IN THIS ISSUE:
Feature Article:
RECENT DEVELOPMENTS: 1996 TAX LEGISLATION
Stretching It Out:
Planning Distributions From Your IRA
he purpose of your IRA is to accumulate funds for your retirement, isn't it? While that may be true, an IRA can also be used as a vehicle to transmit wealth to your heirs. Extending the tax-free growth of an IRA to children and other beneficiaries is becoming increasingly common. But it requires passage through a minefield of arcane tax regulations, and it requires attention to some critical time deadlines.
The Power of Deferral
Actually, IRAs and other qualified retirement plans are not tax-free; they are tax deferred. Income tax is payable when funds are withdrawn, even if that occurs after the death of the account owner. The key to planning in this area is to continue the tax deferral as long as possible, delaying the day when Uncle Sam takes his cut.
Assets grow more quickly when they are not burdened with current income tax. To illustrate, assume an IRA owner has reached age 59 1/2 and is eligible to withdraw the funds from his account without penalty. The red line in the graph below plots the value of the assets, assuming the owner withdraws all of the funds from the IRA in 1996, pays the income tax on the funds withdrawn, and invests the net proceeds in an account subject to current income tax. The blue line shows the result of taking only the minimum required distributions from the IRA, and leaving the rest to accumulate tax-free. After 30 years, even after taking into account the potential income tax on the funds remaining in the IRA, the deferral option produces almost $2 million more than the lump sum distribution. Click on the graph for computation details.
Essential Terms
Before we get into the details of how the "IRA stretchout" technique works, you'll need to be familiar with some technical concepts.
Required Beginning Date (RBD)
The tax law does not permit you to accumulate funds in an IRA indefinitely. You must begin to receive distributions from the IRA when you reach retirement age. For this purpose, retirement age is 70-and-one-half years of age. The law requires you to take your first distribution from the IRA no later than April 1 of the year after you reach age 70 years and 6 months. That date is referred to as the "required beginning date." As we will see, the date is critical because some of the tax aspects of your account are fixed irrevocably as of that date.
Life Expectancy
You don't have to take all of the funds out of your IRA when you reach the required beginning date. You can begin a series of withdrawals based on your life expectancy, or the joint life expectancy of you and your beneficiary if one is designated. The life expectancies are calculated based on actuarial tables published by the IRS. For example, a person age 70 has a statistical life expectancy of 16 years. If he elects a payout based on his single life expectancy, and if he doesn't choose the recalculation option discussed below, he will be required to withdraw his IRA balance over that life expectancy of 16 years. That is, he must withdraw 1/16th of the account in the first year, 1/15th in the second year, and so on. By year 16, the fraction is 1/1, and he is required to withdraw all of the funds left in the account.
Recalculation
Age Recalculated
Life Expectancy70 16.0 75 12.5 80 9.5 85 6.9 90 5.0 95 3.7 100 2.7 105 1.8 110 1.0 The "straight" life expectancy rule summarized above requires you to withdraw all funds from the IRA by the time you reach age 87. Under that rule, those who live to a ripe old age are required to empty their IRA account long before they die. To prevent this, the law permits the owner to use a recalculated life expectancy each year in determining the amount of the required withdrawal. The table at right shows the recalculated life expectancy of persons at various ages. By using a recalculated life expectancy, you can ensure that you will not be required to fully deplete your IRA during your lifetime.On your death, however, your recalculated life expectancy changes to zero. This has important implications, as we'll see later.
RBD: A Critical Deadline
The decisions that you make (or fail to make) when you approach your Required Beginning Date will determine whether income tax deferral on your IRA must end at your death, or can continue for your heirs. That's because the beneficiary designation and recalculation option in effect at that time determines the schedule of required minimum distributions from the account. After the deadline passes, you are permitted to select a new beneficiary for the account, but the change will not extend the period over which the account can be withdrawn.
An Example
Joe is a widower. When he reached his RBD, his estate was named as the beneficiary of his IRA, and he elected to recalculate his life expectancy. Because there is no designated beneficiary, the funds in the IRA must be withdrawn over Joe's life expectancy; no joint life may be used. Worse yet, after Joe's death, his recalculated life expectancy changes to zero. Thus, all funds in the account must be withdrawn before December 31 of the year following his date of death.
Joe learns of these disadvantages and decides to name his children as beneficiaries of the IRA. He can do so, and the account will be paid to them after his death. But, because he is past his RBD, naming the children does not extend the time period within which the account must be paid out. Joe still must withdraw the funds over his life expectancy, and the possibility of further income tax deferral after his death is lost.
The IRA Stretchout: An Illustration
Graphic courtesy of Moneysearch
Mom and Dad have two children, Jack and Jill, born eight years apart. Dad names Mom as the beneficiary of his sizable IRA. At the time of Dad's death, Mom is 68 years old, Jack is 40 and Jill is 32. Mom divides the IRA into two accounts and names one of the children as the beneficiary of each account.
When she reaches age 70, Mom begins to take distributions from each account based on the joint life expectancy of herself and the child who is the beneficiary of the account. This life expectancy is 26.2 years for both accounts. Mom chooses to recalculate her life expectancy.
Why is the life expectancy the same for both accounts, when Jill is eight years younger than Jack? These life expectancies take into account a special rule called the Minimum Distribution Incidental Benefit (MDIB) rule. Simply put, your designated beneficiary (other than your spouse) is considered to be no more than ten years younger than you for purposes of calculating the payout during your lifetime. Thus, the payout for both accounts is based on the joint life expectancy of a 70-year-old and a 60-year-old.
When Mom dies, Jack is 45 years old and Jill is 37. Each child decides to continue taking minimum distributions over his or her life expectancy. But an important change occurs. After Mom's death, the MDIB rule no longer applies. Now, distributions from Jack's account can be based on his true life expectancy of about 38 years. For Jill, the period is even longer: about 45 years. If Jack and Jill adhere to this schedule of distribution, the last dollars will not be subject to income tax until more than 50 years after Dad's death.
What if Mom dies first?
In our example, Mom was named as the primary beneficiary of Dad's IRA. Naming your spouse as beneficiary is often the best choice because a surviving spouse has the most options in dealing with the account. A spouse-beneficiary can make a rollover distribution to his or her own IRA, or can simply elect to treat the inherited IRA as his or her own. These options are not available to any other beneficiary. But naming your spouse as beneficiary limits the ability to stretch out the IRA distributions if the non-owner spouse dies first.
Example
Dad names Mom as the beneficiary of his IRA. He elects to take minimum distributions over their joint life expectancy, without recalculation. Dad reaches his RBD and begins taking distributions, which are calculated based on their joint life expectancy of about 23 years.
Five years later, Mom dies. After her death, Dad can continue taking minimum distributions over the remainder of the 23-year joint life expectancy. He can name the children as beneficiaries of the IRA, but he cannot extend the payout period. When Dad dies, the children can continue to receive distributions over what remains of the 23 years. However, they cannot stretch the withdrawals over their lifetimes.
To ensure that the distributions could be stretched out over the children's lifetimes, even if Mom died first, Dad could have named the children, and not Mom, as beneficiaries. While this strategy permits more income tax deferral, it has disadvantages of its own. The IRA funds would not be available to Mom for her living expenses. And because the estate tax marital deduction is not available, estate tax may be due on Dad's death.
Skipping a Generation
You can achieve even more tax deferral by skipping your children's generation and designating a grandchild or grandchildren as beneficiary of the IRA. In our illustration, if Mom had named a 5-year old grandchild as the beneficiary of the account, distributions during her lifetime would still be based on a 26.2 year life expectancy because of the MDIB rule. However, after her death, the grandchild's withdrawals could be stretched over a life expectancy in excess of 70 years!
Of course, you'll want to consider whether you really want to cut your children out of the IRA proceeds. Another factor to consider is the federal generation-skipping transfer tax, which applies to transfers to grandchildren in excess of $1 million.
Further reading
IRS Publication 590 (Individual Retirement Arrangements) PDF|PCL|Postscript|SGML
"Questions You Didn't Ask [your IRA Sponsor] But Should Have," Forbes Magazine, August 26, 1996
"Final Payments," Forbes Magazine, June 17, 1996
RECENT DEVELOPMENTS
This summer, Congress passed and the President signed three significant pieces of tax legislation: the Taxpayer Bill of Rights 2, the Health Insurance Portability and Accountability Act, and the Small Business Job Protection Act. This issue summarizes selected aspects of these new tax laws.
Private Delivery Service Eligible for "Mailbox Rule"
Taxpayer Bill of Rights 2, P.L. 104-168, Sec. 1210
Under the "mailbox rule," a tax return or other document required to be filed with the IRS is considered timely filed if it is mailed by the due date, even if it is delivered afterwards. As reported in a previous issue of Foresight, this rule applied only to delivery by the U.S. Postal Service, and not by a private company such as Federal Express or UPS.
The new law permits the use of a private delivery service, provided that the service is "at least as timely and reliable on a regular basis as the United States mail," and meets other criteria to be established by the IRS.
This new law applies to filings with the IRS and the Tax Court, but does not apply to charitable contributions of cash or securities, notes attorney Conrad Teitell of Cummings & Lockwood, Stamford, Connecticut. Last-minute gifts at year-end will have to be placed in the U.S. Mail by December 31 to be eligible for a 1996 charitable contribution deduction. Teitell, Philanthropy and Estate Planning, Trusts & Estates, October 1996, p. 62.
Self-Employed Health Insurance Deduction Increased
Health Insurance Portability and Accountability Act, P.L. 104-191, Sec. 311
Self-employed individuals (including partners in a partnership and more-than 2% shareholders of an S corporation) can currently deduct as a business expense only 30% of the premiums they pay for health insurance. The new law gradually increases the percentage deductible, to a maximum of 80% in 2006.
Tax years beginning in % Deductible 1997 40% 1998 through 2002 45% 2003 50% 2004 60% 2005 70% 2006 & after 80%
Accelerated Death Benefits Tax-Free
Health Insurance Portability and Accountability Act, P.L. 104-191, Sec. 331(a)
Accelerated death benefits are life insurance proceeds paid during the lifetime of the insured, typically under a rider providing for early payment to a terminally-ill individual. Under the new law, these payments will be income tax-free, just as life insurance proceeds paid after death are normally tax-free. To be eligible, the payment must be to a "terminally ill" person, meaning one who is certified by a doctor as having a condition reasonably expected to result in death within 24 months.
S Corporation Rules Reformed
Small Business Job Protection Act of 1996, P.L. 104-188, Secs. 1301 et seq.
The new law amends the rules that apply to S corporations in several respects. In general, the new rules make it easier to qualify as and operate an S corporation. Some of the changes:
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The maximum number of shareholders is increased from 35 to 75.
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A new type of trust, the "electing small business trust", may be an S corporation
shareholder. However, these trusts are subject to special rules taxing their
income in the highest bracket.
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An S corporation may own 80% or more of the stock of a regular corporation,
and may own a "qualified subchapter S subsidiary."
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Revocable living trusts and other grantor trusts may own S corporation stock
for two years after the death of the grantor. A trust receiving stock under
a will may retain it for two years. Previously, the time limit was 60 days
for many of these trusts.
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A corporation whose election to be an S corporation was terminated or revoked
before January 1 1997 may reelect S status without IRS consent and without
a waiting period. Under previous rules, a five-year waiting period was
required.
Medical Savings Account Program Established
Health Insurance Portability and Accountability Act, P.L. 104-191, Sec. 301
The Health Care Act establishes a pilot program permitting tax-favored Medical Savings Accounts (MSAs). Employer contributions to to an MSA are deductible by the employer and are not included in the income of the employee. Earnings on MSA assets are not taxable, and distributions from the account for qualifying medical expenses are tax-free, with some exceptions.
Only small employers (those with no more than 50 employees) are eligible to set up an MSA. Because this is a pilot program, no more than 750,000 taxpayers may benefit annually from an MSA contribution. No new contributions will be permitted after December 21, 2000 unless the program is extended by future legislation.
Long-Term Care Expenses Deductible
Health Insurance Portability and Accountability Act, P.L. 104-191, Sec. 322
The new law allows an income tax deduction for:
1) the cost of qualified long-term care services, such as nursing home expenses, and
2) the payment of premiums on eligible long-term care insurance, subject to limitations on the annual premium amount.
These expenses are deductible as medical expenses, which are itemized deductions. Thus, they are subject to the overall "floor" on medical expense deductions (only those in excess of 7.5% of adjusted gross income are deductible) and to the reduction of total itemized deductions for certain high-income taxpayers.
Adoption Expenses Eligible for Credit
Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1807(a)
Beginning in 1997, credit against income tax is allowed for qualified adoption expenses. The actual expenses paid or incurred are credited, subject to a limit of $5,000 per child, or $6,000 for a child with special needs. Unless extended, the $5,000 credit will expire after December 31, 1001, and only the $6,000 credit for special needs children will be allowed thereafter.
New Rules on State Tuition Prepayment Programs
Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1806
Under a typical state-sponsored tuition prepayment program, a parent or other relative deposits money in a state college fund, to be used for the future expenses of the designated beneficiary at that school. Under some plans, the payment is guaranteed to cover the cost of tuition, regardless of future increases. The new law clarifies the tax treatment of these plans in several respects:
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The fund itself is generally exempt from income tax on its earnings.
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Distributions from the fund to pay tuition are included in the student's income to the extent they exceed the contributions made for that student.
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Amounts distributed to a contributor (e.g., a refund) are included in the contributor's income to the extent they exceed the contributions made by that person.
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Contributions to a tuition prepayment plan are not treated as completed gifts for gift tax purposes. When a distribution is made to pay tuition expenses, that transfer is a gift for tax purposes. However, it qualifies for the special gift tax exclusion for educational expense payments.
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If the contributor dies while funds remain on deposit in the plan, the amount attributable to the contributions is included in the gross estate of the contributor for federal estate tax purposes.
Many states have already established tuition prepayment plans. With the rules clarified, it is expected that more states will follow. In New Jersey, recently introduced legislation proposes to establish the New Jersey Prepaid Higher Education Expense Program.
SIMPLE Retirement Plans Created
Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1421The new law establishes a new, simplified retirement plan for small businesses called the Savings Incentive Match Plan for Employees (SIMPLE). Only employers with 100 or fewer employees and with no other qualified retirement plan are eligible to create one of the new plans. Like other qualified retirement plans, contributions (within limits) are deductible to the employer and excluded from the employee's income. The new plans differ from traditional plans in that the nondiscrimination rules usually applicable to retirement plans do not apply, and the annual reporting requirements are less burdensome. The new rules become effective in1997.
For Some, Pension Distributions May be Postponed Until Retirement
Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1404Under current law, distributions from an IRA or qualified retirement plan must begin no later than April 1 of the year after the participant reaches age 70 and one-half years, even if he or she is still working. (See the feature article in this issue). Beginning in 1997, the participant in a qualified plan (but not an IRA) will be permitted to delay the commencement of distributions until actual retirement. However, this new rule does not apply to any participant who owns 5% or more of the company.
Spousal IRAs Expanded
Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1427(a)Beginning in 1997, a deductible IRA contribution of $2,000 may be made by each spouse, for a total of $4,000, even if only one spouse is employed. Under prior law, the deductible total was limited to $2,250. The new rule applies only to couples filing joint returns.
Excess Distributions Tax Suspended
Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1452(b)The 15% excise tax on excess distributions penalizes those who take "too much" out of a qualified retirement plan in one year. The permitted withdrawal amount is adjusted for inflation, and is $155,000 during 1996. Together with the excess accumulations tax that applies at death, this penalty limits the effectiveness of building a large balance in a tax-qualified plan.
The excess distributions tax (but not the excess accumulations tax) will be suspended during 1997, 1998 and 1999. By making large withdrawals within that window, a participant can avoid the application of both taxes. But the benefit of doing so should be weighed against the cost of paying income tax that could otherwise be deferred.
Medicaid-Motivated Transfers Made a Crime
Health Insurance Portability and Accountability Act, P.L. 104-191, Sec. 217That's right -- a crime. Section 217 of the Health Care Act makes one guilty of a crime, punishable by a $10,000 fine and/or a jail term, if he or she
...knowingly and willfully disposes of assets (including by any transfer in trust) in order for an individual to become eligible for medical assistance under a [Medicaid] State plan under title XIX, if disposing of the assets results in the imposition of a period of ineligibility for such assistance under section 1917(c)...
The "period of ineligibility" referred to is the waiting period (sometimes referred to as the "lookback period") during which a person is ineligible for Medicaid after making an asset transfer. It is based on the value of the assets transferred. Under the pre-Health Care Act law, the denial of Medicaid eligibility is the "penalty" for making a transfer by gift. The addition of potential criminal liability adds additional uncertainty to an area where planning is already extremely difficult.
The effective date of the new provision is January 1, 1997.
This issue of Foresight is dedicated to the memory of Theresa Giordano De Maio, who died July 19, 1996. By the grace of God, she lived on this earth for 95 years. She lives on in the hearts of all who knew her.
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