agree, and if so, what can we do to repair his excess IRA contributions? Will he have to pay a penalty? He has already filed his income tax returns for 2009 and 2010 on a timely basis.

Answer: Because Bill reached age 70½ in 2009, all his contributions to his traditional IRA in the three years 2009-2011 were "excess contributions." An individual cannot contribute to a traditional IRA on his own behalf in or after the year in which he reaches age 70½. The traditional IRA is the only retirement plan that has an age limit on making contributions.

There is a 6% annual cumulative penalty on excess IRA contributions. However, Bill can fix some of these excess contributions and reduce the penalty. Let's look at each year separately.

2011:
There are two ways Bill can avoid the penalty for the 2011 excess contribution.

Two Ways

Bill Can Avoid the Penalty

The first way is to take a corrective distribution from the IRA. He would have to withdraw the contribution he made in January 2011 along with the "net income" attributable to the contribution. The deadline for completing this corrective distribution, in order to avoid having the 6% penalty slapped on the 2011 excess contribution, is "on or before the day prescribed by law (including extensions of time) for filing such individual's return for such taxable year." That could be as late as October 15, 2012; see discussion of the 2010 excess contribution below for more on what this deadline means. See "Resources" at the end of this article for how to compute the "net income" on an excess contribution.

The distribution to him of the returned contribution is tax-free. However, any earnings that must be distributed to him along with the returned contribution will be includible in his gross income.

The second way Bill could avoid an excess contribution penalty for his 2011 contribution would be to go back to work and earn $6,000 or more of compensation income in 2011, then "recharacterize" his 2011 contribution as a 2011 contribution to a Roth IRA; see discussion of 2010 for more on this approach.

2010: Recharacterize as a Roth Contribution
Though Bill was not entitled to contribute to a traditional IRA in the year 2010 (because he was over age 70½), he could legally have contributed to a Roth IRA for that year. He was eligible to contribute $6,000 to a Roth because:

1.  He had compensation income (earned income) of at least $6,000.
2.  His modified adjusted gross income for 2010 was under $105,000.

Different standards apply in determining eligibility to contribute to a Roth IRA than apply to a traditional IRA. Although one must have compensation income to contribute to either type of IRA, there is an age test applicable to traditional IRA contributions (no contributions if age 70½ or older), but no age test applicable to Roth IRA contributions. There is an income test applicable to Roth IRA "regular" contributions, but no income test applicable to traditional IRA contributions (and no income test applicable to Roth IRA conversions).

Since Bill was not eligible to contribute to the type of IRA he contributed to, but was eligible to contribute to the other type of IRA, he can "recharacterize" his traditional IRA contribution as a contribution to a Roth IRA instead. He does that by moving  the $6,000 contribution (plus or minus any "earnings" thereon) out of the traditional IRA and into a Roth IRA. For more details on this remedy see my March 2010 column.

The deadline for doing this is the same as the deadline for making a "corrective distribution" (see the 2011 discussion above), namely, the due date of his tax return including extensions. Under the IRS's regulations, that means he can make this switch up until Oct. 15 of this year (2011) even though he has already filed his 2010 tax return (and even though he didn't actually get an extension of time to file) as long as the 2010 tax return was filed on time.

If he gets that recharacterization done on time (or withdraws the contribution and the earnings thereon altogether, if he prefers to go the "corrective distribution" route) there will be no penalty for the 2010 excess contribution.

2009: Too Late to Avoid the Penalty
Since the latest possible "extended due date" of Bill's 2009 income tax return was on or about Oct. 15, 2010, it is too late to either do a "corrective distribution" or to "recharacterize" that contribution. Thus Bill owes the 6% penalty for 2009 and also for 2010, since the penalty continues to accrue each year until the excess contribution is either distributed or "absorbed" (treated as part of a contribution for a later year). Barring extraordinary relief from the IRS, he owes 6% of $6,000 ($360) for each of those years, a total of $720. He can avoid having an additional penalty accrue (for the calendar year 2011) on account of that old excess contribution by withdrawing the $6,000 2009 excess contribution from the traditional IRA by the end of calendar 2011.

Note that he only has to withdraw the actual excess contribution ($6,000) by the end of 2011, not any earnings thereon, to stop the penalty on that old 2009 excess contribution accruing for the year 2011. Computing "earnings" on a contribution is involved only when you are trying to do a corrective distribution or recharacterization.

Is there any possibility of getting IRS relief from this penalty? One avenue is to request permission for a "late recharacterization" of the 2009 contribution as a Roth IRA contribution rather than a traditional IRA contribution. The IRS can grant permission for a late recharacterization if there is good cause--for example, if he was receiving erroneous professional advice about his eligibility to contribute to an IRA.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits.
The views expressed in this article are the author's.

Estate Transfers: IRA to Beneficiary

The "stretch" or "life-expectancy-of-the-beneficiary" payout is available only to a "designated beneficiary."

 by Natalie Choate 04-08-11 |

Judging by the number of questions I get on this topic, this is one of the hottest issues out there. I've consolidated the most common questions into one typical scenario:

Question: "Yuri" died in 2010 at age 68 without having named a beneficiary for his IRA. Under the account documents for this particular IRA, the default beneficiary is Yuri's estate. He also left no will, so under the applicable intestacy laws, the estate passes half to Yuri's wife "Lara" and half to their daughter, "Tonya." The estate has no other assets. Lara, as administrator of the estate, has instructed the IRA provider to transfer Yuri's IRA in equal shares, via direct IRA-to-IRA transfer, half to Lara's own IRA and half to an "inherited IRA" payable to Tonya as beneficiary. The IRA provider refuses to do this unless an "inherited IRA" is opened in the name of the estate first. We are at an impasse. If the IRA provider insists on this condition, then the IRA will be subject to the "5-year rule." We want to instead have Lara do a spousal rollover of her half, and Tonya wants a life expectancy payout for her half. We also don't want to have to report the account as an estate asset for probate purposes. How can we resolve this dilemma?

Answer: On this one, the IRA provider is doing it right.

To back up a little bit, there is nothing wrong (in my opinion) with your goal of transferring the IRA out of the estate, intact, to the estate's two beneficiaries. Some IRA providers permit estates to do this, requiring only that the executor or administrator of the estate take control of the account and then give proper instructions for the transfer. Some IRA providers permit the transfer but have more substantial requirements--for example, the IRA provider might require an IRS ruling, legal opinion, and/or hold harmless agreements from the beneficiaries. And some IRA providers do not permit such transfers under any circumstances.

But whether or not the IRA provider permits the estate fiduciary to transfer the account out to the estate's beneficiaries, the IRA provider cannot deal with the fiduciary at all until the fiduciary has provided proper documentation to establish the fiduciary's right to give instructions with respect to this asset. Typically this means the fiduciary must (1) provide documentation of its right to deal with the account, such as a certificate of appointment from the Probate Court, and (2) sign the IRA provider's paperwork agreeing that the estate (as IRA beneficiary) is bound by the IRA provider's terms and conditions. Only once the IRA provider has this documentation can the provider begin taking orders from the estate fiduciary with respect to the deceased participant's IRA.

If the estate is going to transfer the asset out to the beneficiaries immediately, the IRA provider may or may not require the opening of an actual formal "inherited IRA account" in the name of the estate, before allowing that account to be closed as the IRA is transferred to the beneficiaries. If this step is required, the new "inherited IRA" account will be titled "Yuri IRA, payable to the estate of Yuri as beneficiary" or "Lara, administrator of the estate of Yuri, as beneficiary of Yuri." Some IRA providers might be willing to dispense with formally opening an account in the name of the estate as beneficiary, once the executor has provided evidence of its authority, written acceptance of the IRA provider's terms, and instructions for the transfer.

The transfer instructions would say in essence, "I, Lara, as administrator of the estate of your deceased IRA customer Yuri (see my certificate of appointment attached) hereby instruct you to divide the above account [i.e., Yuri's IRA] into two separate equal inherited IRAs, one titled 'Yuri, deceased, IRA, payable to Lara as successor beneficiary' and the other titled 'Yuri, deceased, IRA, payable to Tonya as beneficiary.'"

So the "good news" is that (one way or another) Lara can do these transfers. If the IRA provider she is dealing with won't allow the transfers, the account can be moved (still as an inherited IRA in the name of the estate as beneficiary) to a more cooperative IRA provider.

The bad news is that, unfortunately, Lara is misinformed about the effects of doing this transfer. Transferring the account to Lara and Tonya individually will not magically transform them into "designated beneficiaries" for minimum distribution purposes.

The "stretch" or "life-expectancy-of-the-beneficiary" payout is available only to a "designated beneficiary." A "designated beneficiary" means an individual or a qualifying "see-through trust." When Yuri died, there was no designated beneficiary on his IRA account. His estate was the default beneficiary, and (under the IRS' regulations) an estate cannot be a "designated beneficiary." Therefore the stretch or life expectancy payout method is not available for this IRA. Transferring the account out of the estate has absolutely no effect on the "applicable distribution period" for the account. It does not cause the transferees to become "designated beneficiaries" with respect to the account.

Yuri died before his required beginning date, with no designated beneficiary, meaning that the applicable distribution period for his IRA is the "5-year rule." All funds must be distributed out of his IRA no later than Dec. 31, 2015. As a result of the transfer, Tonya is now the successor beneficiary of "her half" of Yuri's IRA, but she is not entitled to use the life expectancy payout method.

The only bright spot here is that, although the IRS regulations never permit a life expectancy payout for benefits payable to or through an estate, the IRS applies more lenient standards when the issue is the spousal rollover rather than the life expectancy payout. Because Lara, the surviving spouse, was entitled to half the IRA through the estate as her intestate share, the IRS might well allow her to "roll over" her half into her own IRA, thus salvaging substantial income tax deferral.

I understand that families and their advisors can be very upset when they receive this answer, because it may mean they have to incur probate costs they hoped to avoid and the daughter does not get the life expectancy payout she hoped for. These bad results are caused by Yuri's failure to do proper estate planning, not by some evil intent on the part of the IRA provider.

Resources: The following sections of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011) provide complete discussion and citations to authority for the points discussed in this answer.

The views expressed are the authors.

Five Reasons to Make an IRA Part of Your Planning Strategy

IRAs typically give investors access to a wider range of investment options than workplace-sponsored plans, such as a 401(k).

IRAs typically give investors access to a wider range of investment options than workplace-sponsored plans, such as a 401(k).

There could be an important tool already in your portfolio that can help you save more for retirement. It's your IRA.

Nearly 50 million American households own an IRA, but it is often an overlooked component of most investors' financial planning strategies. In fact, over the past two years, only 15% of households that were eligible to contribute to an IRA did so.¹

Have you forgotten your IRA? If you don't have one, should it be part of your overall investment plan? Here are some compelling reasons why this vehicle can help you plan for your future.

1.      Tax deferral: Traditional IRAs allow your investment earnings to grow tax-deferred until withdrawn, typically at retirement. For 2011, the maximum contribution is $5,000, but for those aged 50 and over, the limit is $6,000. The limits are the same for a Roth IRA, but to be eligible to fully contribute, an investor must have a 2011 modified adjusted gross income of less than $107,000 for singles and $169,000 for married couples filing jointly. Singles earning up to $122,000 and couples earning up to $179,000 are eligible for partial contributions.

2.      Deductibility: If you are a single taxpayer who doesn't participate in an employer-sponsored plan and you earn less than $56,000 in 2011, you can deduct your contributions to a traditional IRA off your income taxes. Couples earning under $90,000 are also eligible for a full deduction. Partial deduction limits also apply, up to $66,000 for singles and $110,000 for couples. Note that Roth IRA contributions are not deductible.

3.      Investment flexibility: IRAs typically give investors access to a wider range of investment options than workplace-sponsored plans, such as a 401(k). Depending on the financial institution you use to open your account, you can invest in a broad array of mutual funds, ETFs, individual stocks and bonds, CDs, annuities, even commodities and real estate.

4.      Convertibility: Traditional IRA holders can convert to a Roth IRA to enjoy some of the additional benefits listed below. But before you decide make a switch, be sure to investigate the tax consequences of such a move.

5.      Portability: If you have assets in an employer-sponsored plan and you leave your job, you can easily roll over those assets into an IRA. Rolling over your assets can make sense, particularly if you change jobs frequently and don't want to devote too much time to coordinating and tracking your accounts.

Additional Benefits of Roth IRAs

•          Qualified tax-free withdrawals: Since Roth IRAs are funded with after-tax dollars, your withdrawals are tax free, as long as you have held the account for at least five years and are over age 59 1/2.

•          No RMDs: Unlike traditional IRAs, Roth IRAs are not subject to required minimum distributions (RMDs) once the accountholder reaches age 70 1/2.

Contact your financial professional to discuss a strategy for your IRA or to see if investing in an IRA makes sense for you.

¹Source: Investment Company Institute, The Role of IRAs in U.S. Households' Saving for Retirement, December 2010 (http://www.ici.org/pdf/fm-v19n8.pdf).

© 2011 McGraw-Hill Financial Communications. All rights reserved.

April 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by  James P Ellman, ChFC, and Barry Mendelson,CFP local members of the FPA.

Annuitizing an IRA

Annuitizing an IRA

Which set of distribution rules should you use?

by Natalie Choate 02-11-11

Question: A 70-year old client owns a variable annuity contract inside his IRA. The contract provides a guaranteed life income feature that begins whenever the client triggers it, and overrides the value of the underlying investments. To provide retirement income for himself, the client triggered the provision upon reaching age 70, at a time when the contract's cash value base was $1,000,000, so now he is guaranteed to receive six percent of that cash value ($60,000 per year) for the rest of his life. The cash value of the contract will continue to be adjusted upward and downward for changes in the value of the underlying investments and to reflect distributions, but as long as he does not make any withdrawals in excess of the $60,000 per year the payments to him will continue for life even if the cash value of the contract goes below zero. Furthermore, if there is still a cash value at his death, it will pass to his beneficiary. How is this contract treated for minimum distribution purposes?

Natalie: The IRS has one set of minimum distribution regulations for "defined contribution plans" (also called "individual account plans") and another set for "defined benefit plans" (including defined contribution plans that have been "annuitized"). The two sets have completely different rules and are based on completely different concepts. In fact, if an IRA has been partly "annuitized," the IRA is treated as two separate plans for minimum distribution purposes-one set of rules applies to the annuitized portion, and the other set of rules applies to the rest of the account.

The defined contribution rules are the most familiar: The annual minimum required distribution is computed by dividing the prior year-end account balance by a life expectancy factor obtained from an IRS table.

The defined benefit/annuity minimum distribution rules take a different approach. There is no concept of computing an annual distribution, and no need to look at a prior year end account balance. Instead, these rules dictate what type of annuity can be purchased by an IRA or other retirement plan. Basically, only life annuities, or joint life annuities with the designated beneficiary, are allowed, but there can be annuities for fixed terms (or with minimum guaranteed terms) that do not exceed the applicable life expectancy. Payments under the annuity must be level, or increase by no more than a cost of living adjustment or specified fixed annual percentage. Once the annuity is in place, all distributions under the contract are considered "minimum required distributions."

And the IRS rules specify that a variable annuity contract, until it is actually "annuitized," is treated as just another asset held inside an individual account plan, with special valuation rules that apply.
 

The trouble with this neat little bifurcated universe is that the insurance companies keep coming up with new hybrid products. It's not always clear which set of rules applies to these products. Your client's guaranteed income variable annuity is a perfect example. It has a cash value (so to that extent it behaves like a defined contribution/individual account plan) but it also has a guaranteed life income feature (like a true annuity).

Recently, the IRS ruled that a similar sort of guaranteed withdrawal product had to be treated as an annuity contract for purposes of the spousal consent rules applicable to qualified retirement plans (spousal consent required in order for employee to take retirement distributions in any form other than a qualified joint and survivor annuity). But as yet there are no IRS pronouncements on how the minimum distribution rules apply to these hybrid contracts.

There are two minimum distribution concerns we would have about a product like this:

* First we want to be sure that the contract complies with the minimum distribution rules.

* Second we need to know the status of distributions the client receives; any distribution that is a minimum required distribution cannot be rolled over.

Until there is an IRS pronouncement, a client may be forced to be cautious and conservative regarding how the minimum distribution rules may apply.

One thing is clear: The life annuity itself does not violate the minimum distribution rules, because it lasts only for the client's own actual life. The defined benefit/annuity minimum distribution rules always permit an individual to buy a level payment single life annuity for his own life.

The potential compliance problem that arises would be if the cash value of the account increases beyond what is needed to support the $60,000 life annuity. The only way the client can be sure he is complying with the minimum distribution rules is to withdraw from the account, each year, the $60,000 minimum guaranteed payment, or (if greater) the minimum distribution computed based on his age and the prior year-end cash value. Such extra withdrawals might impair his guaranteed income stream, unless the contract has an exception permitting minimum required distributions to be made without prejudice.

The next problem is whether each $60,000 annual distribution is considered a minimum required distribution, which would be the case if this is treated as an "annuitized" IRA. If the guaranteed payments are considered minimum required distributions, they cannot be rolled over to another IRA.

For many clients, these questions will not be of significant concern because (1) in many cases there is almost no chance the cash value will increase after the guaranteed payout begins and (2) in most cases the guaranteed income payments are for spending, with no desire to "roll them over" into another IRA. However, for clients who may wish to roll over some of their guaranteed payments, and/or where cash value may grow significantly, the insurance companies issuing these products may wish to obtain an IRS ruling regarding their minimum distribution treatment.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.