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IRA
The Top 10 Ways to Hand Over Your IRA to the IRS
by Dan Casey (Write for us!)
(Click on the links within the article to get definition of that word)
As the World War II generation begins to die, leaving their IRAs to their heirs, there will be
an epidemic of problems pertaining to withdrawals. The point at which your IRAtransfers from your name to another can be the most critical time in the lifespan of an IRA. The next critical area are required minimum distributions (RMD). RMDs are one of the most complex areas of the entire IRStaxcode. And, since the IRA beneficiaryformoverrules the stipulations of a will, passing assets to your heirs can be hair-raising, if not downright hairy. This bookletaddresses these issues and more.
Trillions of dollars are invested in IRAs, making them one of the largest, if not the largest, asset retirees own. But these accounts, designed to simplify your retirement years, are quite complicated. According to the Wall StreetJournal (February 2002), a whopping 80 percent of your IRA can go to the IRS if it's not properly set up. Ouch!
Would you like to pass your hard-earned dollars to the IRS or to your heirs? If it's the latter, read closely. This page will guide you through the top 10 mistakes that people make when setting up their IRAs, and will help you avoid falling into these common traps.
The IRS may be entitled to some of your IRA money, but you have the power to minimize the amount that ends up in their hands. There's only a one-letter difference between IRA and IRS; make sure you keep them as separate as possible.
Number One - Don't Find Out if Your Custodian Allows 'Stretch' IRAs
The stretch IRA is a powerful technique that can result in your IRA remaining in your family for many years to come*. The idea is upon your death your young beneficiaries will be able to take out smaller withdraws. These withdraws will be based on their long life expectancy allowing your IRA to potentially grow into a fortune if the IRA is set up properly.
If your heirs die or disclaim your IRA, it's no big deal - it can still be passed to younger beneficiaries. However, your beneficiaries and successor beneficiaries need to be properly identified on the beneficiary forms.
It can be extremely upsetting if you take all the necessary steps to stretch your IRA, only to discover that your custodian, the financial institution that handles your account, won't allow it! This happens all too frequently. Not all custodians have changed their plans to incorporate the recent changes in the tax law that permit you to stretch your IRA.
If employing the stretch strategy is important to you, make the necessary calls before transferring or rolling over your IRA to a particular custodian. Make sure they don't thwart your efforts to create this wealth-building strategy.
Number Two - Not Naming Your Spouse As Sole Beneficiary
Your spouse may be your soul mate. They can also be your sole beneficiary. Your spouse has many options available when inheriting your IRA. They can easily roll over the IRA into their own name. (Your spouse is the only entity allowed to do this.) All other beneficiaries must begin withdrawing money from the IRA. If your IRA is set up properly, these withdraws would be over the beneficiaries life expectancy. If not, the IRS could force your heirs to withdraw the entire amount of your IRA on an accelerated schedule.
Once the IRA is in your spouse's name, they can postpone taking the required distributions until reaching age 70 1/2, provided you haven't already begun taking distributions yourself. This can be a great way to pass on your IRA's benefits, and let it continue growing tax deferred until your spouse needs the funds.
This is not allowed if your spouse is not the sole beneficiary. Many people will name children, or other entities, as co-beneficiaries. This can be a huge mistake -- much bigger than forgetting the kids' birthdays when they were growing up. Your spouse can only roll over your IRA into their own name if they are the sole beneficiary.
NOTE: Another pitfall could occur if your spouse needs the money, and decides to roll over the IRA into their own name before reaching age 59 1/2 . In this case, your spouse will incur a 10 percent early withdrawal penalty. There are options that will allow your spouse to have access to the funds and avoid the penalty.
You've spent time and money ensuring that your estate plan is in order and that trusts have been drawn to your specifications. Now you need to integrate your trusts with your potentially largest asset - your IRA. The rules governing IRA distributions are some of the most complex of the entire tax code. Be careful. If you have trusts as beneficiaries, it can further increase the complications. Since a trust is not a living, breathing person, the distributionplanning can be quite different.
The first possible pitfall is integrating it with the stretch strategy. For instance, creating a stretch IRA is dramatically different if a trust is the beneficiary rather than a spouse or other younger heirs. Since the stretch is computed according to the birth date of the beneficiary, the outcome may be different than what you had planned. The stretch will be based
on the birth date of the oldest trustee. Because most people set up a trust with their spouse as the main trustee and their children as secondary trustees, the birth date of the spouse will be used. Unless your spouse is dramatically younger than you are, the stretch aspect could be virtually gone. It could be more effective if you use a child or grandchild's birth date.
In a worst-case scenario, the IRS could decide that your trust doesn't qualify as a 'look-through' or 'see-through' trust. This would not allow your heirs to stretch out their distributions at all. This could happen if the beneficiaries are an entity such as an estate, a charity, or another trust.
A second possible pitfall of naming a trust as a beneficiary of your IRA is that your heirs may have to pay higher taxes than if they inherited the IRA outside of the trust. Trust tax rates are higher than the rates for most individuals. The 35 percent tax rate begins on a trust when income exceeds $9,750, compared to $326,450 for individuals.
As with most estate planning decisions, it ultimately boils down to a decision between control and taxes. For people whose highest priority is financial control, naming the trust as the main beneficiary may be the best option, especially if your heir will be a minor child or a person with a disability, or if you're sheltering assets in a divorce.
Certain procedures can be used to have the best of both worlds. It's possible to create your trust so that your spouse has full control of the IRA upon your death, and can initiate changes to the IRA so that the stretch can be set up to achieve its fullest potential. The trust can also kick in if something happens to both of you.
If you have a trust and you want to create a stretch IRA, it's important to explore your options.
Number Four - Procrastination
Changes to your beneficiary forms should be made as soon as possible. If you have multiple beneficiaries and the stretch is important to you, this section is of utmost importance. This situation may arise when you have more than one child, and each is listed as a beneficiary. The problem may occur when you die, as the required minimum distributions will be based on the oldest living beneficiary. In this scenario, the stretch IRA may not be able to work to its fullest potential.
There are two ways to avoid this pitfall.
Thanks to the recent tax law changes, your beneficiaries can split the account, so each person receives an equal share. The required minimum distribution can then be based on each person's own life expectancy. Your beneficiaries have until September 30th of the year following the year of your death to facilitate this change. The potential drawback with this option is that it relies on your beneficiaries to get this done before the deadline. If they or the financial advisors they work with aren't current with the law - your wishes may be sidetracked.
Another option -- and perhaps the best -- is to split the IRA while you're still alive, and allow each IRA to have its own beneficiary. This will result in each beneficiary receiving exactly what you intended, and the required distribution amount will be based on that individual's life expectancy. This option would allow for different investmentstyles that are age appropriate for each individual beneficiary. For example, the youngest beneficiary may be able to take on greater risk, while the oldest one may opt for a more conservativeasset allocation. Once you decide how to handle these situations, act quickly and efficiently.
Number Five - Not Converting to a ROTH
It's hard to argue that ROTH IRAs aren't a great idea for the young. The funds grow tax-deferred and can be withdrawn income tax-free. If you believe your children would benefit from the tax deferred and income tax-free withdrawals, consider converting your traditional IRA to a ROTH. If you don't, the chance will be lost forever once you die. Your children can't convert your IRA to a ROTH once it's inherited. It must remain as an IRA, and they'll pay taxes on all the gains in the account. Let's review some highlights on why you may want to convert to a ROTH IRA now, and bequeath an even better inheritance to your children or grandchildren. No Required Minimum Distributions (RMDs): If you want to avoid the confusing tax code behind RMDs, or if you don't plan to withdraw money from your traditional IRA for personal use during your lifetime, a ROTH conversion may be for you. ROTH IRAs have no RMDs - you're never required to withdraw any money at all. You can let it grow tax deferred, and pass it on to your heirs, who can enjoy income tax-free withdrawals.
NOTE: While it's true that there are no RMDs for your ROTH IRA, the rules change for the various entities that could potentially inherit your IRA.
Tax Savings: All gains inside your traditional IRA are taxed as regular income. If you deducted any contributions to your traditional IRA, or the contributions were from a company plan, your gains and contributions will be taxed as regular income. Once converted to a ROTH IRA, however, the tax clock stops! Your gains from that point on will grow tax deferred and income taxfree. NOTE: Because money withdrawn from a ROTH IRA is income tax free, it's not considered income when computing Social Security tax. Withdrawals from traditional IRAs are considered income, and could potentially cause you to pay tax on your Social Security income, or increase the tax you already pay.
The decision on whether or not to convert your traditional IRA to a ROTH IRA is dependent on many different factors. If the two items mentioned on the previous page that make ROTH IRAs so popular are of concern to you then you owe it
to yourself to crunch the numbers.
Number Six - Missing A One-Time Opportunity
If you own highly appreciated company stock in your 401k or other company plan, this little-known tax break could be for you. It's called netunrealizedappreciation (NUA) and can allow you to pull out all, or some, of your company stock when you rollover your plan into an IRA. (Company stock is defined as stock in the company that you work for.)
Here's how it works: You put your company stock into a taxable account (non-IRA), and put the rest of your 401(k) assets into an IRA. You'd then pay tax on the stock based on the original cost. The difference -- or the NUA -- wouldn't be paid until you sell the shares. If the cost of the stock in your plan was $10, and now it's worth $50, your stock has appreciated by $40. This $40 is the NUA.
The great thing about NUA is that it's taxed at the lowlong-termcapital gainsrate of 15 percent. If you rolled it over into an IRA with the rest of the assets and then withdrew those funds, it would be taxed as ordinary income.
NOTE: NUA can have an enormous impact on what's left to your heirs; but the parties involved must have a very clear understanding of the process. Taking advantage of NUA can affect the stepped-up value of the stock. The withdrawal of company stock and rollover must be done in the same calendar year, and the entire plan must be included in this technique, not just the company stock.
Number Seven - Neglecting Special Tax Breaks for People Born Before 1936
If you feel that taking a lump sum distribution from your company plan is in your best interest, you may be able to use 10-year averaging for the tax bill. This method would be used to lower your liability if you need to withdraw your plan balance for living expenses, medical bills, or other pressing financial needs. You may also do this if your balance is so small that the tax bite wouldn't be huge.
To qualify for 10-year averaging:
You must be born before 1936.
The distribution must be from a qualified plan, such as a 401(k).
The distribution of your entire plan balance, excluding your voluntaryemployee contributions, must be made in one tax year.
You must have participated in the plan for at least five years before the year of the distribution.
You cannot have used 10-year averaging for any previous distribution after 1986.
If you're a beneficiary, the person from whom you inherited the account must have been born before 1936. NOTE: If you have a large plan balance and don't need all your money now, you're probably better off rolling it over into an IRA and withdrawing only what you require, because 10-year averaging demands that you withdraw your entire plan balance at once.
Number Eight - Allowing Double Taxation
If you inherit an IRA where federalestate tax has been paid, you're entitled to a tax break called the Income in Respect of a Decedent (IRD). In the past, the IRS charged a tax on your inheritance claiming that it was income that the decedent earned, but had yet to pay tax on. Therefore, when the beneficiary inherited and collected the income, he or she would owe the income tax.
However, the IRS realized that the IRD caused double taxation (estate and income tax), and they created the IRD deduction. Very few beneficiaries know this.
To determine if you qualify for this deduction please contact a financial advisor with your 1099-R and the decendent's estate tax return (Form 706).
NOTE: This deduction is only applicable to federal estate tax. Currently, there's no deduction for state estate taxes.
Number Nine - Allowing Beneficiaries to Roll Over Inherited IRA to Their Own Name
Non-spouse beneficiaries, usually children or grandchildren, must be aware of this pitfall when they inherit your IRA. Spouses are allowed to roll an inherited IRA into their own names. All other beneficiaries are not. I see this mistake far more than I should. I have even seen estate planning attorneys and CPAs advise their clients that this is allowed. They should know better.
If a non-spouse beneficiary rolls over the inherited IRA into his own name, the IRS considers the IRA null and void, with all taxes becoming due. Your IRA that you've worked so hard to build and maintain is gone forever.
Your non-spouse beneficiary must remain as the beneficiary. But there are things that they must do in order to inform the IRS that the original IRA owner (you) is deceased. This requires a re-titling of the IRA and it needs to be done right. The proper wording of the inherited IRA is important, as it lets the IRS know who is involved and whose social security number to use for future tax filings. After a briefconsultation, the proper wording can be determined.
Two of the more important items to pay attention to for non-spouse beneficiaries are:
If the beneficiary is older than you, they may use your birth date to calculate required minimum distributions. This
would result in smaller distributions and help the IRA last longer.
The table for calculating your beneficiaries' required minimum distributions. Beneficiaries who are spouses are able to update the life expectancy every year when figuring required minimum distributions. This is called 'recalculating.' Non-spouse beneficiaries are not permitted to do this. They must use the table for the first year, and subtract one year for each of the following years. These items and more are why it's important to have a financial advisor to assist you. Wouldn't it be nice knowing that if you pass away your spouse has someone he or she can trust to do the right thing with your IRAs. And also to be there if children are involved that aren't sure of the proper procedure when handling inherited IRAs.
Number Ten - Forgetting to Take Your Money
You probably know that the IRS requires you to withdraw money from your traditional IRA when you reach age 70 1/2 . This is in accordance with a schedule based on your life expectancy. But here's something you probably don't know. If you neglect to withdraw the appropriate amount of money by the required date, you may be charged a 50 percent penalty on the amount that you didn't take but should have! (Since 2004, the institutions that hold your IRA funds are required to remind you to take this mandatory distribution. They're also required to rat you out if you don't.)
The date that this required withdrawal must begin is aptly called your required beginning date (RBD). The deadline is April 1st of the year following the year you turn 70 1/2 . Here's how it works: If you turn 70 in November of 2005, you won't be 70 1/2 until 2006. Your RBD won't be until April 1st of 2007. Every year thereafter, including that year, the deadline is December 31st.
NOTE: Beware of taxes! If you take advantage of the first grace period, you'll have two withdrawals in the same year, the year following the one in which you turn 70 1/2 . This may result in your paying more taxes than if you took the withdrawals in separate years. Therefore, you may NOT want to take advantage of this grace period, and take your first withdrawal in the year you turn 70 1/2 .
As always, when dealing with the IRS, there are exceptions. You can delay taking money out of your retirement plan in the following cases:
If you're still working - You can delay your RBD until April 1st of the year following the year you retire. This only applies to the monies in your company plan.
NOTE: This is not applicable if you own more than 5 percent of the company.
Old and new money in a 403(b) - Any money you've put into a 403(b) plan before 1987 doesn't need to be withdrawn until you reach age 75. Money deposited after 1987 must use the normal RBD and required minimum distribution rules.
NOTE: If the plan has not tracked when the money was deposited, or the plan was rolled into an IRA, then this age 75 exception is lost. So if you've been able to figure out when you must begin taking distributions your next step is to figure out how much. This amount is called your required minimum distribution (RMD) and I could write another booklet for this subject alone. It may sound simple but several IRAs, both ROTH and traditional and a few inherited in your portfolio can make for some sleepless nights. Your nights will either be spent tossing and turning or researching how to properly take out the right RMD.
This is where having help from an experienced financial professional can help. In general terms, you must divide your life expectancy into your IRA balance (as of December 31st of the year prior). This life expectancy figure is given to you by the IRS in various tables. The tricky part is figuring which table to use and how often to update the figure given.
For instance, each of these scenarios has their own RMD and/or frequency of updating your life expectancy:
Your spouse is ten years your junior.
If you inherited an IRA from your spouse
If you inherited an IRA from a non-spouse
If you inherited an IRA through a trust where RMDs were not yet taken
If you inherited an IRA through a trust where RMDs were being taken Does all this seem confusing? It should be, the laws governing IRAs are very complicated. The point of this material is to help you keep as much of your hard-earned retirement money in your pocket as possible. In order to accomplish this mission, it's important to have help commandeering your financial spaceship.
When will you need to begin withdrawing your funds?
Which tax bracket will you be in upon retirement?
What is the status of your health, and do you need to budget for special needs?
How much money will you need to support the lifestyle to which you've become accustomed?
How does the IRA fit in with your overall estate plan?
Do you plan to continue working?
Is it advantageous to use Rule 72(t) to withdraw IRA funds before age 59 1/2 without the 10 percent early withdrawal penalty?
Do you know ROTH conversions techniques? When you should and shouldn't convert and how to spread the conversion tax over several years?
The bottom line is that IRAs are confusing. In order to make sense of them, you can either spend hours researching them, or consult with a financial professional like myself who already has the knowledge and specialized training to help you make the most of your retirement funds.
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