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So you missed the 70½ date for taking money out of your IRA
Before April 1 of the year after they turn age 70½, owners of traditional IRAs face some important choices regarding how they take distributions from their IRAs. The tax rules call this date a person’s required beginning date (or RBD). It’s the date by which distributions from traditional IRAs must begin—even if the money isn’t needed. The decisions that are made by the RBD (or the default options that apply if no decision is made) can have a significant impact on the taxes the IRA owners (and their heirs) pay for years to come.
Although the main focus should be on planning ahead for the IRA elections that are available until the RBD, there are still many who let the date slip by without adequate planning. The focus of this letter is on what those individuals can do to recover from this missed opportunity. Read on if this applies to you or someone you know.
No Designated Beneficiary
Until your RBD, the life expectancy of any beneficiary you name for your traditional IRAs can be used (along with your own life expectancy) to determine how much you must take from your IRAs each year beginning no later than the year after you reach 70½. Any beneficiary you name after this date still affects who inherits the IRA funds but doesn’t impact the minimum amount that must be distributed from your IRAs during your lifetime (unless the new beneficiary is older—in which case your annually required distributions will go up).
What happens if you pass your RBD without naming a beneficiary? This means the IRA plan from your custodian (your bank, broker or mutual fund company) will determine your IRA beneficiary for you. Often the default will be your estate, which means that the entire IRA balance will most likely have to be paid out within the year after your death. That’s bad news if you have a significant balance in your IRAs, because dumping all of that income out in a short period of time could push your heirs into a much higher tax bracket.
So what can you do? First things first. Check with the financial institution (your IRA custodian). It’s a long shot, but maybe it actually has an executed IRA beneficiary form on file where you named someone as your IRA beneficiary. If so, you’re covered. You have a designated beneficiary. Not only that, but you may have been using only a single life expectancy to determine the minimum you have to take out each year. Now that you’ve found out you have named a beneficiary, you can switch to a joint life expectancy. This will lower your required distributions and the related income tax.
The plan’s default could help. If your IRA custodian doesn’t have a beneficiary designation form on file for you (and you can’t produce your copy of one that you signed), it’s time for Plan B. Check the custodian’s own IRA plan. If you have not named a beneficiary, the plan will name one for you. As we said earlier, that usually results in your estate being the beneficiary—however, that’s not always true. More and more banks, brokers, and mutual fund companies have changed their standard IRA plan provisions to first name a married individual’s spouse. If you’re unmarried, the plan may first name your surviving issue (meaning your children and grandchildren). If you fit within either of those situations, you’re in luck. You have a designated beneficiary.
For example, an IRA plan document may default first to your spouse, if there is a surviving spouse, and then to your children if any, and finally to your estate. This leaves you with two lines of defense before defaulting to your estate.
Name a beneficiary now! If Plan B fails, here’s Plan C. You’ve passed your required beginning date and have no beneficiary. Name a beneficiary now! You’re still stuck without a designated beneficiary for purposes of determining how much you have to withdraw from your IRA each year, but there may yet be a way out of this mess. If you are married, you can name your spouse as your IRA beneficiary. Assuming he or she survives you, they can roll over your IRAs or treat them as their own and all your IRA mistakes are forgiven. Regardless of your spouse’s age, a fresh start is available by naming new beneficiaries and a new distribution method.
What if you name your spouse, but she dies first? You’re back to where you started, with no designated beneficiary. Now what? Well, you could always get remarried, but even then the chances are good that if you have children you’ll want them to be your IRA beneficiaries. They may still have to distribute (and pay tax on) the entire IRA balance in the year after your death, but at least the right beneficiaries will receive the after-tax IRA funds. In addition, this approach could avoid probate problems that might occur if you simply leave the IRA to your estate and its creditors. And finally, if your taxable estate exceeds the estate tax exemption (currently $675,000), the kids may be entitled to a special itemized deduction that could offset part of the income they have to report from the IRA distributions.
If you are unmarried, childless, and failed to name an IRA beneficiary by your RBD, you should still name someone now. You will avoid potential probate problems and know that your IRA will be inherited by the person you select. Of course, the right person could also inherit the IRA through your will, assuming you leave the estate as your IRA beneficiary. However, doing this could cause the IRA to be eroded by attorney, accountant, or other fiduciary fees, not to mention taxes, expenses, and creditors’ claims.
Charity Solution
If none of the previous solutions we’ve discussed will work in your situation, you may be able to use a charity to alleviate the problem of not naming a beneficiary by your required beginning date. For example, even if you’re not that charitably inclined, it may pay to name a charity as the IRA beneficiary through a Charitable Remainder Trust (CRT). The CRT will inherit the IRA when you die, but the trust will pay out an income stream to your children (or other intended beneficiaries) over their lives or a certain term (often 20 years). What’s left in the trust once the income interest terminates goes to charity.
If you left the IRA directly to the children, they’d owe tax on the entire balance in the year after your death and lose up to half of the account immediately. The trust guarantees an extended payout to your beneficiaries and you’ll be doing some good for the charity as well. Also, if you have a taxable estate, some estate taxes will be saved because of the charitable estate tax deduction. This should provide some extra funds for your beneficiaries to invest.
Roth Conversion
A Roth conversion can provide a fresh start for traditional IRA owners who have blown the beneficiary designation deadline. Once a traditional IRA is converted to a Roth IRA, you can name new beneficiaries who will be able to stretch distributions over one of their own life expectancies after your death. That’s the good news. The bad news is that to convert and take advantage of this remedy, your income can’t exceed $100,000 in the year of your Roth conversion. (If your income is over this amount, don’t give up. Sometimes with proper planning it’s possible to squeeze your income below the wire, especially since it’s only for that one year.)
In addition to having to fit below the $100,000 threshold, income tax is due at the time of the conversion. However, even with this up-front tax, things may still work out better than keeping your traditional IRA, which without a named beneficiary may have to be paid out within the year after death and be taxed in one year anyway.
And finally, if there’s a terminal illness in the picture, and a large estate that’s going to be subject to estate taxes, consider a death-bed Roth conversion. The income tax owed on the conversion will be an estate tax deduction, which makes the government effectively pay as much as 55% of the conversion tax because of the estate tax savings.
To Recalculate or Not
In addition to designating beneficiaries, the other big decision you’re supposed to make before April 1 of the year after you turn age 70½ is whether you’ll recalculate your life expectancy (and if your spouse is your beneficiary, your spouse’s life expectancy) each year. Recalculating life expectancies minimizes the amount you’re required to take out each year and lessens the chances that you’ll outlive your IRA, because with each additional year that you live, your life expectancy decreases by slightly less than a year. (The other method, known as the term certain method, simply reduces your life expectancy by one each year.) However, if you (or your spouse) should die prematurely, using the recalculation (rather than the term certain) method can reduce your heirs’ options for stretching out the IRA distributions and benefiting from the IRA’s tax deferral feature. If you fail to choose between the recalculation and term certain methods, most IRA plan documents default to the recalculation method for you and your spouse and to the term certain method for any other beneficiaries (since the recalculation method isn’t allowed for them).
If you’re married and name your spouse as beneficiary, you can sort of have it both ways. You can choose what’s known as the hybrid method by selecting the recalculation method for one of you and the term certain method for the other.
Interaction of Beneficiary Selection and Life Expectancy Calculations
Sometimes if you’ve named the wrong (or no) beneficiary prior to your required beginning date (RBD) but, based on your circumstances, you’ve selected the right distribution method (recalculation or term certain), you may be able to at least partially overcome the beneficiary problem. Even better, if you’ve elected the wrong distribution method but the right beneficiary, your IRA plan may be totally salvaged. Here’s what we mean.
Wrong beneficiary/right method. Assume that sometime after your RBD, your spouse, who is named as your IRA beneficiary, dies prematurely. You change your IRA beneficiary to your son. However, because the change takes place after your RBD and you were using the recalculation method for you and your spouse, your son will have to withdraw the entire IRA by the end of the year after your death.
If you instead had elected either the hybrid or joint term certain method for calculating the life expectancies of you and your spouse, your son could stretch the IRA distributions over the remaining term. Thus, even if you named the "wrong" beneficiary (in this case, someone who predeceases you), selecting the right method (anything but recalculation) can allow the IRA to live on after your and your spouse’s deaths if both of you should die prematurely. That generally beats a full IRA payout in the year after your death.
Right beneficiary/wrong method. Suppose you’ve named your daughter (or some other non-spouse) as your IRA beneficiary but you are taking minimum distributions based on your recalculated single life expectancy. The general rule is that IRA distributions after your death must continue at least as rapidly as prior to your death. Because those distributions are based on your single recalculated life expectancy, the year after death (when, not surprisingly, your life expectancy has dropped to zero) your daughter normally would need to empty out the entire IRA.
Fortunately, the IRS recently ruled that a non-spouse beneficiary could continue post-death distributions over his remaining term certain life expectancy, even though the IRA owner had based distributions during his life time only on his single recalculated life expectancy. The key here was that the IRA beneficiary was named by the IRA owner’s required beginning date. In this case, having named a beneficiary by the appropriate date corrected a poor distribution method choice.
Throwing Money at the Problem
Sometimes the best way to correct a poor beneficiary or distribution method choice is simply to make sure there’s enough money available to pay the tax. Usually this is accomplished with life insurance.
An IRA might have to be emptied in the year after death, but at least the resulting taxes won’t hurt as much if there are insurance proceeds available with which to pay the taxes, and maybe even some leftover to invest. This can provide a lifetime stream of income for your beneficiaries. It’s not exactly an IRA, but it simulates the idea.
Your children could buy life insurance on your life and they would be the owners and beneficiaries of the policy. They could also pay the premiums from money you, the IRA owner, will gift them. The gift money can come from IRA distributions, which are required anyway, or from other non-IRA funds. The insurance could also be purchased by an irrevocable life insurance trust, which, if properly set up, would keep the life insurance proceeds estate and income tax free to your beneficiaries.
Conclusion
This letter is longer than we’d like for it to be and yet we’ve barely scratched the surface on this topic. If April 1 of the year after you turned age 70½ has unfortunately gone by without proper planning for your IRAs, please call us. We’d be glad to help you review the planning options you still have available.