Frequently there are issues that come up in our office that affect the taxability of IRA distributions. We regularly get questions from our clients regarding their IRAs and the options that are available to them and who they should name as IRA beneficiaries. Today we will discuss some of these issues.
IRA charitable contribution reduces taxes.
If you are over age 70½, you can direct your IRA trustee to make qualified charitable distributions (QCDs) from your IRAs to eligible beneficiaries, which do not include donor-advised funds, grant-making foundations or charitable gift annuities. The annual limit is $100,000, per person, or $200,000 per married couple.
QCDs are not taxable on your income tax return, but you also do not get the charitable contribution itemized deduction. QCDs are also not subject charitable contribution limitations and are ignored for phase-outs of any deduction, exclusion, or tax credit. QCDs also count towards your annual IRA required minimum distribution (RMD).
In Washington, the “Charities Helping Americans Regularly Throughout the Year Act of 2017,” has been introduced in the Senate to encourage charitable giving. This bill, also called the “CHARITY Act,” is currently in committee and would allow QCDs to donor advised funds, such as those held by the Community Foundation of St. Clair County.
One IRA rollover per year.
If you receive a distribution from an IRA or other qualified retirement plan, and re-deposit it to an IRA or other qualified retirement plan within 60 days of the distribution, it is not included in your taxable income. You are only allowed one of these rollovers per year. Any additional rollovers in any one year are fully taxable. However, there are no limitations on direct transfers from one IRA or other qualified retirement plan to another IRA or other qualified retirement plan. You can have as many as you want with no tax effect.
10% early withdrawal penalty tax can be avoided.
If you take a distribution out of your IRA or other qualified retirement plan before age 59½, not only do you have to pay income tax on the distribution, you have to pay an additional 10% early withdrawal penalty tax. However, you can avoid the 10% early withdrawal penalty tax for the following distributions:
- for your disability;
- as part of a series of substantially equal periodic payments;
- due to your loss of employment;
- if less than or equal to your deductible medical expenses;
- for health insurance premiums if you are unemployed;
- for qualified higher education expenses of you or your spouse, children or grandchildren;
- for first-time purchase of a principal residence by you or your spouse, child or grandchild;
- subject to loan agreement;
- if you are a beneficiary of an estate of the participant on or after the participant’s death;
- as a participant of an employee stock ownership plan;
- pursuant to Federal tax levy on plan;
- to alternate payee under qualified domestic relations order;
- if you are a Federal retiree electing lump sum credit and reduced annuity;
- to correct excess contributions;
- upon conversion from traditional to Roth IRA
Beneficiary IRA stretch-outs reduce taxes.
If you are a beneficiary of an IRA, you generally have to take the whole balance out of the IRA by December 31 following the 5th anniversary of the participant’s death and pay income taxes on it. This usually puts you in a higher tax bracket. If however, you set up an inherited IRA and start distributions right away, you may be able to stretch out those distributions over your lifetime, keeping you in a lower tax bracket and allowing the inherited IRA to grow tax-deferred. If the IRA custodian or trustee does not allow you to stretch out distributions under the options provided by the tax code, transfer the inherited IRA to a custodian or trustee that does.
Inherited IRAs do not offer the creditor protection of participant IRAs and are fully accessible by creditors of the beneficiary owner. In addition, after the death of the inherited IRA’s original beneficiary owner, the next beneficiaries cannot do any additional stretch-outs.
Must probate inherited IRAs of minor beneficiaries.
Minors generally cannot legally hold title to financial accounts. If an IRA beneficiary is a minor, a conservator must be appointed by the probate court to hold the beneficiary IRA funds until the beneficiary is no longer a minor. When the beneficiary turns 18, they gain all the wisdom and insight of adulthood and can handle large sums of money and are thenentitled to withdraw the entire balance of the inherited IRA funds.
Spousal IRA rollovers defer taxes.
Spouses are the most favored of all IRA beneficiaries. If your spouse dies and names you as IRA beneficiary, you can treat it as an inherited IRA and take distributions in accordance with those rules. Or you can roll over the IRA into a spousal rollover IRA of your own. If you do this and you are under age 70½, you can defer all distributions and taxes on those distributions until you are age 70½. As a spousal rollover IRA, the funds are generally not accessible by your creditors. In addition, your IRA beneficiaries will be able to stretch out the IRA distributions in an inherited IRA after your death.
Naming a trust as IRA beneficiary offers many protections.
By naming your trust as the primary beneficiary of your IRA, you can provide lots of protections for your beneficiaries that you cannot get with inherited IRAs or spousal rollover IRAs. These include creditor protection, divorce protection, re-marriage (Bambi & Thor) protection, addiction protection, disability protection, minor/young adult protections, governmental benefit preservation (special needs) trusts, pet trusts, family real estate trusts, education trusts, incentive trusts and lack of money-management skills protection.
With lifetime trusts properly drafted as designated beneficiaries under the IRA RMD rules, these protections and the stretch-out of the IRA distributions can continue for the lifetimes of the beneficiaries. To keep the overall tax costs down, you have the option of distributing the IRA distributions to the beneficiary, to be taxed at the beneficiary’s lower tax rate. And if you name your spouse and kids as contingent beneficiaries, you still have the option of spousal rollover IRAs and inherited IRAs if your trust disclaims the IRAs.By Matthew M. Wallace, CPA, JD
By Matthew M. Wallace, CPA, JD
Published edited July 9, 2017 in The Times Herald newspaper Port Huron, Michigan as: Right strategy can help avoid IRA taxes