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.”