Multiple retirement accounts owned by any given individual has become the norm these days as IRAs and defined-contribution accounts accumulate over the years from an often diverse collection of employment and contracting opportunities. With this trend comes additional complexity in managing retirement savings. This complexity arises not only because of the number of accounts to be addressed but also because of the applicable rules that vary sufficiently so that a one-size-fits-all approach often does not work well.
Our latest Tax Strategy column covers some of the typical considerations that need to be weighed on the distribution of retirement savings. It also looks at some planning opportunities that may be ending sometime in the future if Congress, or a future administration, has its way.
REQUIRED MINIMUM DISTRIBUTIONS
Once a retirement account holder reaches age 70-½, annual distributions generally must be made based upon life expectancy. The consequence for not making a full requirement minimum distribution, also sometimes called a minimum required distribution, is a 50 percent penalty on any shortfall. While the IRS has discretion to lower this penalty in any given case, this route — even if successful — can be expensive.
For most qualified retirement account owners, the initial RMD generally must take place by April 1 following the calendar year in which the participant reaches age 70-½. An exception may apply, however, if a qualified employer-sponsored plan specifies that the RMD may be delayed past age 70-½ until actual retirement. In any event, however, an employee who is a 5 percent owner cannot delay RMD by staying on after age 70-½.
For IRA owners, postponement until actual retirement if beyond age 70-½ is not allowed under any circumstances. However, as a strategy that remains open so far, rollovers to qualified employer-sponsored plans that allow deferment may be made, provided that the plan allows it. Rollovers from either IRAs or qualified plans apparently count under this exception.
First RMD option. Although making a retiree’s first RMD on April 1 following the year in which they turn age 70-½ is usually the option most retirees take, they may opt for an earlier distribution in the actual year of turning 70-½. This latter alternative follows the general pattern for subsequent RMDs: valuation of retirement assets on December 31 of the prior year, to which the retiree’s life expectancy factor is applied, and then distribution of that computed amount by December 31 of the current year.
If the delayed April 1 distribution is selected for the first RMD, the participant then must receive two RMDs that year: one that is “delayed” from the prior year and one for the current year. A decision regarding the timing of the initial RMD usually depends upon how much other taxable income is realized by the individual in each of those years, since the underlying goal is to even out the level of income between those two years as much as possible for tax-rate efficiencies.
Working the RMD rules. The RMD for each account is determined separately, based upon each account’s value as of the end of the prior calendar year. That RMD, however, need not be satisfied from that particular account, as long as it is accounted for through a taxable distribution from any other qualified retirement account owned by the taxpayer. This allows a greater share of RMD to be taken from an account that perhaps is not performing well or that has an inefficient fee structure. Roth IRAs must be kept separate in determining what is distributed, however, as must IRAs to which the taxpayer is a beneficiary.
Gains or losses during the year of distributions do not change the RMD during that year, which is based on value at the end of the prior year. Further, overpayment in one year does not reduce the payment for the next year by such amount. It only reduces the available balance, which is then redistributed based on life expectancy.
Qualified annuities. RMD payouts over a life expectancy can be satisfied, in whole or in part, through use of a qualified annuity (single or joint life and survivor annuity or a qualified annuity from an employer-sponsored plan). An alternative to the traditional annuity that has become recently available, qualifying longevity annuity contracts, or QLACs, may be purchased to start as late as immediately after the taxpayer’s 85th birthday. To prevent longevity annuities from being used disproportionately to shelter assets for the next generation, premiums cannot exceed the lesser of $125,000 (indexed for inflation) or 25 percent of an owner’s traditional (non-Roth) IRAs.
The Obama administration’s FY 2017 revenue proposals, released this past February, contain certain reforms to the tax rules surrounding retirement plans that may suggest certain strategies before they are considered in Congress. Although the chances of a major tax law during this year of presidential politics is slim to none, use of certain of these proposals to fund “one-off” tax provisions might still be possible.
Roth RMDs. Although no tax is due on distributions from Roth accounts, Roth account holders continue to benefit from the accumulation of tax-free earnings as long as the funds are not withdrawn. While designated Roth accounts held in a 401(k) or other employer-sponsored plans are subject to the RMD rules during the account holder’s life, no RMD is required during the life of the Roth IRA holder. (The RMD rules do apply, however, to any Roth account after the death of the holder.)
The Obama administration has proposed that the same RMD rules apply to Roth IRAs “to support the purpose of the accounts in providing resources for retirement.” In addition, the administration reasons that such a rule would close the current loophole that permits Roth accounts within an employer-sponsored plan to be rolled over into Roth IRAs, which currently have no RMD requirement.
Existing Roth accounts would not be grandfathered in under this proposal. Instead, the proposal as currently written would be effective for taxpayers attaining age 70-½ on or after Dec. 31, 2016, and for taxpayers who die on or after Dec. 31, 2016, before attaining age 70-½.
Five-year payout for non-spouse beneficiaries. If a plan participant or IRA owner dies on or after the required beginning date and there is a non-spouse individual designated as beneficiary, the distribution period under existing rules is the beneficiary’s life expectancy, calculated in the year after the year of death. Under the administration’s proposal, non-spouse beneficiaries of retirement plans and IRAs would generally be required to take distributions over no more than five years. Exceptions would exist for any beneficiary who, as of the date of death, is disabled, a chronically ill individual, an individual who is not more than 10 years younger than the participant or IRA owner, or a child who has not reached the age of majority.
This change would prevent a current estate planning technique under which some much younger, non-spouse beneficiaries are enjoying tax-favored accumulation of earnings over long periods of time. The proposal would be effective for distributions with respect to plan participants or IRA owners who die after Dec. 31, 2016.
DIRECT CHARITABLE DONATIONS
The Protecting Americans from Tax Hikes Act of 2015 (P.L. 114-113) provides an exclusion from gross income for qualified charitable distributions of up to $100,000 each year received from an IRA. The exclusion from gross income of such an IRA distribution effectively provides three benefits to the taxpayer not ordinarily available: the exclusion effectively reduces adjusted gross income, and resulting deduction limitations; the exclusion effectively realizes the benefit of an itemized charitable deduction without having to itemize; and the qualified charitable distribution also counts toward satisfying a taxpayer’s RMDs from a traditional IRA.
The top $100,000 contribution limit each year (per spouse) may hide the fact that any amount up to $100,000 qualifies. For example, a retiree who normally donates $2,000 each year might save a few tax dollars using this benefit, especially if the retiree does not ordinarily itemize deductions. RMD is also effectively lowered by the amount of the donation, potentially allowing the taxpayer to keep more within the tax-deferred environment of the IRA.
Although most retirees no longer will simply make ends meet by way of a monthly check from a defined-benefit plan, retirement assets within qualified defined-contribution plans and a variety of IRAs can still promise to provide for a comfortable retirement. The tax law is now structured, however, to leave certain decisions and compliance actions up to each individual taxpayer. Within that structure, mistakes can happen and opportunities to maximize their savings can be lost. Nevertheless, the current state of affairs also provides tax practitioners with still another way to provide service to their clients.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer US, Tax & Accounting.
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