A. Designating A Beneficiary

Choosing the best beneficiary(ies) to an IRA is one of the most important planning techniques available to the IRA owner because determining who will be the designated beneficiary will have a dramatic effect on the wealth passed on to the IRA owner's heirs.

Some key planning issues to note include:

1. Income tax deferral methods permitted under the "life expectancy of the beneficiary" (or stretch) payout method are available only to designated beneficiaries; the payout options for non-designated beneficiaries are less favorable than the "life expectancy of the beneficiary" method.  That is why commentators frequently emphasize that if an IRA owner does nothing else, they should designate a beneficiary. 

2. One beneficiary designation that will result in favorable income tax deferrals is designating the owner’s grandchildren as beneficiaries. This option can provide dramatically more wealth to beneficiaries if neither the deceased IRA owner’s spouse nor children need IRA funds.

Under this option, the required minimum IRA withdrawals will be spread out over the life expectancy of the oldest grandchild, or, with planning, for each grandchild.  Presumably grandchildren are many years younger than the owner’s spouse or children.  Required minimum withdrawals will therefore be smaller and stretched out over a greater number of years. The result is a dramatically larger IRA that will grow at a tax-free rate over a period of decades.

3. Each of several beneficiaries can use their own life expectancy as the applicable distribution period, if separate accounts are properly established. Upon the owner’s death, separate accounts consist of allocating the owner's account into separate interests, one for each beneficiary, in accordance with the plan or the Designation of Beneficiary forms. Reg. 1.401(a)(9)-8, A-3 .

Separate accounts in a deceased owner’s IRA are permitted if the owner’s Designation of Beneficiary form provides for multiple beneficiaries.

Unlike the September 30th deadline for a beneficiary to be removed by cashing out, or by disclaimer, separate accounts must be established by December 31st of the year following the year of the IRA owner’s death to qualify for payments over the beneficiary’s life expectancy (the applicable distribution period “ADP”).

4. A surviving spouse who is the sole beneficiary of an IRA can defer required minimum distributions from the IRA until reaching April 1st of the year after age 70 ½ while non spouse beneficiaries must start taking required minimum distributions by the end of the year after the year of the owner’s death. 

Also, a surviving spouse who is the sole beneficiary of an IRA can take required minimum distributions by using the Uniform Life Expectancy Table.  It has a longer life expectancy than the Single Life Expectancy Table.  Beneficiaries that are not spouses must take required minimum distributions by using the Single Life Expectancy Table (their fixed term single life expectancy).

Further, a surviving spouse may rollover a qualified plan distribution under the same terms and conditions that would be applied to the deceased spouse. I.R.C. § 402(c)(9).

The Pension Protection Act of 2006 provides that a beneficiary who is not a spouse may also rollover a qualified plan distribution. There are however, a number of differences in the law concerning beneficiaries who are spouses and beneficiaries who are not spouses.

5. A disclaimer can be very useful in post mortem planning. Changing the beneficiary after the IRA owner dies utilizes income and estate tax benefits in ways the decedent may not have anticipated.

6. A trust's beneficiaries may qualify as designated beneficiaries if the trust complies with various rules. It is an exception to the rule that IRA benefits can be paid out over an individual’s life expectancy only if the individual has been designated as a beneficiary. The trust can be looked through and its individual beneficiaries can be treated as “designated beneficiaries” as if the owner named them directly. 

Using an IRA trust for younger beneficiaries assures that younger beneficiaries who have longer life expectancies (and therefore, smaller required minimum distributions) can take advantage of the longer life expectancy (stretch) option available to them. 

7. It is also important to note leaving the IRA to a younger generation may incur generation skipping transfer tax (GST) if the IRA exceeds the generation skipping tax exemption.

GST can be avoided by designating children or the surviving spouse as beneficiary(s) to the extent the IRA exceed the GST exemption.  The children are not a skip generation and they will inherit the excess over the GST exemption.  However, if the surviving spouse inherits the excess, she can designate grandchildren as beneficiaries (including possibly great-grandchildren) and to the extent the IRA exceeds the GST exemption, she can leave the excess to her children and avoid GST because they are not a skip generation.  This techniques avoids GST for the GST exemption of the IRA owner, and also for the surviving spouse, but postpones a portion of the inherited IRA until the spouse’s subsequent death.

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B. Contributions, Transfers and Rollovers to IRAs

Individuals who are under age 70 ½ during the tax year and receive compensation, including alimony, may make contributions to traditional individual retirement accounts (IRAs). I.R.C. § 219(f).  Amounts earned in IRAs are not taxed until distributions are made.  I.R.C. § 408(e)(1). 

Additional key issues to note include:

1. Because the amounts earned in IRAs are not taxed until distributions are made, IRA owners’ should determine when and how to structure such distributions to take advantage of the tax advantages available to them.  For example, taking extra IRA distributions when the owner’s tax rate is lower due to a change in the tax laws or as a result in a change in their financial circumstances that year, may be a good time to take extra IRA distributions. 

Although, if the owner is under 59 ½ the effect of the 10 percent penalty must be factored into any tax savings derived from the distribution unless one of the exceptions to the 10 percent penalty is available to the IRA owner.

2. The general contributions rule for traditional IRAs is the lesser of: (1) the deductible amount for that year or (2) the individual’s compensation includible in gross income for the year. This rule applies to single individuals, head of household or a married person filing separately from their spouse. I.R.C. § 219(b)(1).

3. For tax years 2005 through 2007, the maximum combined contribution to a traditional IRA and Roth IRA was $4,000, and $5,000 in 2008. I.R.C. § 219(b)(5)(A).  Individuals over 70 ½ cannot make contributions to traditional IRAs.  Individuals have until the due date of their tax returns (not including extensions thereof) to make contributions to their IRAs. 

Individuals who will be 50 years old by the end of the tax year are allowed to make an additional contribution, a catch-up contribution, to a traditional IRA or a Roth IRA. For tax years beginning after 2005, the maximum annual amount of the catch-up contribution is $1,000. I.R.C. § 219(b)(5)(B). An individual who will reach age 50 before the end of the calendar year is deemed to be age 50 as of January 1 of that tax year. Reg. §1.414(v)-1(g)(3)(ii).

4.Married individuals can make contributions to their IRAs up to the annual dollar limit when filing a joint return. If one spouse has little or no compensation, that spouse can “borrow” his or her spouse’s compensation for purposes of deducting the maximum contribution. I.R.C. § 219(c).

Phase outs:  Beginning in 2007, for an individual who is not an active participant, but whose spouse is, the maximum deductible amount that could be contributed to a traditional IRA phased out at an adjusted gross income between $156,000 and $166,000 (jointly computed). Rev. Proc. 2006-53.  This phase-out range is from $159,000 to $169,000 (jointly computed) in 2008.

If both individuals are covered by an employer-maintained retirement plan, the maximum deductible amount they can contribute to a traditional IRA is determined by their modified adjusted gross income.  See Chapter 2, Contributions, Rollovers and Transfers to IRAs, for details.

The phase-out range for 2007, for active participants who are married and filing jointly is from $83,000 to $103,000. I.R.C. 219(g)(8) as added by the Pension Protection Act of 2006 P.L. 109-280; Rev. Proc. 2006-53. This phase-out range is $85,000 and $105,000 in 2008.

5. The IRA deduction will begin to be phased-out when a single person or head of household is covered by an employer’s retirement plan. For 2007, the IRA deduction began to phase-out when modified adjusted gross income reached $52,000 and will be completely phased-out when modified adjusted gross income reached $62,000. For 2008, the IRA phase-out range for single taxpayers and heads of households phases out ratably for modified gross incomes between $53,000 and $63,000.

6. The phase-out range for individuals who are married filing separate returns if the individual, or their spouse, is covered by an employer-maintained retirement plan, is $0 to $10,000. I.R.C. § 219(g)(3)(B)(iii).

7.  Individuals may withdraw all or part of their assets from a traditional IRA and exclude the withdrawal from income if it is transferred to another traditional IRA or returned to the same IRA within 60 days of the withdrawal.

Only the amount that is transferred (or returned) to a traditional IRA will not be taxed. Any amount withdrawn that is not transferred to a traditional IRA within 60 days of the withdrawal will be taxed as ordinary income and may be subject to a 10 % penalty for someone under 59 ½. 

The rules surrounding the transfer of assets from one IRA to another are tricky and IRA owners should always be advised to make such transfers cautiously to assure they have followed the rules properly because stiff penalties may occur if the transfer of assets from one IRA account to another is not done properly.

For example, the 60 day rule does not apply to a nonspouse beneficiary taking a distribution from an inherited plan.  A nonspouse beneficiary taking a distribution from an inherited plan, even if taking the distribution was accidental or unintentional, constitutes a mistake that cannot be fixed.  The IRS has no power to authorize the contribution of the distributed amount to the same or another plan.  PLR 2005-13032.

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C. Required Minimum Distributions

IRA required minimum distribution (RMD) rules can be very confusing because RMDs are calculated differently under different situations; most notably, either during the owner's lifetime or after the owner's death (inherited IRAs).

Some key RMD issues to note include:

1. Distributions from any of several IRA accounts count towards required minimum distribution requirements for all the owner’s IRA accounts.  Therefore, the owner can total all the required minimum distributions they need to take for the year and can take the total amount from any of their IRA accounts. 

2. Distributions to the owner of a traditional IRA must begin no later than April 1st  following the calendar year in which the owner reaches age 70 ½ . Reg. 1.408-8, A-3.  IRA owners have the choice of receiving their first distribution in the year they reach 70 ½ or postpone the distribution until the following year when two distributions are required to comply with RMD rules.

Subsequent distributions must be received by December 31^st of the applicable distribution year.  If the owner receives his first RMD on April 1^st, and the following year’s RMD by December 31^st of the same year (as is required in the regulations), both distributions will be includible in that year’s tax return.  If the owner receives the first distribution in the year the owner reaches 70 ½, it is treated as the RMD for that year.

The tax consequences of reporting both the first and second RMDs on the same tax return must be taken into consideration when determining which year the owner will take their first RMD.

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D. Roth IRAs

In general, Roth IRAs are subject to the same rules as traditional IRAs, except where the Code specifies otherwise. I.R.C. § 408A(a). There are, however, three important distinctions:

(1) contributions to Roth IRAs are not deductible;

(2) distributions from Roth IRAs may be free from federal income tax; and

(3) individuals over 70 ½ years old, may make contributions to Roth IRAs. I.R.C. § 408A(c)(1); § 408A(d)(1); § 408(A)(c)(4).

IRA planning techniques and strategies include determining whether a traditional or Roth IRA provides the best tax advantages for the owner and when and how to rollover a traditional IRA to a Roth or vice versa.

Some key traditional v. Roth IRA issues to note include:

1. Because distributions from Roth IRAs may be free from federal income tax and individuals over 70 ½ years old, may make contributions to Roth IRAs, IRA owners may want to take advantage of the tax benefits afforded to them by rolling over a traditional IRA to a Roth IRA. 

For example, a woman inherits an IRA from her deceased husband in a year where she has very little taxable income and very high tax deductions that she got as a result of her husband’s death.  The woman can convert the traditional IRA to a Roth and offset the taxes owed as a result of the rollover with the expenses she incurred as a result of his death.  She will then be entitled to take tax free distributions from the Roth IRA when she has met the “ordering rules.”

2. A 6% tax applies to any excess contribution to either a traditional or to a Roth IRA therefore Roth IRA owners should pay particular attention to the amount they contribute to their Roth IRA in any given year.  The annual limit of contributions to Roth IRAs is the lesser of (1) the annual limit to traditional IRAs, $4,000 for 2005 through 2007 and $5,000 for 2008, or (2) the owner’s taxable compensation for the year.  However, if the owner’s modified adjusted gross income is above a certain amount, their contribution limit may be reduced.

The maximum annual contribution is the amount that may be contributed to both traditional and Roth accounts, combined, not the amount that can be contributed to each account.

3. Roth IRA distributions are generally not included in the owner’s income and hence, are not subject to a 10% penalty for early withdrawals if certain requirements are met.

Qualified Roth distributions are: 1) made on or after the date on which the individual attains age 59 ½ ; 2)  made to a beneficiary (or the individual’s estate) on or after the individual’s death; 3)  attributable to the individual being disabled; or 4)  distributed to pay for “qualified first-time homebuyer expenses” (up to a $10,000 lifetime limit).  I.R.C. § 408A(d)(2)(A).

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E. The 10 % Penalty

Withdrawals from a retirement plan to an owner younger than 59 ½ are subject to a 10 % additional tax, commonly referred to as the 10 % penalty. This penalty does not apply to withdrawals made after the owner reaches 59 ½ .  Per §72(t) of the I.R.C., the additional tax equals 10 % of the withdrawal to the extent the withdrawal is includible in gross income.  

Some key issues to note include:

1. There are 14 exceptions to the application of the 10 % penalty. The exceptions to the 10 % penalty are limited and confusing to practitioners and their clients.  The IRS and the courts do not waive the penalty unless the requirements for an exception are met.

Although each exception can be helpful in the appropriate situation, they are overly complex relative to the benefit provided and infrequency of use. It is difficult for a client’s tax advisor to profitably apply an exception for a first-time homeowner or Health Savings Account exception that may arise one or two times over a period of years. 

2.If any of the following situations exist, the IRA owner (or their heirs) may be entitled to take IRA distributions without being subject to the 10 % penalty:  (1) the IRA is inherited; (2) distributions are a result of a Qualified Domestic Relations Order; (3) the distributions are used to cover the costs of medical expenses; (4) the distributions are used to pay for health insurance premiums; (5) distributions are used to fund Health Savings Accounts; (6) the distributions are used for higher education expenses; (7) there is an IRS levy on the  account;  (8)  withdrawals from IRAs are used for first-time home purchases; (9) the distribution is a qualified reservist withdrawal; (10) the owner is disabled;  (11) the owner has been separated from their employer’s service after the attainment of age 55; (12) 404(k) employer stock dividends are involved; (13) the SOSEPP exception is available to anyone who owns an IRA; or (14) the distributions are comprised of contributions to an IRA for which no deduction has been taken.

Although each exception can be helpful in the appropriate situation, they are very complex and the IRA owner should seek the advice of a tax advisor concerning any IRA withdrawals from their IRAs before they are 59 ½ years old.  This list does not cover the complexities and requirements of the exceptions listed.

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