Most boomers think of individual retirement accounts as safe havens, at least until the time comes to draw down their nest eggs. Fewer among them are aware of the myriad IRS rules that, once violated, can compromise the IRA’s tax-favored treatment.
Enter the tax-savvy financial advisor.
“Most financial professionals who meet with prospects can talk about such investment concepts as asset allocation and the efficient frontier,” says Robert Keebler, a partner at Virchow, Krause & Company, and chair of the Virchow, Krause Estate and Financial Planning Group, Green Bay, Wis. “What’s usually missing is the tax knowledge. That’s the knowledge that will allow them to capture a share of the estimated $18 trillion now invested in pension plans that will move to IRAs as boomers retire.”
Consider, for example, what happens when an IRA owner or beneficiary fails to withdraw the required minimum distribution for the tax year. The result, says Keebler, is a 50% excess accumulations tax on the difference between the RMD and what was taken during the tax year. If, for example, the client were required withdraw $30,000 from the IRA but only took out $20,000, then the penalty would be $5,000 [($30,000 -$20,000) x 50%]. And the client would still be required to withdraw the $10,000 deficiency.
Keebler, who spoke on the subject at LIMRA International’s Advanced Sales Forum earlier this year, says boomers who inherit IRAs also frequently err by drawing down account benefits faster than required. The reason: The advisor improperly counseled them not to calculate their RMDs based on the life expectancy method, a formula that generally permits payouts over a longer period of time than the alternative 5-year rule.
Conversely, IRA inheritors can get hit with a 50% tax penalty should they invoke the life expectancy rule when, in fact, the 5-year rule applies. This rule, Keebler says, would govern in cases where the IRA owner dies before the required date to begin taking distributions and the IRA has a non-designated beneficiary.
If the IRA is payable to a trust, the IRS will qualify the vehicle as a non-designated beneficiary in cases involving older or non-identifiable contingent beneficiaries; powers of appointment (often used in generation-skipping trusts); or “poisonous language” contained in the trust document. Keebler notes, however, that taxpayers can “reform” the trust–making it a designated beneficiary–so long as revised trust language is implemented by September 30 of the year following the IRA holder’s death.
“Many people die before they retire from their companies,” says Keebler. “And that could mean money coming out of the retirement plan and taxes being paid under the 5-year rule. By understanding the tax implications on distributions, advisors can help clients avoid these consequences and bring more assets under management.”
Also to watch out for, he says, is the non-spousal beneficiary who rolls over (or retitles) an IRA inherited from a decedent into his or her own IRA. The result is the entire IRA account balance of the decedent is deemed to be distributed and, thus, subject to ordinary income tax. In all cases, says Keebler, the inherited IRA should be kept in the name of the deceased owner.
Yet another pitfall: When boomers take IRA distributions from one financial institution in anticipation that the funds are to be rolled over by another into a new IRA. But if, due to unforeseen circumstances, the second institution fails to deposit the funds within the required 60 days, it makes the entire distribution immediately taxable.
Keebler says advisors can seek IRS relief for their clients by requesting a waiver of the 60-day rule. But he cautions that advisors must tread a thin line, absolving the client of responsibility for failing to heed the rule, while not assigning to themselves so much blame as to expose them to a malpractice charge.
“[The IRS'] view is: If the client messed up, tough! But if the advisor messed up, that’s okay and the problem can be fixed,” says Keebler. “Their position makes no sense. I don’t think Congress really intended to draw a line between a mistake by the client and a mistake by the advisor.”
Still more penalties result from early distributions. Often, a surviving spouse who is under 59 1/2 rolls over a decedent spouse’s IRA into her own personal IRA and then takes a distribution. The result is the distribution is subject to the 10% early distribution penalty. Keebler says clients can circumvent this problem by keeping the inherited IRA in the decedent’s name until surviving spouse attains age 59 1/2 , at which point he or she can do the rollover.
Boomers, says Keebler, also need to stay clear of prohibited transactions. Example: A client’s IRA purchases a commercial building that, in turn, leases the building back to the client’s business. This prohibited transaction makes the IRA 100% taxable.
“If you think you’re even close to engaging in a prohibited transaction, then the solution is to create two IRAs,” says Keebler. “The first will be a $1 million IRA where you keep most all of your investments; the second will be a $50,000 IRA where you do whatever foolish thing you were planning to do.”