Individual Retirement Accounts started out as small potatoes. With annual contributions capped at $1,500 in the initial years from 1974 through 1981, then locked in at $2,000 a year from 1982 through 2001, who would have expected IRAs to amount to a major part of retirement savings? Now we know better. By year-end 2005, according to the Investment Company Institute, assets in IRAs had reached $3.66 trillion, well outdistancing the $2.4 trillion in 401(k) plans. Because the laws and regulations governing IRAs are as complex as anything in the U.S. tax code, however, increasing IRA assets means more potential headaches for taxpayers and their advisors.
Mistakes are common, and--when they lead to taxes and tax penalties--expensive. Worse, mistakes are too often made by IRA custodians with an incomplete or faulty understanding of the rules. That puts the ball firmly in your court. As Trow Trowbridge, president of Dominion Wealth Management, Inc. in Reston, Va., noted in a recent edition of Ed Slott's IRA Advisor, "You still have to know more than the custodian if you're going to advise clients."
As everyone knows by now, required minimum distributions (RMDs) from traditional IRAs must begin by April 1 of the year following the year in which the IRA owner reaches age 70 1/2 . But when and how clients take their distributions determines "how much they keep and how much goes to the government," says Slott, a CPA in Rockville Centre, N.Y. and author of Your Complete Retirement Planning Road Map.
Advisors are generally good at investing, but many fall down on the job when it comes to an exit strategy. If distribution issues are not addressed during estate planning--especially critical now that IRAs make up the single largest asset for many clients--more than three-quarters of the account could disappear in a lethal combination of income and estate taxes. As a result, Slott notes, the IRA might wind up as "a savings account for the government."
Because IRA assets should always pass to designated beneficiaries and not through the client's will, the biggest mistake advisors make is ignoring beneficiary designation forms during the client's lifetime. After death, it's too late. So the proactive advisor should:
1. Make sure that the client has filled out a beneficiary designation form;
2. Make sure that the form names both primary and contingent beneficiaries;
3. Review and update the form as the client's life changes.
To elaborate: The client should fill out a beneficiary designation form, keep one copy, and give you a copy of the form for your files. Don't count on the IRA custodian to have a copy of the beneficiary form when it's needed. Years go by, and repeated mergers among banks and brokers sometimes mean that forms cannot be located.
Naming beneficiaries ensures that IRA assets can be paid out over the life expectancy of the beneficiaries in what is commonly called a "stretch IRA." When contingent beneficiaries are in place, the primary beneficiary can disclaim the IRA if the money is not needed. A surviving spouse, for example, might choose to relinquish the IRA in favor of the children.
Perhaps more important, without contingent beneficiaries, the premature death of the primary beneficiary could put the IRA squarely into your client's estate--the worst possible outcome since estates have no life expectancy, and the assets would have to be distributed much more quickly, eliminating future tax-deferred growth.
Periodic review--especially when there is a marriage or divorce, new children or grandchildren--can remind you and your client that it's time to make a change. Remember: The beneficiary form governs. More than one ex-spouse has collected an IRA because the IRA owner neglected to change the designated beneficiary after a divorce. In any case, as Slott points out, periodic review is a way of staying in communication with the client, and staying in communication is good business. The beneficiary form "can build referrals."
Periodic review also helps you to stay on top of changing laws and regulations governing IRAs. For example, too many advisors are still telling clients that inherited IRAs must be distributed within five years. In fact, the rules have changed, and the five-year rule now applies only if the IRA goes into the owner's estate and if the owner dies before starting required minimum distributions. If there is a designated beneficiary, no matter when the IRA owner dies, payouts can be stretched over the beneficiary's lifetime.
Because the stretch IRA is, in fact, one of the most powerful financial planning tools ever devised, clients may want to leave other assets to their spouses and the IRA directly to children or even grandchildren. When a 40-year-old inherits an IRA, she can stretch the distributions over her life expectancy of 43.6 more years. A 10-year-old grandchild could take the money over a life expectancy of 72.8 more years. Be careful, however, of the generation-skipping transfer tax when leaving large sums directly to grandchildren, warns Barry Picker, CPA and CFP at Picker, Weinberg & Auerbach, CPAs in Brooklyn, N.Y.
Since only a surviving spouse may roll an IRA into his or her own name, it is critically important to properly re-title other inherited IRAs if tax benefits are not to be lost. The inherited IRA, says Marvin Rotenberg, director of Individual Retirement Services at Bank of America, must bear the original owner's name plus the beneficiary's name. Let's say Jim Smith inherits his mother Betty's IRA. The correct title of the account would be "Betty Smith, IRA, deceased (date of death), f/b/o Jim Smith."
For the first time, starting in 2007, a child (or any individual other than a spouse) who is the beneficiary of a 401(k) or other company retirement plan can move the assets into an inherited IRA. The big advantage of doing this, Picker notes, is that most 401(k) plans require payouts to a beneficiary within five years, thereby eliminating the stretch payouts possible under an IRA. To retain the stretch advantage, the account must be properly titled and kept separate from any other IRAs.
Moreover, all the other rules still apply. For example, although many people believe that [401(k)] distributions cannot start without a penalty until a recipient reaches age 59 1/2 , a non-spouse beneficiary must actually start taking distributions in the year after the owner dies. Failure to take required minimum distributions produces a tax penalty of 50 percent of the amount that should have been withdrawn.
Multiple beneficiaries pose another potential problem. If your client names three children as joint beneficiaries of a single IRA, and the children fail to segregate the accounts by December 31 of the year following the IRA owner's death, the life expectancy of the oldest child will govern the distributions. This is not a big deal if the children are close in age, but it can have a significant impact if there is a considerable spread in their ages, or if the multiple beneficiaries include two different generations.
Although this does produce additional paperwork, you may want to suggest that separate IRAs be established during the client's lifetime...Otherwise, put a note in your tickler file to remind the beneficiaries that segregating the accounts is one more chore to be accomplished soon after their parent's death.
Worse, if a charity is one of the beneficiaries, and there is a delay in segregating the accounts, the other beneficiaries will never get the stretch. A charity is not a person and has no life expectancy. "They will be forever stuck using the rules that apply when there is no designated beneficiary. There is one less thing to worry about," says Slott, "if there are separate IRAs from the start."
That said, clients with charitable intent should seriously consider leaving IRAs to charity and leaving other assets to their spouse and children. Doing so avoids both income and estate taxes on IRA assets--charities pay no income tax, and the money is out of the taxable estate--while giving family members the benefit of the step-up in basis on assets outside the IRA.
In the short term--only through 2007--clients who are at least 70 1/2 may donate up to $100,000 to charity directly from an IRA. No tax will be due on amounts that are donated in lieu of taking the money as a required distribution. But there is no double dipping, and no tax deduction is available for the donation. Clients should consult their tax preparers about this, but direct donations may make the most sense for those who do not need the income and who do not itemize their deductions for federal income tax purposes.
In general, when expected tax breaks are lost, it isn't good for your clients--and it isn't good for you. Following is an additional grab-bag of IRA tidbits that can put you in the good graces of your clients:
o Pay close attention to the wording of the custodial agreement before clients open a new IRA account. "All IRAs are not created equal," Rotenberg points out. Although the IRS permits wide latitude in investments and allows transfers to new custodians, those custodians may apply their own restrictions. Some impose closing fees. And some limit post-death transfers, effectively eliminating the stretch.
o Urge younger clients to consider conversion to a Roth IRA to "stop the bleeding," in Rotenberg's words, and reduce the eventual tax burden. True, they have to pay income tax on the IRA assets at the time of conversion, but later distributions to both owners and beneficiaries will be completely tax-free. Until 2010, income must not exceed $100,000 in order to make the conversion from a traditional to a Roth IRA. After that, income limits will be removed.
o If a trust is the IRA beneficiary--generally advisable only when the ultimate beneficiary is a minor, incompetent or otherwise in need of protection--the trust must meet specific IRS requirements. Otherwise, says Natalie Choate, an attorney with Bingham & McCutchen in Boston, stretch payouts over the ultimate beneficiary's life expectancy will be disallowed. Clients who need trusts should be careful to work with attorneys familiar with the IRS requirements.
o Don't automatically suggest a rollover from a 401(k) plan to an IRA. Instead, if the 401(k) holds large amounts of company stock, it may make more sense to pull out the stock and transfer the shares to a taxable account. Under the special rules governing net unrealized appreciation (NUA), tax is then due only on the cost basis. Even better, lower capital gains rates apply on any subsequent sale of the shares, even the very next day. When shares are in an IRA, ordinary income tax rates apply on distribution.
o Suggest life insurance to provide cash for estate tax if the money would otherwise have to come from an IRA. Money withdrawn from an IRA to pay estate tax is also subject to income tax.
o Let your clients know about "IRD," income in respect of decedent, a boon that Slott says is "the largest single deduction that most beneficiaries will ever get," yet one that is "missed by most accountants." When an IRA is subject to federal estate tax, a beneficiary who files an itemized federal income tax return is entitled to a deduction for the amount of federal estate tax attributable to the IRA. This is a miscellaneous itemized deduction, but it is not subject to the phase-out for adjusted gross income, and it is one of the rare exceptions to the alternative minimum tax. (For more about the IRD, see "A Sly Deduction," March, p.26.)
Clearly, IRA rules are so complex that most practitioners don't have the time to personally master the details. Successful firms, says Choate, have dedicated professional staff--not clerical workers--trained to follow through on the details. Doing it right means that problems can be headed off in the beginning, rather than engaging in the often fruitless attempt to secure a corrective ruling from the IRS.
Grace W. Weinstein, a freelance financial writer based in Englewood, N.J., is the author of 13 books, including The Procrastinator's Guide to Taxes Made Easy (NAL, 2004). A columnist and contributor to many national publications, she can be reached at firstname.lastname@example.org.