Brush Up on the Kiddie Tax Before Helping Young Ones Invest

Rules aimed at preventing families from sheltering assets affect how much young investors pay.

By Adam Zoll | 09-23-14 |

Question: I plan to open brokerage accounts for each of my children to give them a chance to learn about investing. If the accounts are in their names but they are minors, who pays the taxes?

Answer: Teaching your kids about investing by helping them try it for themselves is a great idea, but unfortunately the tax implications aren't quite so straightforward.
One of the simplest ways to introduce your children to investing is to open an individual retirement account (IRA) in each of their names. This requires that they have earned income of their own--such as from a part-time or summer job--and the amount contributed to the IRA each year cannot exceed what they earned. Getting your kids to direct some of their hard-earned wages toward a long-term goal such as retirement may require an incentive; so, unless you plan to give them the money outright to start investing, you could offer to match IRA contributions they make on a dollar-for-dollar or some other basis.
For young retirement savers, a Roth IRA is often a better choice than a traditional deductible IRA because their tax rate will likely be higher when they retire, and paying lower taxes now beats paying higher taxes later. Plus, Roth contributions (but not earnings) can be withdrawn tax-free prior to retirement; so, if your kids decide they want to use some of the money for another purpose later on--such as to help pay for college--that is an option.

The Ins and Outs of Custodial Accounts
If opening an IRA isn't possible, your next decision is whether you do, indeed, want the accounts to be in your children's names. Doing so can lead to some tax savings--especially for children from high-income families--but there are potential downsides as well. We'll explore these pros and cons in a moment, but first let's talk about how custodial accounts work.
Many brokerages and fund companies offer custodial accounts (sometimes referred to as UGMA or UTMA accounts) as a way to establish ownership of assets on behalf of a minor while control over the account remains with an adult, such as a parent or guardian. It is extremely important to understand that once assets are placed in a custodial account they are legally the property of the beneficiary, and this change of ownership is irrevocable. It also means that once the beneficiary turns age 18 or 21 (depending on the state) he or she can assume control of the assets to do with as he or she sees fit.
Also, keep in mind that there are college-planning implications associated with UGMA and UTMA accounts. Because custodial assets are considered the property of the child, and because student-owned assets are penalized more heavily than parent-owned assets in need-based financial-aid calculations, your child might receive less financial aid for college than he or she otherwise would if the assets were to remain in your name, even if you're not planning to use these assets to help pay for college.

In addition, be aware that the annual gift-tax exclusion currently is $14,000. So, if you plan to contribute more than that amount to your children's custodial accounts in a given year, it could have an impact on your estate taxes down the road (although this is really only of concern to high net-worth investors).

The Ins and Outs of the Kiddie Tax
Whatever the size of your children's custodial accounts, it's important to understand the tax advantages and their limits. One advantage of custodial accounts is that some unearned income (in other words, income that isn't from working) held in your child's name--such as dividends, interest, and capital gains distributions--is taxed at a lower rate than the parents pay, or not taxed at all. However, anything above that amount is subject to something known affectionately (well, maybe not that affectionately) as the "kiddie tax."
To ensure that wealthy families don't sock away investments in their children's names in order to pay a lower federal tax rate, special rules were put into place in the mid-1980s. Under these rules the first $1,000 of unearned income in the child's name is untaxed and the next $1,000 is taxed at the child's rate. Any unearned income above this level is taxed at the parent's rate (or the child's if it is higher).
The kiddie-tax system maintains the same special treatment of long-term capital gains and qualified dividends that would apply to an adult taxpayer, says Jackie Perlman, principal tax research analyst at The Tax Institute. That means that for the second $1,000 of unearned income, any long-term capital gains are taxed at whatever rate applies to the child while for any long-term capital gains above the $2,000 threshold, the parents' long-term capital gains rate applies. Based on this year's tax brackets, a child would need to have at least $36,900 in ordinary income to owe any tax on long-term capital gains or qualified dividends for the second $1,000, and his or her parents would need to have at least $73,800 (if filing jointly, or $36,900 for a single parent) in ordinary income for the child to owe anything after that. For short-term capital gains (those for sales of securities owned for less than a year) and nonqualified dividends, the child's ordinary income rate applies for the second $1,000 and the parents' ordinary income rate applies after that.
As an example, let's consider a child who does not make enough to owe any taxes on long-term capital gains but whose parents make enough to require them to pay a 15% tax on such gains. If the child has $2,500 in unearned income (we'll assume it's all from long-term capital gains), he or she pays no taxes on the first $1,000 and no taxes on the next $1,000 but a 15% rate on the remaining $500. So, effectively, out of that $2,500 in gains, the child would end up owing just $75 in taxes. (If the child also has earned income from a job, that is taxed separately and all of it is subject to the child's rate.)
If the child's unearned income totals less than $10,000, the amount may be included on the parents' tax return (using Form 8814); but if it is greater, a separate return must be filed. Including your child's unearned income on your tax return could reduce your ability to take advantage of some tax credits or deductions. So, if you are unsure how this will affect your tax situation, it might make sense to consult a tax professional.
The kiddie-tax rules apply through age 18, or through age 23 if the child is a full-time student. After that, the child files his or her own tax return and all of the individual's income, including unearned income, is subject to his or her tax rate--thus, ending the kiddie tax.

Potential Impact of the Kiddie Tax
Unless you plan to give your children a rather large sum to invest (or if you have a couple of budding young Warren Buffetts on your hands), the kiddie tax may not come into play for you, at least not for awhile. Interest and dividends alone may not produce enough income to carry your young investors above the $2,000 threshold at which they'd have to start paying taxes at your rate. To illustrate, a portfolio of stocks, bonds, or funds generating 5% in income annually would need to have $40,000 in it to reach that level.
Capital gains are another matter, however. A child who pays $5,000 for a stock in a custodial account and later sells it for $10,000 will owe taxes on the $5,000 in capital gains. The good news is that the first $2,000 of that gain may very well be tax-free, but the last $3,000 will be taxable at your rate.
Scenarios such as this are why some tax professional recommend selling out of the position gradually in order to stay within the $2,000-per-year threshold or holding on to appreciated assets until the child is no longer subject to the kiddie tax (assuming he or she will be in a lower capital gains tax bracket than you at that time). However, allowing tax considerations to be the main driver of your investing decisions isn't usually a great idea and probably isn't the primary lesson you're trying to get across to your kids either.

Confused About Paying IRA Expenses?

Payment of the management fees for an IRA presents planning opportunities--and pitfalls.

By Natalie Choate

Question: Clients may have management expenses or fees with respect to their IRAs. Should these be paid directly from the IRA, or must they be paid that way? Can fees for multiple different accounts be paid all from one account?

Answer: Payment of the management fees for an IRA presents planning opportunities--and pitfalls.
The planning opportunity arises from the following facts: IRS rules provide that management expenses of an IRA may be paid directly from the IRA, and such payment will not be considered a distribution from the IRA for any purpose. Or the IRA owner may alternatively use his outside funds (taxable account) to pay the management expenses of his IRA, and such payment will not be considered a contribution to the account. Thus the IRA owner (or beneficiary, in the case of an inherited IRA) should carefully consider which source of funds is most advantageous. He or she needs to ask: Is my IRA too big (so I should try to shrink it in legal and tax-advantaged ways)? Or is it too small (so I should try to grow it in every legal way possible)?

This is one case in which size does matter.

Ins and Outs of Taking Required Minimum Distributions From Multiple Plans

by Natalie Choate (excerpt) 07/11/2014

Question: I'm turning 70 1/2 this year, so I know I have to start taking required minimum distributions. I have a self-employed profit-sharing plan ("Keogh plan") for my business (I'm the sole owner) and two IRAs--my own IRA plus an IRA I inherited from my father. Can I take the RMD for all these accounts from my dad's IRA?

Answer: No, you cannot.

Generally speaking each retirement plan or account must distribute its own RMD, and you cannot take a distribution from one plan that counts toward your RMD from another plan.
In the case of the profit-sharing plan, for example, that is a "qualified plan," so it must pay you your RMD from that plan or risk losing its IRS qualified status. If you had two profit-sharing plans, each one would have to pay its own RMD. Taking a distribution from one profit-sharing plan does not give you any credit toward your RMDs from any other plan.

With IRAs, there is more flexibility: Generally you can take your IRA distributions from whichever IRA you want (see the next question). But that flexibility does not extend to inherited IRAs. If you are holding an IRA as beneficiary, you must take RMDs attributable to that inherited IRA from that account. A distribution from in inherited IRA cannot be used to fulfill the distribution requirement for your own IRA and vice versa.
And there's more! If you inherit multiple IRAs from your father, you could total your RMDs for all of them and take the combined amount from any one or more of them. But you cannot not use distributions from an IRA inherited from your father to satisfy the distribution requirement for your own IRA or for the distribution requirement applicable to IRAs you inherited from someone else.

So if you inherited one IRA from your mother and another IRA from your father, you would have to take the RMDs for the IRA inherited from each parent only from IRAs inherited from that parent. Even if you cashed out the entire IRA you inherited from your father you would still have to take that year's distribution from the IRA you inherited from your mother!

Rollover Rule Change Will Cause Trouble

Rollover Rule Change Will Cause Trouble

Following the Bobrow Case, the risk of using IRA-to-IRA rollovers (versus direct transfers) is even greater than before.

Natalie Choate, 05/09/2014

A change in the IRA rollover rules starting in 2015 will cause trouble for clients, planners, and plan administrators. Beginning with distributions in 2015, the IRS will enforce the one IRA-to-IRA-rollover-per-12-months rule without regard to whether the distributions came from the same or different accounts. Publication 590 will be amended to reflect this change.

Normally, a retirement plan distribution can be "rolled over" into the same or another retirement plan within 60 days. The effect of the "rollover" is to "erase" the distribution so it is not taxable. There are exceptions to this tax-free treatment, of course--not every distribution can be rolled over. One of the exceptions applies to IRA-to-IRA rollovers: The Code says an IRA distribution cannot be rolled over tax-free to an IRA if any other IRA distribution received within the preceding 12 months was rolled over tax-free to an IRA. In other words if you do an IRA-to-IRA rollover, you cannot roll over, to any IRA, another IRA distribution received within 12 months after the first distribution. Presumably the purpose of this rule is to prevent someone from keeping his IRA money continuously outside of the IRA using a series of tax-free rollovers.

The IRS has always interpreted this provision a little more leniently than the literal words of the Code. The IRS has said (in IRS Publication 590 and in a proposed regulation) that you CAN roll over, to an IRA, a second IRA distribution within 12 months PROVIDED that the subsequent distribution came from an account that was not involved in the first rollover. In other words, if you got a distribution from IRA #1 and rolled it over tax-free to IRA #2, and then you received a distribution from IRA #3, you could roll over the distribution from IRA #3 to an IRA even if you received it less than 12 months after the distribution from IRA #1.

But in a recent case, the IRS went after an IRA owner who tried to take advantage of this account-by-account rule. And both the IRS and the taxpayer lost!

Mr. Bobrow was a tax attorney who represented himself in this Tax Court case. He had two IRAs at Fidelity, IRA #1 and IRA #2. His wife had one IRA there (IRA #3). They also had two taxable accounts there: husband's individual account and a joint account.

On April 14, 2008, Mr. Bobrow withdrew $65,064 from IRA #1. The opinion doesn't say what happened to this money, but the implication is he spent it. On June 6, 2008, he withdrew $65,064 from IRA #2. On June 10, 2008 he transferred $65,064 from his individual (taxable) account to IRA #1, thereby (he believed) completing a tax-free rollover of the April 14, 2008, distribution from IRA #1. On July 31, 2008, Mrs. Bobrow took $65,064 out of her IRA (#3). On Aug. 4, 2008, the couple transferred $65,064 from their joint account to husband's IRA #2, thereby (they believed) effectively completing a tax-free rollover of the June 6, 2008 distribution.

There was dispute about whether and when the third distribution (the distribution to wife from her IRA #3) was "rolled back" into wife's IRA. That seems to have been a factual dispute about amounts and dates, not of interest to the rest of the world.

The main bone of contention, of wider interest, concerned husband's two purported rollovers. The IRS contended that the June 10, 2008, deposit of $65,064 to one of husband's IRAs was an effective rollover of his second IRA distribution June 6, 2008), and that the IRA contribution of Aug. 4, 2008 was an ineffective late rollover of the first IRA distribution on April 14, 2008). In other words the IRS tried to re-assign what deposit matched which distribution.

I am not aware of any other situation in which the IRS has tried to "overrule" the taxpayer's decision as to which distribution is being rolled over. But as it happens, the Court ignored this IRS argument; the Court accepted Mr. Bobrow's decision regarding which distribution he was rolling over when.

Instead, the Court decided the case against Mr. Bobrow based on the "plain language" of the Code (backed up by legislative history, said the Court) to the effect that, regardless of how many IRAs a person has, and regardless of whether distributions come from the same account or different accounts, an individual cannot roll over, to an IRA, more than one distribution received within a 12-month period. Because of that rule, Mr. Bobrow's purported rollover (on Aug. 4, 2008) of the second distribution (June 6, 2008) was no good. Therefore the second IRA distribution was fully includible in his gross income. Oh, and it was also subject to the 10% penalty because he was under age 59 1/2. And a 20% accuracy penalty was also imposed because the couple could produce no "substantial authority" supporting their position that the once-per-12-months limit applied on an account-by-account basis. An IRS Publication is not substantial authority!

So the IRS went to court and, in a way, lost twice. Though the IRS technically won the case and Mr. Bobrow lost (because his second purported rollover was invalidated), the Court rejected the IRS' re-assignment of the deposits attempt AND threw out the IRS' account-by-account rule.

The IRS has announced that it will follow this decision, revise Publication 590, and withdraw its proposed regulation. But since this is a big change for IRA owners, IRA providers, and advisors, the IRS will not enforce the new rule for distributions prior to 2015. Amazingly, after the case ended, the IRS even let Mr. Bobrow use the account-by-account rule for his pre-2015 rollovers; since the Court did not adopt the IRS' theory of reassigning which rollover was matched with which distribution, the IRS conceded that Mr. Bobrow's rollovers were "legal" under the IRS' own Publication 590 rule! Is there any other instance where the IRS won a case against a taxpayer then conceded to the taxpayer and gave him his money back in the end anyway?

The once-per-year rule is a trap for the unwary. For one thing, it's not always clear what a "distribution" is--if you request a cashout of your IRA and the IRA provider sends you two separate checks a month apart, is that one distribution or two? Also, consider "Granny" who has her IRA in six-month CDs. Most banks treat each CD as a separate new IRA, which they then close and distribute when the CD matures. If Granny has multiple CDs in IRAs that close out within 12 months of each other, she won't be able to roll over any but the first one.

The way to avoid getting into trouble with this rule is to always use direct IRA-to-IRA transfers instead of "60-day rollovers." There is no numerical limit on IRA-to-IRA transfers. Direct transfers have always been safer than 60-day rollovers, and now the risks of using rollovers are even greater than before.

Big Water Arbitrage in California

Share this:

Big Water Arbitrage in California
 
By Henry Bonner 
“Water law in California began in earnest in the early part of the 20^th century,” Rick Rule recently wrote for the Bonner Family Office, “when interests in Los Angeles bought up most of the available water rights in Owens Valley of Eastern California.

“This took the rights from ranchers – who had enjoyed them for free – and allowed the new owners to ship that water to Los Angeles, where it fueled the growth of the city.”

But agricultural interests, the dominant political force at the time, were unsettled by these events.
“Farmers disliked fair markets for water,” says Rick. “They wanted to protect their water from being bought up by urban interests who could afford to pay more for it. So they changed the rules for water distribution.
“Water that flowed through agricultural land was reserved for agricultural use unless an exemption was provided for urban use. Farmers who wanted to sell their water to urban users were prohibited from doing so.”

A hundred years later, that system is still in place.

Because agricultural water is protected from being bought up for urban use, agricultural water has remained relatively cheap and water for human consumption has skyrocketed.
The gap between the two is immense…

In San Diego County, untreated water now costs upwards of $1,000 per acre-foot¹ (about 326,000 gallons, or enough to supply three households for a year²). Water used for growing almonds in the San Joachin Valley, meanwhile, only costs around $40 per acre-foot.³

Today, a lot of farmers would make more from selling their water than from growing crops. But the law says they have to use it to farm or give it up.

As a result, agriculture uses 85% of the water that is not reserved for environmental purposes⁴, whereas farming only represents 0.4 percent of gross total regional product.⁵
But with population booming and water supplies dwindling because of the drought, we could see necessity force authorities to loosen the rules that bind water use in California.

If affluent coastal communities in Los Angeles, San Francisco, or San Diego begin to feel the effects of water shortages, will it matter to them that farmers should have a ‘right’ to grow their water-intensive rice paddies or other crops in the arid Central or Imperial Valleys?

We could see California follow the example of southeastern Australia. After a decade of drought, the authorities allowed a kind of market for water rights to occur. As a consequence, agricultural usage became much more efficient – switching water-intensive rice paddies for higher-value crops like citrus fruits and wine grapes.

If agricultural water could be bought and sold more freely, this might allow the $40 water to be sold to people in San Diego, for instance, who are willing to pay 25 times more for the same water. Rick believes some investors could gain from participating in this substantial water price arbitrage.
In particular, he explains, we should look for ways to own those water rights still trapped by the old rules -- and wait until circumstances allow us to sell those rights to a higher bidder.

Rick Rule has devoted over 35 years to natural resource investing.  His involvement in the sector is as broad as it is long; his background includes mineral exploration, oil & gas exploration and production, water, agriculture, and hydro-electric and geothermal energy. Mr. Rule is a sought-after speaker at industry conferences, and a frequent contributor to numerous media outlets including CNBC, Fox Business News, and BNN. He founded Global Resource Investments in 1993 and is now a Director of Sprott, Inc., a Toronto-based investment manager with over $7 billion in assets under management, and CEO and President of Sprott US Holdings, Inc., where he leads a team of skilled earth science and finance professionals who enjoy a worldwide reputation for resource investing.

¹ http://www.sdcwa.org/san-diego-county-water-authority-adopts-rates-and-charges-2013
² http://www.epa.gov/WaterSense/pubs/indoor.html
³ University of California Cooperative Extension, 2011. Sample Costs to Establish an Orchard and Produce Almonds
⁴ http://www.californiawater.org/cwi/docs/CIT_AWU_REPORT_v2.pdf
⁵ http://aic.ucdavis.edu/publications/socal.pdf

Rolling a 401(k) into an IRA? Six Questions to Ask First.

Feb. 10, 2014
 Rolling a 401(K) into an IRA? Ask 6 questions first.
 By Joe Lucey 
Since the creation of the 401(k) and other employer-sponsored retirement plans, most advisers and investors have focused on how to get money into them — not necessarily how to best take money out of them.
 Now, with baby boomers entering their retirement years at a rate of over 10,000 a day, investors have to change their focus from accumulation of assets to generating a lifetime of income from these assets.

Typically, once your employment ends, you have four options for your company-sponsored retirement assets:

1) Leave the money in your former employer's plan;
2) Roll the funds into a new employer's plan (assuming you continue to work);
3) Transfer the assets into an IRA account; or
4) Cash out the balance, paying the applicable taxes and penalties (which depend on your age and circumstances).

 Whether you are transitioning to a new employer or retiring from the workforce, you'll want to avoid some very common — and irreversible — mistakes. Fortunately, by asking a few key questions, you can make well-informed decisions, analyze trade-offs and avoid surprises.

Here are some critical questions to consider:

When will I need income? 

Upon leaving a company at age 55 or older, a former employee can take penalty-free withdrawals from their company-sponsored 401(k) account. However, if that 401(k) is rolled into an IRA, the penalty-free withdrawal age increases to 591/2. (One notable exception is public-service employee plans, such as those for firefighters, police officers or emergency medical personnel, which may allow penalty-free withdrawals as early as age 50 if left in their employer plan.)
There is well-documented loophole regarding early withdrawal penalties, based on the 72(t) Substantially Equally Periodic Payments. Essentially, the IRS approved several methods of calculating withdrawals from an IRA before age 591/2; these can sidestep the 10% penalty — but if you plan to take this route, use caution. Once a 72(t) payment plan is established, it locks you in for a minimum of five years or until age 59 1/2, whichever is longer. Your IRA cannot be modified or changed during the payment period (except in case of death); failure to follow every strict rule of this strategy results in some very ugly tax consequences.
A superior option may be to leave some assets in your former employer's 401(k) plan, before completing a rollover, if income will be needed before age 591/2. For example, perhaps you have a million-dollar 401(k), and you plan to take withdrawals totaling $200,000 in the first three years of retirement. Keep $200,000 in the 401(k) and roll the remaining $800,000 into your IRA.
Because employer plans can vary, it is important to discuss your strategy with the company plan administrator to ensure you're complying with the rules of that specific 401(k).

 What are my fees and investment options?

 Rolling your 401(k) into an IRA can reduce your management fees and provide more investment options, but if price was the only factor to consider, everyone would be driving a Kia. It is important to know what you're paying for and feel comfortable with the value provided.
In addition, the Financial Industry Regulatory Authority, or Finra, recently issued a regulatory notice, warning firms against overselling clients on the strategy of shifting retirement dollars from 401(k)s to IRAs when they retire or change jobs. Whether you leave your 401(k) where it is or you move it into an IRA, make sure that you're assessing which retirement plan will serve you best.

Does my career put me at risk of being sued?

 Company-sponsored plans generally provide greater protection from lawsuits than IRAs. If you are a physician, own a construction company, or work in any field with heavy liability issues, you may be at higher risk for a lawsuit down the road. In that case, it might be wise to consider keeping your 401(k) where it is.

Have I made nondeductible, after-tax contributions to the plan? 

 Often, participants make contributions to their 401(k) that weren't deducted from their annual income (in the year of the contribution). Check with your plan administrator to ensure that these contributions are separated from the remaining retirement funds and not commingled with other IRA assets. Failure to do so would require you to file an additional IRS form (8606) with your annual tax return to protect what should be tax-free withdrawals of those contributions.

Do I own company stock in the plan?

 If your 401(k) includes company stock, explore the advantages of Net Unrealized Appreciation (NUA). This allows a participant to withdraw the company stock "in-kind," thereby removing it from your retirement account. The cost basis of the stock will be recognized as income in the year of the withdrawal, but NUA can substantially reduce future taxation (when required distributions force their liquidation) and ensure the most optimal taxation of these assets.
Just like plumbing and electrical work, some things are best left to a professional. This is certainly true with NUAs, so let the pro's take over. Discuss this strategy with a competent financial or tax adviser — before its implementation — or you could put yourself at risk for some unfortunate mistakes.

 Who does my adviser work for and what are they qualified to do?

 Your retirement accounts represent years of sacrifices. Contributions meant fewer dollars to spend on family vacations, dining out, new cars and homes. You made a conscience decision to sacrifice certain things today so you would have more security tomorrow. Now that tomorrow is fast approaching, you want to make sure you get the most from your assets.
Developing a savvy strategy to pull money out your retirement accounts — without paying any more in taxes and penalties than is absolutely necessary - depends on the guidance of an adviser who adheres to a high fiduciary standard, and has the credentials and expertise to turn your years of sacrifice into a lifetime of financial security.
That strategy begins with the answers to these questions. So know your options and issues before you roll your 401(k) anywhere, and position yourself to preserve and maximize every single dollar you've saved.

Trust RMDs After a Spouse Dies

by Natalie Choate  
12/2013

There is probably no such thing as a simple question regarding minimum distributions.
 

This reader illustrates how there is probably no such thing as a simple question regarding minimum distributions. Rarely do I answer "yes" or "no." More often the answer is, "It depends!"

Question: The IRA owner or participant ("Husband") died in 2007. His IRA was payable to a trust. The trust was a qualifying "see-through trust" under the IRS' minimum distribution regulations. Husband's surviving spouse ("Spouse") was the sole beneficiary of the trust. Required minimum distributions (RMDs) have been computed based on Spouse's life expectancy as the oldest trust beneficiary. Spouse died in 2013. Upon her death, the trust is to terminate and be distributed outright to the couple's four children. Do we continue to calculate RMDs based on the Spouse's life expectancy, or do we now switch over to the oldest child's life expectancy?

Answer: First we have a terminology issue. When you say Spouse was the "sole beneficiary" of the trust, do you mean the trust was a conduit trust? Or do you merely mean that she was the sole life beneficiary? The trust was a "conduit trust" if the trustee was required to transmit to Spouse, upon receipt, all distributions the trustee received from the IRA during Spouse's lifetime (minus applicable expenses).

If the trustee had the power to "accumulate" (not immediately distribute to Spouse) any distributions the trust received from the IRA during her lifetime, then the trust was an "accumulation trust," not a "conduit trust." Either type can qualify as a "see-through trust" for minimum distribution purposes, but the answer to your question could be different depending on which type it was.

Now to your question. The basic answer is, you NEVER "flip" over to someone else's life expectancy just because a trust beneficiary dies. The death of a beneficiary (in your case, Spouse) after the participant has died has basically NO EFFECT on the Applicable Distribution Period (ADP).

The "Applicable Distribution Period" (ADP) for an IRA is "carved in stone" once the participant dies. We determine who the designated beneficiary(ies) is (or are) at the moment of the participant's death, and that's it. Subsequent events (such as the death of a beneficiary or the termination of a trust) will have NO effect on the ADP. Regardless of how many deaths or trust terminations there may subsequently be, the ADP "is what it is" on the participant's death.

So basically you don't have to worry about the ADP somehow changing on Spouse's death or flipping over to the children's life expectancy--it ain't gonna happen!

Of course there are ALWAYS exceptions in the minimum distribution rules. Here are the four exceptions to the "carved in stone" rule. In these situations the stone may crumble or expand or otherwise get "uncarved":

Spousal rollover: If the benefits are payable to the surviving spouse, and he or she "rolls them over" to his or her own IRA, the ADP will thenceforth be determined based on the surviving spouse as "owner," and ceases to be governed by the rules applicable to the deceased participant's IRA. This rollover could occur at any time after the participant's death, since there is no deadline for a spousal rollover. It can even occur when the benefits are payable to an estate or a trust, if the surviving spouse has the power to take the money out of the trust. But this was not the case in your example--even if the spouse could have withdrawn the money from the IRA and the trust, she didn't do so.

Separate accounts: If the benefits are payable to multiple beneficiaries in percentage or fractional shares, the beneficiaries can divide the inherited IRA into separate inherited IRAs, one payable to each of them. If such "separate accounts" are established by Dec. 31 of the year after the year in which the participant died, then each separate account is treated as a separate inherited IRA, and the ADP for each is determined on that basis, rather than being based on, say, the life expectancy of the oldest one of the multiple beneficiaries. But this exception also doesn't apply to your situation; it can never apply when the IRA is payable to just one beneficiary (in this case a trust).

"Removing" a beneficiary by the Beneficiary Finalization Date: A person or entity who is a beneficiary of the IRA as of the date of the participant's death, but who ceases to be a beneficiary by Sept. 30 of the year after the year of the participant's death (the "Beneficiary Finalization Date" or BFD), does not count as a beneficiary for minimum distribution purposes. Typically "removal" would mean that the beneficiary either received or disclaimed all of his, her, or its share of the benefits prior to the BFD. But this exception also does not apply in your situation, where there was no change in the makeup of the beneficiaries prior to Sept. 30, 2008.

When both spouses die young: Finally, there is a quirky rule that was probably intended to help families but that usually has the opposite effect. If the participant died before age 70 1/2, leaving his IRA to his spouse as sole beneficiary, and then the spouse also later died, before the end of the year in which the decedent would have reached age 70 1/2, the Applicable Distribution Period after the spouse's death is determined "as if" the spouse were the participant! In other words, the APD will be the life expectancy of the spouse's "Designated Beneficiary," or it will be the end of the fifth year after the spouse's death if the surviving spouse did not have a Designated Beneficiary. This rule WOULD apply in your situation, IF the trust was a "conduit trust" as to the surviving spouse (so she was considered sole beneficiary of the IRA) AND both spouses died young. If the trust was an accumulation trust and/or if either spouse died after the participant's age 70 1/2 year, this exception does not apply.

If none of the above exceptions applies, then the death of the surviving spouse has no effect on the ADP of this IRA. The successor beneficiaries must continue to withdraw the benefits in annual installments over what's left of the original life expectancy of the now-deceased surviving spouse. Like I mentioned, the ADP is normally "carved in stone" when the participant dies!

Titling the Inherited IRA

There are two main reasons to properly take care of this important step following an account owner's death.

Natalie Choate, 11/08/2013

Question: I attended your recent presentation at the Notre Dame Tax & Estate Planning Institute. In "The Fiduciary's Guide to Retirement Benefits" and the seminar material, you suggest that the fiduciary should (promptly after the participant's death) rename an IRA account to be titled "John Doe, f/b/o Estate of John Doe" or "XYZ Bank, Executor of the estate of John Doe, as beneficiary of John Doe." Why do you recommend such retitling at the time of death, and what are the benefits of such retitling?

Answer: I'm sorry I didn't make this clearer in the seminar presentation! Here's what "retitling" is all about.

Suppose John Doe dies, leaving his IRA to "my estate" as beneficiary, or fails to name any beneficiary, causing the estate to become the beneficiary of the IRA by default. Now the estate "owns" the IRA as beneficiary, but the executor has not established that ownership with the IRA provider. As far as the IRA provider is concerned, this account still belongs to John Doe. It will take instructions only from John Doe. Once the IRA provider realizes that John Doe is dead, it will not take instructions from anybody until the account beneficiary shows up and establishes his or her identity.

This is required for any beneficiary of an IRA of a deceased person. In the particular example I discussed at the seminar, the beneficiary of the IRA happened to be the estate of the deceased participant, so I'll illustrate with that.

Suppose Rita Roe has been duly appointed as executrix of the estate of the deceased IRA owner John Doe. As executrix, Rita wants to start getting the monthly statements for the account and otherwise take control of it, maybe to sell the investments inside the IRA or take a distribution from the IRA. But she can't do any of these things until the account is formally registered in the estate's name on the IRA provider's books. If she just calls up the IRA provider and says, "Hi! I'm the executrix of John Doe. Please send me some account statements and, by the way, sell all the IBM stock and send me a distribution for $10,000," the IRA provider will say, "Who the heck are you?"

In short, the IRA provider will not deal with the executrix until the account has been formally retitled, or reopened, in the name of the estate. As of now, the only "customer" the system recognizes is John Doe. The executrix is "nobody" until she:

--Presents her certificate of appointment to the IRA provider, to prove she is entitled to act for the estate of John Doe.

--Gives the IRA provider her name, address, email address, and phone number, and the tax ID number of the estate, so they can communicate with her and do the IRS-required reporting for this account.

--Signs the IRA provider's standard form account agreement showing she agrees to their standard account terms and so they have her signature on file.

The minute John Doe died, the IRA "belonged" to his estate as beneficiary. But until the paperwork catches up with the real-time events, the executrix (or trustee, or child, or spouse, or whoever is the beneficiary of the account) can't do anything with it. It's like when you buy a house. You give your money to the seller, and the seller gives you a signed warranty deed. You now "own" that house, but the property tax bills are going to keep coming addressed to the seller unless and until you record your deed, because the property is still in the seller's name on the record.

So all I'm saying is, in order to take any actions, or even get any information with respect to this inherited IRA, the executrix has to complete all the paperwork to get the account documented into the name of the estate as beneficiary. That's the step I call "retitling." There are two reasons I put so much emphasis on this step.

First, some beneficiaries handle this step in a casual or even careless manner with the result that the IRA provider thinks a distribution is being requested, and the IRA provider simply closes out the IRA account and distributes 100% of the proceeds to the beneficiary. That occurrence is an all-too-common tax disaster, because once money has been distributed from an inherited IRA, there is no way to get the money back INTO the tax sheltered IRA (unless the beneficiary who receives the distribution is the surviving spouse). That's why the owner of an "inherited IRA" has to be extremely careful in communications with the IRA provider. All communications should emphasize that the beneficiary is not seeking a distribution; he or she is merely asking for a change of title.

Second, I regularly get emails from upset beneficiaries and their advisors complaining that "I want to transfer this inherited IRA to the financial firm we usually deal with, but the decedent's IRA provider is telling us we have to open an inherited IRA with THEIR firm!" These callers don't understand that they have to open the inherited IRA at the decedent's IRA provider's firm FIRST before that IRA provider can take any instructions from them--and then after they do that, they can transfer the IRA to another firm. But the beneficiary cannot transfer his or her inherited IRA to another IRA provider unless he or she, as beneficiary, is first established as a "customer" or account holder with the original IRA provider.

 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.

How to Pay IRA Expenses

Payment of the management fees for an IRA presents planning opportunities--and pitfalls.

Natalie Choate, 10/11/2013

Question: Clients may have management expenses or fees with respect to their IRAs. Should these be paid directly from the IRA, or must they be paid that way? Can fees for multiple different accounts be paid all from one account?

Answer: Payment of the management fees for an IRA presents planning opportunities--and pitfalls.

The planning opportunity arises from the following facts: IRS rules provide that management expenses of an IRA may be paid directly from the IRA, and such payment will not be considered a distribution from the IRA for any purpose. Or the IRA owner may alternatively use his outside funds (taxable account) to pay the management expenses of his IRA, and such payment will not be considered a contribution to the account. Thus the IRA owner (or beneficiary, in the case of an inherited IRA) should carefully consider which source of funds is most advantageous. He or she needs to ask: Is my IRA too big (so I should try to shrink it in legal and tax-advantaged ways)? Or is it too small (so I should try to grow it in every legal way possible)?

This is one case in which size does matter.

Ferdinand Example: IRA too small. Ferdinand is trying to maximize the value of his tax-deferred retirement plans. Though he earns $300,000 a year, he is over 50 and hasn't saved enough for a retirement that is now just a few years away. He has already made the maximum IRA contribution allowed for 2013. His investment advisor charges $10,000 a year to manage Ferdinand's $1 million IRA. If the fee is paid out of the IRA itself, that diminishes the IRA unnecessarily. By using outside funds to pay the fee, Ferdinand avoids "wasting" some of the IRA money, keeping his IRA intact. The account can grow faster, giving him retirement security sooner, if he uses outside funds to pay the fee. Even though the IRS does not treat this as a contribution to the account, it functions like an additional contribution in terms of its financial effect.

Another benefit of using outside funds is that this type of fee is tax deductible if paid using outside funds, as an expense for the management of property held for production of income. However, such "miscellaneous itemized deductions" are deductible only to the extent the total of such deductible expenses for the year exceeds 2% of Ferdinand's adjusted gross income, so he will most likely only get a partial income tax deduction for this management fee, even if it is all paid from outside funds.

Rhonda Example: IRA too big. Rhonda is 69 years old and still working. She has the opposite problem from Ferdinand: Her IRA is too big. She has a $5 million traditional IRA, incurring a management expense of $37,500 per year. She refuses to take IRA distributions before she has to, or to consider Roth conversions as a way to diminish the impact of future required minimum distributions (RMDs) that will inevitably start flowing out of her IRA in just a couple of years. Paying the management fee directly from the IRA itself will help (a little) to diminish the size of those future RMDs, while paying the fees using outside funds would just increase the income problem she will soon face.

While it is nice that this flexibility in the rules allows planners and their clients to achieve varied goals, it also presents some tricky hurdles and pitfalls:

It's OK for the IRA to pay the expense directly, but not reimburse the expense: Suppose the IRA manager takes his fee directly from the IRA funds he is managing. Can the IRA owner reimburse this amount to the account? No. That would be considered a "regular contribution" to the IRA.

A Traditional IRA cannot pay management fees for a Roth IRA: Each type of IRA must pay no more than its own properly allocable share of any management fees. If the IRA owner has both a traditional and a Roth IRA under management by a professional advisor, it would be nice tax planning to pay both IRAs' fees out of the traditional account, but you can't do it. The IRA can pay only its own expenses; if it pays expenses attributable to some other account (such as a Roth IRA, or the owner's taxable account) that would be considered a distribution from the traditional IRA (and a contribution to the Roth, if applicable).

Yes this can be cumbersome for an asset manager: Joel manages multiple accounts for his client--a traditional IRA, a Roth IRA, and a taxable account. The simplest way to handle the combined management fee would be to take it all from the taxable account. That would be perfectly "legal" and would not be considered a contribution to the IRA or Roth IRA. But if Joel determines it would be more advantageous for this client to have the fees paid directly from the IRAs (or if the client can't afford to pay the fees any other way), Joel will have to do some homework, apportioning the fee (each quarter if that's how he charges!) among the three accounts based on their relative values, and collecting a share of the fee separately from each of the three accounts.

Management fees only, not transaction expenses: The flexibility to use either plan assets or outside assets to pay fees applies only to "management expenses," such as an annual investment management fee (typically based on the amount of assets under management). Brokerage commissions and other "transaction expenses" can be paid only out of the transacting account.

Roth management fees not deductible if paid with outside assets: The owner of a Roth IRA may well wish to maximize its potential tax-free future growth by paying any applicable management fees for the account with outside assets--and he is welcome to do so. However, unlike with a traditional IRA, such payment will not create an income tax-deductible expense. Expenses incurred for the management of property that generates tax-free income are not deductible.

Resources: See Internal Revenue Code § 212 (deduction for expenses incurred in managing property held for the production of income) and § 67 (limit on deductibility of miscellaneous itemized deductions). Regarding denial of a deduction for management of a Roth IRA, § 265 denies a deduction for otherwise-deductible expenses "allocable" to income that is tax-exempt, or, as the regulations put it, "Wholly excluded from gross income under any provision of Subtitle A" or any other law. Reg. § 1.265-1(b)(1)(i). For confirmation that separately-paid administrative fees of an IRA may be deductible as miscellaneous itemized deductions, see IRS Publication 590 (IRAs), 2012, page 12. For the rule that payment of IRA management fees using outside assets is not considered a contribution to the account, see Rev. Rul. 84-146, 1984-2 C.B. 61. For the rule that commissions and similar transaction costs are not considered management expenses, see Rev. Rul. 86-142, 1986-2 C.B. 60.

Three Popular ETF Questions Answered

   

Although exchange-traded funds, commonly known as ETFs, have existed for almost two decades, they’ve only recently caught on with investors. The ETF market has evolved, and investors now have hundreds of ETFs from which to choose. Here are three commonly asked questions to consider when adding ETFs to a portfolio.

Q: What is the difference between the ETF market price and net asset value (NAV), and why do ETFs trade at a premium or discount?

A: An ETF’s NAV is the value of all the fund’s assets divided by the total number of shares. This calculation is done at the close of each trading day and can be affected by changes in the market value of the underlying securities. The market price is the price at which the ETF is trading on the exchange, which can be affected by supply and demand. During times when demand for an ETF exceeds supply, the market price of the ETF is higher than its NAV and the ETF is said to trade at a premium; when supply exceeds demand, the market price of the ETF is lower than its NAV and the ETF is said to trade at a discount. ETFs generally do not trade at persistent large premiums or discounts.

Q: What are the tax advantages of ETFs?

A: Taxable capital gains are realized when a fund buys and sells securities at a profit, which is then passed on to investors. When an ETF buys and sells (creates and redeems) shares, it is usually done in-kind, which means no cash is involved, as ETF shares are exchanged for an equivalent basket of its underlying securities instead. This helps the ETF to minimize realizing and then passing taxable capital gains on to investors.

Q: Is it a good idea to use ETFs in retirement accounts?

A: Buying and selling ETFs incurs a brokerage fee, along with other potential costs. If an investor makes frequent contributions, brokerage fees can add up and pose a significant drag on long-term performance. Different plan providers will charge participants differently. That said, several brokerage platforms offer commission-free trades for certain families of ETFs, so check with your plan provider.

Holding an exchange-traded fund does not ensure a profitable outcome and all investing involves risk, including the loss of the entire principal. Since each ETF is different, investors should read the prospectus and consider this information carefully before investing. The prospectus can be obtained from your financial professional or the ETF provider and contains complete information, including investment objectives, risks, charges and expenses. ETF risks include, but are not limited to, market risk, market trading risk, liquidity risk, imperfect benchmark correlation, leverage, and any other risk associated with the underlying securities. There is no guarantee that any fund will achieve its investment objective. In addition to ETF expenses, brokerage costs apply. Fees are charged regardless of profitability and may result in depletion of assets.

The market price of ETFs traded on the secondary market is subject to the forces of supply and demand and thus independent of the NAV. This can result in the market price trading at a premium or discount to the NAV which will affect an investor’s value. The market prices of ETF’s can fluctuate as a result of several factors, such as security-specific factors or general investor sentiment. Therefore, investors should be aware of the prospect of market fluctuations and the impact it may have on the market price. ETF trading may be halted due to market conditions, impacting an investor’s ability to sell the ETF. Please consult with a financial or tax professional for advice specific to your situation.

Three Planning Ideas

Examining strategies for avoiding early-retirement penalties, rolling over life insurance proceeds, and more.

By Natalie Choate  9-13-2013

Planners who work with retirement benefits often come up with creative ideas for helping their clients maximize the value of those benefits. Here are three that I recently received. Note that the questions are paraphrased and do not reflect the exact facts presented to me.

Do these ideas work? You be the judge!

Idea No. 1: If an employee who has not yet attained age 55 is fired or quits his job, I know he is not eligible for the "early retirement" exception that shelters some distributions from the 10% tax on pre-age-59 1/2 distributions. To preserve his potential eligibility for that exception, can he start a new business, have the new business adopt a qualified plan, and roll his benefits from the old employer's plan into that new plan, then take the money out penalty-free if he retires after age 55?

Comments: As you know, if an employee terminates his employment at age 55 or later, he can receive distributions from the former employer's qualified retirement plan penalty-free under the "early retirement" exception (one of the 13 exceptions to the 10% penalty on pre-age-59 1/2 distributions). And as you also know, if service is terminated before age 55, he totally loses eligibility for that exception--even if he waits until age 55 to take out the money, the exception won't apply because he "retired" prior to age 55.

As for the planning idea, it basically does work. The former employee can get a new job, roll the old plan money into the qualified retirement plan at his new place of employment, and then retire from the new job after he eventually reaches age 55, accessing his money penalty-free. The problem is, not everyone is capable of starting a new business, incorporating it, and causing the new company to adopt a new qualified retirement plan. The "new job" could not simply be self-employment, because it's not clear how a self-employed person ever meets the definition of "retired"; that's why I'm suggesting he would have to incorporate his new business to use this idea. And obviously if there is no real "business" (i.e., income-generating), this idea is a nonstarter.

Idea No. 2: If a surviving spouse receives life insurance proceeds as part of the death benefit payable to her under her deceased spouse's qualified retirement plan, can she roll that over tax-free into a Roth IRA? What if the beneficiary is a non-spouse designated beneficiary--for example, the decedent's child? Can he or she have the insurance proceeds rolled directly into a Roth IRA? This would seem to be a way to achieve an inherited Roth IRA with little income tax impact if it is allowed.

Comments: As you know, life insurance proceeds paid under a qualified plan to the surviving spouse or other beneficiary of the deceased employee are not totally income tax-free (unlike life insurance proceeds paid outside of a retirement plan, which are totally income tax-exempt under § 103). Proceeds of a plan-owned life insurance policy are tax-free only to the extent of the "pure" death benefit amount. The amount of the cash value of the policy immediately before the employee's death is taxed as ordinary income, just like any other retirement plan distribution. However, even so, rolling over plan-owned life insurance proceeds into an inherited Roth IRA would be a very cheap (though not totally tax-free) way to acquire an inherited Roth IRA.

I am unable to find anything in the Code or IRS Regulations that would prevent or prohibit this type of rollover. Once upon a time, nontaxable plan distributions were not eligible for rollover, but that prohibition was repealed years ago--and the repeal did not contain any exceptions for life insurance proceeds as far as I can see. I'm not saying I want to be the first one to try it, but I'm darned if I can figure out why it wouldn't work.

Idea No. 3: For Medicaid-planning purposes, my client (age 74) wants to invest his entire IRA into a three-year fixed annuity. The client would like to take the payments under the annuity contract, treat part of each payment as his minimum distribution for the year (using the value of the contract as his "account balance" value), and roll the rest of the annuity payment back into another IRA for continued tax deferral. However, you have stated in seminars that all the payments under the annuity contract would be considered "minimum required distributions," not eligible for rollover. Is that in fact your position?

Comments: If all or any part of an IRA account balance is used to purchase a true annuity, two consequences flow: First, all payments under the annuity contract are considered minimum required distributions and thus are not eligible for rollover. Second, if only part of the IRA balance was used to buy the contract, then (beginning the year after the purchase occurs) the non-annuitized portion of the IRA must continue to pay minimum distributions computed in the regular way; the annuity contract value is excluded from the account balance valuation, but the annuity payments don't "count" toward the minimum required distribution for the non-annuitized portion of the account.

The regulations seem to be mainly designed for an individual who is taking an annuity for his lifetime or a joint and survivor life annuity with his beneficiary. However, they also clearly apply to the purchase of a fixed-term annuity, such as the one your client is contemplating. Unfortunately there does not seem to be any exception for the purchase of a short-term annuity. Thus, even though your client could have purchased a much longer-term annuity with much smaller annual payments, if he buys a three-year fixed-term annuity when he is older than age 70 1/2, he is going to be stuck with non-rollable distributions liquidating his entire balance in three years.