Florida Bar Journal

IRA Accounts and Possible Stretch Reduction

The current technical federal income tax Individual retirement account (IRA) rules concerning required minimum distribution and post-death payout options are confusing to most attorneys and clients. Despite the complex RMD rules, IRAs are tremendously popular and are frequently one of the primary assets available in retirement and at death. If managed properly, IRAs afford individuals and their family members a powerful wealth accumulation tool; if not managed properly, adverse income tax results and substantial penalties may ensue. Therefore, it is critical to understand the applicable requirements.

In an attempt to update some of these laws and raise revenue, on May 23, 2019, the U.S. House of Representatives passed a bill simplifying the post-death RMD rules and allow, under certain circumstances, such accounts a little more time to grow tax-deferred. The Senate is now considering a similar bill.

This article discusses IRAs in two parts. Part I discusses the basic rules relating to IRAs and Part II briefly considers the proposed changes to the current laws.

IRAs Generally

To encourage retirement savings, Congress created §408(a) of the Internal Revenue Code in 1974 to permit individuals to save for retirement through the use of IRAs without incurring immediate income taxes on the original contributions and subsequent investment gains (traditional IRAs). Specifically, taxpayers are allowed a deduction for amounts contributed to traditional IRAs, but only until age 70½. Generally, contributions to IRAs must be in cash unless they involve certain transfers known as “rollovers” of property from one IRA to another IRA.

Currently, individuals must be at least age 59½ to withdraw funds from a traditional IRA without incurring early withdrawal penalties.^[1] Taxpayers who take out distributions from traditional IRAs prior to age 59½ are required to pay a penalty of 10% on the amount withdrawn in addition to the applicable income tax. There are several exceptions to this rule, however, under certain circumstances, such as incurring large medical bills, disability, a first-time home purchase, and expenses for higher education.^[2]

Notably, not everyone can take advantage of traditional IRAs. Congress restricted their use by phasing out the applicable deduction in some cases. In addition to income limitations, there are contribution limits applicable to traditional IRAs. Qualifying taxpayers permitted to make maximum contributions to traditional IRAs can contribute up to the lesser of 100% of earned income or $6,000 in 2019 ($7,000 for those age 50 and older).^[3]

The primary benefit of traditional IRAs is the ability to defer income tax on contributions to and accumulate and invest funds within IRAs without being subjected to current income taxation of any income or capital gains when assets within the account are sold. The tax deferral benefit is actually two-fold because the retirement account owner is not merely accumulating and investing his or her own money on a tax-deferred basis, but he or she is also investing and achieving gains on the money, which would have been paid to the Internal Revenue Service (IRS) for income taxes each year. The income tax deferral afforded to traditional IRAs is currently a tremendous boon to most taxpayers who subsequently receive retirement distributions at a time when perhaps they are in a lower tax bracket than they were at the time the contributions were made to their IRAs. Of course, this benefit could change if the income tax rates increase in the future.

Current Minimum Distribution Rules

Unfortunately, assets cannot be held indefinitely in tax-advantaged IRAs. The RMD rules were devised to support the policy of providing retirement funds by mandatory distributions at a “required beginning date,” i.e., age 70½, and preventing IRA owners from completely deferring retirement benefits and transferring wealth to subsequent generations. The RMD rules are located in §401(a)(9) of the code, which describes when mandatory distributions from IRAs must begin and how much must be distributed each year.^[4]

Traditional IRA distributions generally constitute ordinary income to the recipient.^[5] To the extent such interests are not fully distributed, account balances left at account owners’ deaths are includible in his or her gross estate under §2039 of the code.^[6]

Taxpayers who do not take the prescribed RMD by the applicable IRS deadline may be liable for a 50% penalty on the difference between the actual amount taken, if any, and the mandatory RMD. It is, therefore, critical for attorneys, financial advisors, and taxpayers to clearly comprehend the RMD requirements.

There are two sets of RMD rules: One set is applicable during an IRA owner’s life (§401(a)(9)(A) of the code), and one set is applicable after the death of the IRA owner (§401(a)(9)(B) of the code). Individuals may always take out more than the mandatory RMD amount; however, any excess that is taken out does not count toward the RMD amount for future years (i.e., there is no carryover).

While IRA owners may begin receiving distributions from their traditional IRA accounts penalty free upon attaining age 59½, they are not required to take mandatory distributions in required minimum amounts at that time. Permitted distributions made before the IRA owner’s required beginning date (e.g., after age 59½) do not have to be made in accordance with the RMD formulaic rules, but once the required beginning date is reached, the RMD rules take effect, regardless if the IRA owner took previous distributions.

Under §401(a)(9)(C) of the code, the latest date at which retirement account owner is permitted to begin taking distributions from a retirement account, known as the required beginning date (RBD), is April 1 of the calendar year following the year in which he or she reaches age 70½. Individuals with birthdates from January 1 through June 30 will reach age 70½ in the year of their 70th birthday; and those with birthdates from July 1 through December 31 will reach age 70½ the following year. The RMD liability essentially starts in the year the individual attains age 70½ (the “first distribution calendar year” or “RMD Year 1”) even though the required beginning date is April 1 of the following year. As an example, if Larry Lane’s 70th birthday was on January 1, 2019, he attained age 70½ on July 1, 2019, his RMD Year 1 is 2019 and his required beginning date is April 1, 2020.

Although the first RMD payment may be deferred until April 1 of the year after RMD Year 1, all subsequent payments must be made by December 31 of the applicable distribution calendar year (RMD year) to avoid the 50% excise tax penalty.^[7] If the IRA owner delays receipt of the first RMD until April 1, he or she will receive the first two RMD payments in the same year (RMD Year 2). For example, if Larry Lane delayed taking his first (2019) RMD until April 1, 2020, his second RMD must still be made by December 31, 2020.

To determine the actual amount required to be taken from a traditional IRA during the lifetime of the account owner in any calendar year, the account balance of the IRA as of the close of business on December 31 of the preceding year is divided by the applicable distribution period or life expectancy (the maximum number of years over which individuals are permitted to take distributions) located on the life expectancy tables within Treasury Regulations §1.401(a)(9)-9.^[8] For example, if Larry Lane reached age 70½ on January 30, 2019, his RMD Year 1 is 2019, his required beginning date is April 1, 2020, and his applicable “account balance” for purposes of determining Year 1 RMD is his IRA’s fair market value on December 31, 2018. Using the uniform life table within the regulations, the distribution period correlating to Larry’s age is 26.5 years. If Larry’s account balance on December 31, 2018, was $100,000, his RMD for 2019 is $3,773.58 ($100,000/26.5 = $3,773.58).

The good news is that individuals do not have to prepare these RMD calculations on their own; IRA custodians or issuers are required to report the RMD to IRA beneficiaries for each calendar year. For taxpayers maintaining more than one traditional IRA, the RMD must be calculated separately for each account, but individuals have the flexibility and ability to take their combined total RMD amount from either a single traditional IRA account or a combination of Traditional IRA accounts.^[9] Generally, only amounts in traditional IRAs that an individual actually owns may be aggregated.^[10] Distributions from Roth IRA accounts will not satisfy the distribution requirements for traditional IRAs and vice versa.^[11] In addition, while taxpayers have the flexibility to take the total RMD amount from either a single IRA or a combination of IRAs they own, RMDs from inherited IRAs must be calculated separately, and can only be taken from these respective accounts.

Roth IRAs

Roth IRAs were established by the Taxpayer Relief Act of 1997, which added §408A of the code. Like traditional IRAs, annual contributions to Roth IRAs can be made until the income tax filing deadline of the following year (typically April 15). Unlike the rules applicable to traditional IRAs permitting funding with pre-tax dollars, Roth IRAs allow individuals to use income that was already taxed to fund these nontraditional IRAs and subsequently withdraw amounts free of income tax. Because the distributions from Roth IRAs are not taxable, there generally is no penalty for early withdrawals (excluding earnings) and no requirement forcing lifetime distributions starting at age 70½. Gains withdrawn before age 59½ are subject to a 10% penalty plus income taxation as are certain pre-59½ distributions of converted funds. Assets in a Roth IRA may be withdrawn after age 59½ tax-free if any Roth account was opened more than five years earlier. In addition, unlike traditional IRAs, which cap the ability to contribute at age 70½, there are no age-based restrictions on contributions to a Roth IRA. Thus, Roth IRAs allow far greater flexibility and control for taxpayers prior to or during their retirement.

The criteria for taking advantage of the Roth IRA’s benefits and limits on contribution amounts are different from those applicable to traditional IRAs, although the maximum contribution amounts are the same ($6,000 or $7,000 for those 50 and over). While distributions from Roth IRAs are not subject to lifetime RMDs, the post-death RMD rules that apply to traditional IRAs also generally apply to Roth IRAs.^[12]

Individuals can convert traditional IRAs to Roth accounts, which can subsequently be withdrawn without being subject to the withdrawal penalties or income tax under certain circumstances. Upon the conversion to a Roth account, the account owner must pay income taxes on the amount transferred. Prior to 2010, the code only permitted conversions to Roth IRAs where annual income did not exceed $100,000, but this income limit was repealed.

In addition, using a conversion to a Roth account, there is a work-around for taxpayers who earn too much to open a Roth IRA. Individuals who earn over the existing income limits may nevertheless be able to obtain a Roth account by first opening a traditional, nondeductible IRA and converting it to a Roth IRA since income restrictions for Roth IRA conversions no longer exist.

Transfer of IRA Accounts Upon Death of Owner

Upon the death of an account owner, the code does not force liquidation of IRAs but instead allows such accounts to remain for the benefit of others so long as the account is transferred to a permitted “designated beneficiary,” which includes natural persons but excludes estates^[13] and trusts.^[14] If the designated beneficiary is not a natural person, the IRA account will be treated as having no designated beneficiary.^[15] The RMD rules applicable after the death of the IRA account owner are located within §401(a)(9)(B) of the code and generally apply to both traditional and Roth IRAs.^[16]

• IRA Owner Dies Before the Required Beginning Date — If an IRA owner dies before the required beginning date (April 1 of the year after attaining 70½) and has not designated a beneficiary, the general rule is that an IRA owner’s entire interest must be completely distributed by the end of the fifth year after his or her death.^[17] This is commonly known as the “five-year rule.” For example, if Larry Lane died at age 70 on January 1, 2019, his IRA account must be distributed by December 31, 2024. There are many exceptions to the five-year rule, however, as discussed below.

• Designated Beneficiary — The Pension Protection Act of 2006 added §402(c)(11) to the code, which created the opportunity for individuals who inherit a traditional IRA from anyone other than a deceased spouse to effectively roll over post-2006 distributions from a deceased’s IRA owner’s retirement account into an IRA that is 1) established for the sole purpose of receiving the distributions from the decedent’s IRA; and 2) established in the deceased account owner’s name for the benefit of the designated beneficiary (inherited IRA).^[18] Such a rollover is allowed so long as the rollover distribution is made directly from the original IRA administrator to the administrator/custodian of the inherited IRA (i.e., in a plan-to-plan transfer).^[19] Such transfers from one IRA to another IRA are not considered distributions and the amount transferred will not be included in the beneficiary’s gross income in the year of the rollover.

The beneficiary of an inherited IRA cannot treat the inherited IRA as his or her own and, therefore, cannot make any contributions to the IRA and cannot generally roll over any other amounts into or out of the inherited IRA. However, the beneficiary of an inherited IRA may 1) choose to take the full value of the inherited IRA as a lump sum; or 2) stretch the RMDs over his or her life expectancy (“life expectancy payouts” or “stretch”) so long as the rollover is completed before December 31 of the year following the year in which the original IRA owner died.^[20] Notably, using the stretch, younger beneficiaries who take no more than the RMD each year from an inherited IRA have the opportunity to see the retirement account increase tremendously over their lifetimes.

Where a deceased IRA owner has designated multiple beneficiaries on a single account, the distribution period is determined by reference to the life expectancy of the oldest designated beneficiary.^[21] However, a separate account exception permits the creation of individual accounts for each designated beneficiary using each beneficiary’s life expectancy to determine the distribution period of each individual’s share.^[22]

• Surviving Spouse — If the designated beneficiary is the account owner’s surviving spouse, the spouse may either roll the IRA assets into his or her existing IRA account or transfer the IRA into an inherited IRA account. Further flexibility is provided to spouses because a surviving spouse is permitted to delay the commencement of the distributions from the deceased spouse’s IRA until December 31 of the calendar year in which the deceased IRA owner would have attained age 70½.^[23]

Surviving spouses may also elect to treat their deceased spouse’s entire IRA interest as their own IRA.^[24] To make this election, however, the surviving spouse must: 1) be the sole beneficiary of the IRA; and 2) have an unlimited right to withdraw amounts from the IRA. If, on the other hand, a trust is named beneficiary of the IRA, this election is not available even if the spouse is the sole beneficiary of the trust.

When a surviving spouse makes the election to treat a deceased spouse’s IRA account as his or her own, the RMD for the year of the election and each subsequent year is determined under §401(a)(9)(A) of the code (i.e., the lifetime RMD rules) with the spouse as the IRA owner. If the surviving spouse’s election is made in the calendar year of the deceased spouse/IRA account owner’s death, the surviving spouse is not required to take an RMD as IRA owner for that particular calendar year. Instead, the surviving spouse is required to take the deceased IRA owner’s RMD to the extent such a distribution was required but was not made before death.^[25]

The result of the spousal election is that the surviving spouse will then be considered the IRA owner for all purposes under the code and will no longer be subject to any of the spouse’s post-death RMD rules but will instead become subject to the RMD rules that apply to IRA owners upon reaching age 70½.^[26]

• IRA Owner Dies On or After the Required Beginning Date — If an IRA owner who has not designated a beneficiary dies on or after the required beginning date, the distribution mode in effect at the owner’s death may continue (but no further deferral is allowed). The RMD for the year of death is determined as though the owner lived throughout the year and the applicable distribution periods for each subsequent year are the owner’s remaining life expectancy as of his or her birthday during the year of death, subtracting one each subsequent year (i.e., it is not recalculated annually).^[27] If the account owner has a designated beneficiary, the remaining IRA interest must be distributed to the beneficiary over the longer of the remaining life expectancy of the beneficiary or of the IRA owner.^[28]

When the surviving spouse is the sole designated beneficiary, the distribution period is calculated using the spouse’s age in each subsequent distribution year (i.e., it is recalculated annually). The surviving spouse may also use the decedent’s life expectancy as of the deceased spouse’s age at the end of the year of his or her date of death (without annual recalculation), if longer, unless the surviving spouse elects to roll over or treat the deceased spouse’s IRA as his or her own.^[29]

Upon the death of the designated beneficiary, any remaining IRA balance must continue to be distributed at least as rapidly as under the current mode of distribution in effect, subtracting one from the beneficiary’s age in the year of his or her death each subsequent year.

Trust as Beneficiary

While a trust itself cannot be a permitted designated beneficiary because it is not a natural person, trust beneficiaries may qualify as designated beneficiaries if the trust meets the following rules: 1) The trust must be valid under state law; 2) the trust must be irrevocable or become irrevocable upon the death of the IRA owner; 3) the trust must have identifiable beneficiaries (which essentially means that on the date of the IRA owner’s death, it will be possible to determine the identity of the oldest individual who could receive IRA proceeds); and 4) a copy of the trust instrument or a trust certification must be provided to the financial institution administering the IRA by October 31 of the year following the death of the account owner.^[30] All relevant beneficiaries must be individuals, and the life expectancy of the oldest beneficiary will be the measuring life for purposes of computing the RMD.

Many advisors and clients like to consolidate assets and consequently designate a trust as the beneficiary of an individual’s assets, including IRAs. Even though permitted, it may not be best to name a trust as the beneficiary of an IRA because of some important disadvantages of doing so, which include the paucity of legal authority concerning such transactions, the potentially adverse results if the trust is not drafted properly (e.g., losing the ability to use the stretch), the likelihood of higher taxes when naming a trust as IRA beneficiary because of the compressed tax rates imposed upon trusts, and the additional fees involved in naming a trust beneficiary of an IRA, such as legal fees, trustee fees, and accounting fees.

Proposed Change in the Law

For many years, varying proposals to alter the laws pertaining to retirement benefits have garnered increased support. Notably, on May 23, 2019, the U.S. House of Representatives overwhelmingly (417-3) passed the Setting Every Community Up for Retirement Enhancement Act (SECURE), which included some of the biggest changes in retirement benefit laws in over a decade.

With regard to IRAs, key provisions within the SECURE Act: 1) remove the current cap of age 70½ for contributions to traditional IRAs; 2) delay the required beginning date for RMDs from age 70½ to 72 years of age; 3) allow additional exceptions for costs of up to $5,000 from the 10% excise tax on early IRA withdrawals if they relate to birth or adoption; and, perhaps most critically, 4) severely limit the available stretch period available to nonspousal beneficiaries inheriting IRAs to a period of 10 years unless the beneficiary is an “eligible designated beneficiary.” Eligible designated beneficiaries include 1) spouses; 2) minor children of the IRA owner; 3) disabled or chronically ill individuals; and 4) persons less than 10 years younger than the IRA owner. Those beneficiaries not qualifying as eligible designated beneficiaries (including trusts) will have to withdraw 100% of the IRA by the 10th anniversary of the deceased IRA owner’s death if SECURE is enacted.

When the SECURE Act passed, it proceeded to the Senate with the hope that it would be approved in its current form by unanimous consent since it had bipartisan support. However, objections of a few senators relating to nonretirement considerations stalled its passage. The Senate is currently considering a similar bill known as the Retired Enhancement Savings Act (RESA), which would reduce the stretch to five years for account balances over $400,000.

As of this writing, it is not clear what type of IRA-related reform will emerge. While it is not typically useful to delve into the minutia of proposed legislation that may never be enacted or may be enacted in a form varied from the proposed law’s original form, in light of the fact that lawmakers have been attempting removal of the existing IRA stretch provisions since approximately 2012, it is wise for advisors to at least be cognizant of such proposals and consider how such legislation might affect clients’ past and future planning.

This column is submitted on behalf of the Tax Law Section, Janette M. McCurley, chair, and Taso Milonas, Charlotte A. Erdmann, and Jeanette E. Moffa, editors.