You may have a traditional, Roth or rollover IRA or other retirement accounts. The funds that are held inside these retirement accounts grow (hopefully) income tax free. The contributions to non-Roth accounts have not yet been taxed. The contributions to Roth retirement accounts have already been taxed.
You are taxed on the non-Roth retirement funds only when you withdraw them from your retirement account. Roth retirement funds and their earnings are generally withdrawn income tax free. There are rules about how much and when you can take distributions out of these accounts.
You do not want to take a distribution too early. If you take a distribution out of your retirement account prior to age 59½, you may be subject to the early withdrawal penalty tax of 10%. You can avoid the early withdrawal penalty in certain circumstances such as if you take distributions out in substantially equal payments over your lifetime; or pursuant to certain divorce orders; or to pay for certain educational, medical or first time home buyer expenses; or to satisfy an IRS tax levy. For Roth IRAs, the early withdrawal penalty is only upon the income portion of the distribution, but also applies when distributions are made within the five tax years after the year the Roth IRA is established.
You do not want to take a distribution too late. Distributions from retirement accounts must begin no later than April 1 following the calendar year you reach age 70½. For employer plans and if you are not at least a 5% owner, you can wait until you retire if it is later. If you do not take your required minimum distribution in any given year, you are subject to an excise tax of 50% of the shortfall. This too-late penalty generally does not apply to Roth IRAs.
You do not want to take too little of a distribution. When you reach your required beginning date of age 70½, you must use the IRS published single life table to determine your distribution unless your spouse is more than 10 years younger than you and is named as your sole beneficiary. In that case, you may use the IRS published joint and last survivor table. This too-little penalty generally does not apply to Roth IRAs.
To determine the required minimum distribution that you must withdraw by December 31 of each year, you just simply divide your account balance as of December 31 of the previous year by the distribution period provided on the appropriate table for your given age. This process continues annually until your death.
Upon your death, if your surviving spouse is named as your beneficiary of your retirement plan account, he or she can generally roll over the balance of your retirement account into his or own rollover IRA and then take distributions after age 70½ over his or her lifetime.
You may name individuals other than your spouse such as children or grandchildren as beneficiaries of your retirement account. They could also receive their share over their lifetimes as set forth in the IRS published single life table, so long as distributions start within one year of your death. Your surviving spouse also has this option, but can delay the distributions until you would have reached age 70½. This is also called a “stretch-out” of the distributions, since the distributions are “stretched out” over the beneficiaries’ lifetimes.
To determine your beneficiary’s required minimum distribution, the balance of your retirement plan account on the previous December 31 is divided by the distribution period on the single life table for the age of your beneficiary at the time of your death. Each year thereafter, the beneficiary just reduces by one, the number from the table, to determine the annual distribution. With this option, if you had already started receiving required minimum distributions during your lifetime, your beneficiaries could use your published life expectancy if it is longer than their own.
If your beneficiaries do not choose to take lifetime distributions out of your retirement account, then they have to complete all withdrawals out of the account within five years of your death. This five year rule also applies to non-individual beneficiaries, such as corporations and most trusts, since these non-individual beneficiaries generally cannot elect lifetime distributions.
Certain trusts can avoid the five year rule for non-individual beneficiaries if the trust is drafted to be a designated beneficiary. As a designated beneficiary, the IRS looks through the trust to the individual trust beneficiaries and their ages to determine lifetime distributions. In order to qualify as a designated beneficiary, your trust must 1) be valid under State law, 2) have only individual beneficiaries, 3) have all beneficiaries identifiable, 4) be delivered to the plan administrator, and 5) be irrevocable upon your death.
Not all trusts are drafted to be designated beneficiaries. If you do name your trust as a beneficiary of your retirement plan account, and your trust is not a designated beneficiary, your retirement plan account must be completely withdrawn within five years of your death and all income taxes must be paid.
We try to give our clients the most options possible. When we prepare trust-based estate plans in our office, we also prepare the retirement plan beneficiary designation forms or letters of direction to ensure that they track with the instructions in the trust.
In these cases, we generally name your trust as your primary beneficiary of these retirement accounts. If you are married, we usually name your spouse as your contingent beneficiary; and if your plan allows second level contingent beneficiaries, we then can also name the kids. If you are single, we usually name the kids as your contingent beneficiaries.
These beneficiary designations give your loved ones the most options after your death. If there is a change in the law or a change in circumstances after your death, your trust can disclaim or give a legal “no thank you” to the retirement account. In that instance, the distribution options would then go directly to the contingent beneficiaries.
If the trust is the retirement account beneficiary, because the trusts we draft in our office are designated beneficiaries, they qualify for the “stretch out” of the retirement account distributions over the beneficiaries’ lifetimes. If the beneficiary does not need to spend the distribution, he or she can keep it in the trust. If the beneficiary wants to forego the protections of the trust and possibly pay less taxes, the beneficiary could opt for a distribution out of the trust
Although I have written about it on many occasions and even though the IRS issued final regulations regarding retirement account minimum distributions in 2002, I am still often questioned by financial advisors, tax preparers, bankers and insurance agents if I meant to name a trust as primary beneficiary of retirement accounts. Yes, I meant to do that!
Usually these discussions about retirement account distributions focus only on minimizing taxes. However, if the focus is only on taxes, your beneficiaries may lose all the protections of your trust. These include divorce protection, creditor protection, probate avoidance, family privacy, re-marriage protection, governmental benefits protection, addiction protection, disability protection, pet protection, cottage protection, incentive trust protection, greedy beneficiary protection, predator spouse protection, minor protection, beneficiary death protection, and many others.
When planning with retirement accounts, it is important to seek counsel of a knowledgeable estate planning and tax professionals in order to keep you in control during your lifetime when you are alive and well; provide for you and your loved ones in the event of your mental disability; and when you are gone, you can give what you have to whom you want, when you want, the way you want; all at the lowest predictable overall cost to you and your loved ones.
By: Matthew M. Wallace, CPA, JD
Published edited November 16, 2014 in The Times Herald newspaper, Port Huron, Michigan as: Don’t touch those IRA funds unless you know the rules