Although individual retirement accounts were officially created in 1974, most Americans will remember 1981 as a seminal time in the development of this tax-deferred savings vehicle. The year of the fledgling Reagan presidency saw IRA provisions liberalized to allow individual contributions up to $2,000 per year (previously $1,500), and coverage was extended to employees already participating in corporate pension plans.
But the unprecedented economic growth of the following 18 years focused a disproportionate share of attention on the accumulation phase of retirement planning at the expense of the distribution phase. While the Internal Revenue Service proposed regulations in both 1987 and 2001 in an attempt to better define distribution and estate planning issues, they were never finalized. In their non-finalized state, the old rules became a complex set of regulations that often caused more confusion than clear guidance.
But in 2002, the IRS finalized the interim rules, which took effect at the beginning of 2003, and simplified and expanded on many of the previously proposed regulations. Rule changes in 2005 also eased eligibility requirements for those looking to convert to Roth IRAs. All of this now adds0 up to new distribution options for clients, and new sales and marketing opportunities for advisors.
The new rules
"There are a number of beneficial changes that have come about as a result of the recent IRS changes," explains Barry Picker, CPA, CFP, a Brooklyn, N.Y.-based financial advisor and author of "Barry Picker's Guide to Retirement Distribution Planning." "Once an individual reaches age 701?2, they must begin taking Required Minimum Distributions from their IRAs. But I have a number of clients who do not need, or want, to take the money. The calculation tables on which the minimum distribution amount is based changed to reflect theoretically longer life expectancies, so as a result the RMD amount has been reduced."
According to Picker, other important changes over the past few years include:
- Traditionally, the age of the beneficiary was a significant factor in determining the amount an individual would have to take as a required minimum distribution. RMDs with beneficiaries have become much easier to calculate. New tables with built-in younger beneficiary information means that owners have just one simple calculation to make.
- If the individual switched the beneficiary of his account to a younger designee, he could not take advantage of the age benefit when calculating his minimum distribution. Alternately, if he switched to an older beneficiary, he would have to include this person in the calculation, increasing the amount to his detriment. Again, this is no longer the case, as he can now benefit from including the younger beneficiary information in the calculation.
- The "five-year rule" no longer applies. A designated beneficiary, who elected to take the entire balance in the account by the end of the fifth year following the year of the owner's death, may be able to switch to receiving the balance over the beneficiary's life expectancy.
- Starting in 2005, the required minimum distribution will not count toward yearlyadjusted gross income (AGI) for taxation purposes.
The Roth conversion
One frequently heard recommendation from advisors for retirees reluctant to take their minimum distribution is to convert their traditional IRA to a Roth IRA. "Converting to a Roth gives them all sorts of advantages," says John Olsen, CLU, ChFC, AEP, principal with Kirkwood, Mo.-based Olsen Financial Group. "At that point, there are no required minimum distributions. This works well if the client has an estate tax problem. As an example, if they have $300,000 sitting in an IRA and it is converted to a Roth, and $130,000 is paid at that time in taxes, then that is $130,000 that is no longer in your estate that your beneficiaries have to worry about."
By leaving the $130,000 in the traditional IRA and taking it as a required minimum distribution, it would be added to the client's adjusted gross income, possibly inadvertently triggering the alternative minimum tax or other detrimental tax consequences. This would not be the case for the client or his beneficiaries if the Roth conversion were made. However, clients must be reminded that their adjusted gross income must be below $100,000 in order to qualify for the conversion.
As an aside, Olsen notes that advisors often recommend Roths for younger investors (people in their 30s) for "the simple fact that it's better to be tax-free coming out than tax-deferred going in," he says. But another area that is often overlooked is the blue-collar investor. "Obviously, Roth IRAs are tax-free and Traditional IRAs are tax-deferred," he continues. "A lot of blue-collar workers have 401(k)s that are also tax-deferred, but let's face it, they will be paying tax on the accumulation at some point. Since a lot of their retirement income comes from their pension product, it could cause their Social Security benefits to be heavily taxed. Wouldn't it then be better if their other sources of income were tax-free?"
An end-run strategy
As Picker said, advisors often have a sizable number of high-net-worth clients who either don't need or don't want to begin taking distributions from their IRA. They would rather leave it for their children. In this instance there are a number of "end-run" strategies that can help. According to Olsen, the client can begin taking withdrawals, paying the resulting tax (which they will be forced to pay at some point anyway) and then begin using the payments to fund an irrevocable life insurance trust. The benefits are two-fold. The first is that the net amount to heirs is often greater by using the life insurance strategy than if the funds had remained in the IRA and been drawn down as a required minimum distribution. The second is that the funds that were carved out and placed in the insurance policy are now guaranteed, removing any uncertainty for at least that portion of the individual's estate.
"If the client's estate is big enough, they might be subject to a top marginal estate tax rate of 48 percent," Olsen says. "This is in addition to the ordinary income tax that the beneficiary will have to pay on the same money. So it could add up to well over 60 percent. Why not use an end-run strategy?
If appropriate, I suggest the client begin taking distributions before 591?2, which is allowed under Rule 72(t), and putting it into a irrevocable life insurance trust."
Something of a stretch
A number of stretch opportunities have arisen from the finalized rules. Stretching an IRA is simply the ability to have an IRA's assets outlive the account owner. By "stretching-out" an IRA, the life of an investment is maximized and the tax-deferred status of assets held in the account is extended. Stretching an IRA extends its tax-deferred growth for the beneficiaries, resulting in substantially more growth than if the IRA were paid out immediately following the original owner's death. Until recently, IRA assets were usually liquidated shortly after the beneficiary's death. The beneficiaries can now avoid immediate liquidation and extend the life of the IRA because beneficiaries are now allowed to make the required distributions from the IRA over their own life expectancy. While utilizing the stretch IRA is a sound strategy, Olsen cautions that the term is often misunderstood, and IRA owners sometimes do not realize that employing the strategy can result in a loss of control of those assets.
"A stretch IRA strategy is a non-specific term that means to stretch the tax-deferral status of any IRA distribution out as long as possible, whether it is a spousal rollover or going to the kids," he explains. "As a general rule of thumb, if the owner of the IRA wants the maximum control when it comes to a stretch IRA strategy, then there will be less options available to them. As example, by ceding control to the spouse, it allows for more opportunities for the money, but one has to just hope that the wife eventually passes it on to the kids."
Fix your client's car
While the distribution rules have been simplified, there is still no cookie-cutter approach when dealing with IRA distribution planning. Because an IRA could be one of the largest assets a client has, seeking professional advice to avoid potentially costly mistakes could be one of the cheapest steps he takes. And as Olsen emphatically states, IRA distribution planning cannot be done in a vacuum. Simply explaining this to the client can lead to increased sales and marketing opportunities.
"There are a number of ways to skin this cat, and they all have to be looked at," he concludes. "I often use the car analogy. A client would never take their car to a mechanic and tell them 'look at this one specific part and nothing else.' How confident do you think they would be that the car is fixed when they drove it away? None of us would permit this with our car, but we do it all the time when it comes to our financial future and the future of our loved ones. IRA distribution planning has to be comprehensive and the job of the advisor is to make the client understand this."