when are taxes reduced on withdrawals from inherited retirement plans? (Natalie Choate)

12 No-Tax and Low-Tax Retirement Plan Distributions

If a recipient qualifies for one of these deals, the distribution may be taxed more favorably than as a 100% taxable chunk of ordinary income.

Natalie Choate, 08/12/2016

Question: A client has inherited a retirement plan account from the deceased participant. The client plans to cash out the account as soon as possible (he needs the money). He has asked me whether the distribution is taxable. My first reaction was yes, the distribution would simply be treated as ordinary income in the year received. But now I'm not sure--is that response correct?

Answer: The answer is probably yes--the distribution is probably fully includible as ordinary income in the recipient's gross income, but here's how to be sure: Run through the following checklist of no-tax and low-tax retirement plan distributions. If your recipient qualifies for one of these deals, the distribution may be taxed more favorably than as a 100% taxable chunk of ordinary income.

This checklist was prepared to cover ANY retirement plan distribution, so some of the items clearly don't apply to your guy. I have added in comments for your particular situation:

1. Roth plans. Qualified distributions from a Roth retirement plan are tax-free. Even nonqualified distributions are tax-free to the extent the distribution represents the return of prior contributions. Is this a Roth account?

2. Tax-free rollovers and transfers. Generally, distributions can be "rolled over" tax-free to another retirement plan, if various requirements are met. But the rollover option is not available to a beneficiary, unless he is the surviving spouse of the deceased IRA owner.

3. Life insurance proceeds, contracts. Distributions of life insurance proceeds from a qualified retirement plan after the participant's death are tax-free to the extent the death benefit exceeds the pre-death cash surrender value of the policy. Distribution of a life insurance policy on an employee's life to that employee during his lifetime may be partly tax-free as a return of his "investment in the contract."

4. Recovery of basis. If the participant has made or is deemed to have made nondeductible contributions to his plan account or IRA, these become his "investment in the contract" in the retirement benefits. This "investment" is nontaxable when distributed to the participant or beneficiary. The problem is figuring out how much, if any, aftertax money the decedent had in the account. For an IRA, start by checking the decedent's last-filed Form 8606 (attached to his/her income tax return). For other plans, ask the plan administrator.

5. Special averaging for lump-sum distributions. Certain qualified retirement plan lump-sum distributions of the benefits of individuals born before Jan. 2, 1936, are eligible for reduced tax. This one never applies to IRAs.

6. Net unrealized appreciation of employer securities (NUA). Certain distributions of employer stock from a qualified retirement plan are eligible for deferred taxation at long-term capital gain rates rather than immediate taxation at ordinary income rates. This one also never applies to IRAs.

7. No tax when annuity contract is passed out. When the plan distributes an annuity contract, there is no tax payable at that time--provided the annuity contract the plan administrator has distributed to the participant (or beneficiary) complies with the minimum distribution rules and is nonassignable by the recipient. Instead, the participant (or beneficiary) pays income tax on the monthly distributions he or she later receives from the insurance company under the contract.

8. Return of IRA contribution. In some circumstances IRA contributions can be returned to the contributor tax-free before the extended due date of the income tax return.

9. Income tax deduction for certain beneficiaries. A beneficiary taking a distribution from an inherited retirement plan is entitled to an income tax deduction for federal estate taxes paid on the benefits, if any.

10. Distribution to charitable entity. If the beneficiary is income tax-exempt, it will not have to pay income tax on the distribution. This one clearly does not apply to an individual!

11. Qualified Health Savings Account Funding Distributions (QHSAFD). An IRA owner is permitted, once per lifetime, to transfer funds tax-free directly from an IRA to a Health Savings Account (HSA). But this option is not available for a beneficiary.

12. QDROs and divorce-related IRA divisions. An individual can transfer all or part of his qualified retirement plan benefits or IRA to his spouse without being liable for income taxes on the transfer if the transfer is pursuant to a "qualified domestic relations order" (QDRO) (in the case of a qualified plan) or similar divorce court order (in the case of an IRA).

In summary: Any retirement plan distribution, whether it's a lump-sum distribution of the entire account or a partial distribution, is taxable. That is to say, it is fully includible as ordinary income in the gross income of the participant or beneficiary who received it--unless one of the above 12 exceptions applies!

Where to read more: "¶" symbols refer to sections of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011; http://www.ataxplan.com/). Regarding the income tax treatment of distributions from Roth IRAs and designated Roth accounts, see ¶ 5.2.03 and ¶ 5.7.04. See ¶ 2.6 for rollovers by the participant, ¶ 3.2 for rollovers by the surviving spouse, and ¶ 4.2.04 for rollovers by other beneficiaries. See ¶ 2.6.08 for why certain IRA-to-IRA transfers are not taxable because they are not considered to be distributions at all. Regarding the income tax treatment of distributions of and under qualified plan-owned life insurance policies, see Natalie Choate's Special Report: When Insurance Products Meet Retirement Plans (http://www.ataxplan.com/). See ¶ 2.2 regarding how aftertax contributions are recovered tax-free from a retirement plan. See ¶ 2.4.06 regarding special treatment of lump-sum distributions for individuals born before 1936. See ¶ 2.5 regarding special treatment of "NUA" in distributions of plan-owned employer stock. Regarding tax-free distribution of annuity contracts, see theSpecial Report: When Insurance Products Meet Retirement Plans. See ¶ 2.1.08(D), (F), regarding tax treatment of returned IRA contributions. See ¶ 4.6.04-¶ 4.6.08 regarding a beneficiary's income tax deduction for estate taxes paid on retirement benefits. See ¶ 7.5.01-¶ 7.5.04 and ¶ 7.5.08 regarding paying retirement plan death benefits to an income-tax-exempt (charitable) entity. Regarding the one-time ability to use an IRA distribution to directly fund a health savings account, see Internal Revenue Code § 223 and § 408(d)(9), and IRS Notice 2008-51, 2008-25 IRB 1163. For information regarding QDROs and divorce-related divisions of IRAs, see § 402(e)(1), § 414(p), and § 408(d)(6) of the Internal Revenue Code and Chapter 36 of The Pension Answer Book by Stephen Krass.

Don't make these retirement account mistakes (Forbes)

Retirement Account Mistakes--Not For Dummies
Janet Novack

a guide to some of the traps created by the insanely complicated rules surrounding IRAs, 401(k)s and other retirement accounts


No, this is not another story lecturing you to save more, diversify, control your investment costs, or ignore the hot stock tip from your brother in law who did time for securities fraud. You’re no dummy.

What this is, instead, is a guide to some of the traps created by the insanely complicated rules surrounding IRAs, 401(k)s and other retirement accounts —traps that can snare not only smart investors, but also financial advisors, lawyers, accountants, and yes, even the Internal Revenue Service itself.

Lest you think that’s hyperbole, consider this: a U.S. Tax Court judge  ruled last year that a tax lawyer couldn’t use an IRS publication in his defense, because the IRS itself  had misinterpreted a provision of the law relating to IRA rollovers. “Even the IRS is confused,’’ marvels CPA Ed Slott, who makes a nice living training other financial pros about IRA rules and fixing the mistakes they and their clients make.

The sad fact is a normal human being not in Slott’s business can’t know all the rules. But taking a few minutes to acquaint yourself with the more common mistakes can help keep you safe and out of the IRS’ penalty zone. At the least, you’ll have a sense of when you need to consult IRS publications (which, despite that court ruling, you can usually rely on) or speak to a retirement account specialist at the financial institution where your IRA or 401(k) is held, or maybe even pay an expert for help.  Two key IRS Publications are  590a on IRA contributions and 590b on IRA distributions.  (There used to be just one publication 590, but it was so long, what with all the rules, that the IRS split it into two.) Note that part of what makes this all so complicated is that there are more than a dozen different types of retirement accounts, each with its own sometimes differing rules. So to be fair, Congress, not the IRS, deserves most of the blame for this mess.

To assemble my list of  25 Retirement Account Mistakes Smart People Make, I  consulted Slott and Robert Keebler, another CPA/IRA expert, and reviewed court cases, private letter rulings and government reports. Most of the mistakes  relate to early withdrawals, inherited IRAs, required minimum distributions and account rollovers. But  you can also get yourself in trouble putting the wrong thing in an IRA. (Tempted to hold gold in your IRA? The gold must be of a certain type and must  be kept with your IRA custodian, not under your bed.) Of course, this list of 25 mistakes is by no means exhaustive. Here’s a bonus tip that’s not on it: never ever, ever put a master limited partnership in a retirement account.

The discussion below offers some extra background on two areas where mistakes are particularly common.

Early withdrawals woes

Withdrawals taken from a traditional IRA or 401(k) before age 59 ½ are generally subject to not only ordinary income taxes, but also a 10% penalty  on the taxable amount. Fortunately, there are 11 separate exceptions, detailed here, that can get you out of the 10% extra hit. On their 2013 tax returns, 1.7 million taxpayers reported that they took early distributions, but only 1.2 million indicated they were subject to the additional 10% tax penalty, the IRS estimates.

The problem is that some of those 500,000 folks who reported themselves exempt from the penalty will get audited by the IRS and then hit with the 10% early withdrawal penalty and possibly an additional penalty for negligence.  That’s because they got the exceptions wrong. One common mistake: thinking you can take an early penalty free withdrawal from a 401(k) to pay college or graduate school bills, or to buy a first home, when in fact these penalty exceptions only apply to IRA withdrawals.

In one classic case, an accountant who had left Deloitte to earn his PhD  got hit with the 10% penalty for using $30,000 from his 401(k) to finance his graduate studies and buy a first home. The tax court rejected his argument that since he could have transferred the 401(k) money to an IRA first, and then used it penalty free for those very purposes, he shouldn’t have to take the extra 10% hit. The judge said he sympathized with the accountant’s confusion, and agreed that the law is “highly technical,’’ but concluded that, well,  the law is the law.

Another common misconception Slott flags: that you can get out of the 10% penalty because you took the money out to deal with a general financial hardship. The widespread confusion may stem from the fact that some employers allow early “hardship” withdrawals from 401(k)s. But that doesn’t get the employee out of paying either tax or the 10% early withdrawal penalty.

If you have a financial hardship, there may be other ways to tap retirement early penalty free. For example, if you’re 55 or older and lose (or leave) your job, you can tap money from your 401(k) penalty free– so long as you don’t roll it into an IRA first. (Yet another trap.)


Death traps

With a growing share of families’ assets in retirement accounts, mistakes made while passing them on are a big deal.  One easy to understand and fix mistake:  failing to keep your beneficiary forms up to date. The form on file with your IRA custodian, not any other estate document, and not an unfiled form you’ve stuck in your desk drawer, determines who gets your IRA.  If you want to make sure your ex-spouse (or an ungrateful child) doesn’t get your IRA, take him or her off that form as well as out your will.

Another batch of inheritance mistakes has to do with “stretch” IRAs. You can roll over an inherited IRA into your own name only if you inherit it from a spouse. (Although you should usually wait until you’re  older than 59 ½ to roll over your late spouse’s IRA  because withdrawals from an inherited IRA can be taken at any age without paying the 10% early withdrawal penalty. Once you roll an account over into your own name, you lose that early withdrawal flexibility.) But any individual beneficiary can retitle an IRA as an “inherited IRA” and stretch out withdrawals over his or her own life expectancy, thus gaining decades of tax deferred, or (in the case of a Roth IRA tax free) growth.

Although some in Washington, including the Obama Administration, would like to eliminate the stretch IRA,  this valuable tax break is available for now. Available, that is, so long as you (the IRA owner) or your heirs don’t make any mistakes.  One huge no-no is rolling an IRA inherited from someone other than a spouse into your own name. If you do that, the whole amount is immediately taxable. Instead, as a nonspousal heir, you must  retitle the IRA, including the original owner’s name and that it is inherited, e.g., “John X. Smith II,  deceased, inherited IRA for the benefit of John X Smith III.”  Similarly, if a trust is named as an IRA beneficiary, you can’t actually transfer the IRA into the trust. Instead, you retitle the IRA and deposit the yearly payouts in the trust. (Note that if you want to change the financial service company holding an inherited IRA,  you must do it in a trustee to trustee transfer.)

What about the mistakes IRA owners make that limit their heirs’ ability to stretch out the account’s life? A common one is naming your estate as your beneficiary on an IRA form. In many cases, that will force the IRA to be distributed within five years, cutting short the potential tax deferral or tax free growth. (The exact rule is this: funds in a Roth IRA left to an estate must be withdrawn within five years. Period. For a  traditional IRA left to an estate, if the deceased turned 70 1/2—the age at which a traditional IRA owner must start taking required minimum distributions–before his death, payments can be stretched out for what would have been his remaining life expectancy, according to IRS tables. That is usually more than five years, but it is probably less than the life expectancy of individual heirs, had they been named as individual beneficiaries.)

A related mistake is neglecting to name a contingent beneficiary. The problem? Should your primary beneficiary die before you, the IRA will likely go to your estate, again cutting short tax deferral. Moreover, if you name a primary beneficiary (say your child) and a contingent beneficiary (say your grandchild), then your child has the option of  ”disclaiming” the IRA in favor of your grandchild.

Still other mistakes have to do with not taking the proper required minimum distributions from inherited IRAs. If you’ve just inherited an account, read William Baldwin’s 11 Step Instruction Guide To Inherited IRAs, Inherited Roth Accounts And RMDs. And for in-depth advice on the best way to pass on a retirement account, spring for a copy of  Estate Planning Smarts by lawyer and former Forbes Senior Editor Deborah L. Jacobs.

Inherited IRA Tips (Forbes Magazine)

http://onforb.es/13LhpwX

Inherited IRA Rules: What You Need To Know

Many people who inherit IRAs are unfamiliar with the rules that apply to them. My article for Forbes magazine, “Five Rules For Inherited IRAs,” gives a broad overview of the subject. In this post I answer questions from two readers with concerns that affect other people, too.

Michael Twersky, a 26-year-old consultant in New York, asks:

I inherited a $15,000 traditional IRA from my father. As a child beneficiary, will I avoid income tax upon withdrawal if I wait until I’m 60? If not, would it be better to withdraw now while I’m still in a pretty low tax bracket?

You don’t have the option of waiting until you are 60 to take withdrawals. Generally, non-spousal IRA heirs must withdraw a minimum amount each year, starting by Dec. 31 of the year after the IRA owner died. Note: This is true whether it’s a traditional IRA or a Roth (a common misconception).

To calculate this distribution, you take the balance on Dec. 31 of the previous year and divide it by the inheritor’s life expectancy, as listed in the IRS’ “Single Life Expectancy” table. (You can find the table in IRS Publication 590, “Individual RetirementArrangements (IRAs),” which downloads here as a PDF.) Unless the account is a Roth, there is income tax on this required payout.

Don’t make the mistake, as some people do, of using the number from the table to figure a percentage. In subsequent years, you simply take the number you used in the first year and reduce it by one before doing the division.

If they choose to, IRA inheritors can draw out these minimum required distributions over their own expected life spans, as explained here. This is known as the stretch-out – a financial strategy to extend the tax advantages of an IRA. Stretching out the IRA gives the funds extra years and potentially decades of income-tax deferred growth in a traditional IRA or tax-free growth in a Roth IRA. This is a wonderful investment opportunity.

If you weren’t aware of the minimum distribution requirement and have not taken the required withdrawals, see my post, “What Happens When IRA Inheritors Miss A Key Deadline.”

6/09/2010 @ 6:00PM

Five Rules For Inherited IRAs

Before they inherited $3 million in retirement accounts from their father last year, the three middle-aged siblings didn’t know it was possible for heirs to stretch out the tax benefits of such accounts for decades. But what they also discovered after his death is that doing this is tricky–and in some cases impossible–if the original owner of the accounts didn’t fill out his beneficiary forms just so. Although their 78-year-old dad was a lawyer, “He may never have realized that it made any difference,” says a daughter, who has spent days trying to sort it all out.

Whether you’re inheriting an IRA or aiming to protect your own heirs, you’ve got to dance the IRS jig.

1. First, do no harm.

If you inherit a retirement account, don’t do anything until you know exactly what rules apply. With your own IRA you can take the money out and redeposit it in another IRA within 60 days without penalty. Not so an inherited IRA. All movement of money must be from one IRA custodian to another–be sure to specify a “trustee-to-trustee” transfer. Moreover, unless you’ve inherited from a spouse, you must retitle the IRA, including the original owner’s name and indicating it is inherited, e.g., “Daddy Warbucks, deceased, inherited IRA for the benefit of Little Orphan Annie, beneficiary.”

If two or more people are named as beneficiaries, ask the custodian to split it into separate inherited IRAs. That avoids investment squabbles and allows a longer stretch-out for the younger heirs.

2. Beneficiary forms rule.

The beneficiary form on file with the custodian of an IRA controls both who inherits it and its ability to be stretched out. If people other than a spouse are named as heirs, they must begin taking distributions from the account by Dec. 31 of the year after inheriting, but they can draw these out over their own expected life spans, enjoying decades of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA. To give your heirs maximum flexibility, name both primary and alternate individual beneficiaries–say, your spouse as primary and kids as alternates or your kids as primary and grandkids as alternates. Your primary beneficiary then has the option of “disclaiming” or turning down the account, enabling it to pass to the younger alternate.

By contrast, if an estate is named as beneficiary, tax deferral is cut short. If it’s a Roth IRA, all funds must be withdrawn within five years. For a traditional IRA the same rule applies unless the former owner was already 70 1/2–the age at which a traditional IRA owner must begin cashing out. In that case the distribution rate for the heir is based on the age of the person who died, notes Rockville Centre, N.Y. CPA Edward Slott.

What if there’s no beneficiary form on file? Heirs are at the mercy of the IRA custodian’s default policy. Vanguard Group and Ameriprise award an IRA first to a living spouse and then to the estate. Merrill Lynch sends it straight to the estate. Few custodians will pass on an IRA directly to the kids without a beneficiary form.

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3. Employer plans are different.

By federal law the money in a 401(k) goes to a spouse, unless he or she has signed a form waiving rights to it. But some employer plans will allow the funds to go straight to the kids if no spouse is living and no beneficiary form is on file. On the other hand, employers usually won’t let nonspouse beneficiaries stretch out 401(k) withdrawals. These beneficiaries should ask the employer to transfer the money into an inherited IRA. They can then divide it into separate inherited iras, says Natalie B. Choate, a lawyer with Nutter McClennen & Fish in Boston.

4. Spouses have more options.

A spouse who inherits–let’s assume it’s the wife–has an option not available to other inheritors. She can roll the assets into her own IRA and postpone distributions from a traditional IRA until she turns 70 1/2. The catch is, like other IRA owners she may have to pay a 10% early-withdrawal penalty if she takes money before age 59 1/2 from her own IRA. So a young widow should generally wait until after reaching 59 1/2 to do the rollover, says Brooklyn, N.Y. CPA Barry C. Picker. Meanwhile, she doesn’t have to take out any money until her late spouse would have turned 70 1/2.

5. Watch for distribution traps.

If the late IRA owner was 70 1/2 or older, beneficiaries must make sure the owner’s mandatory distribution for the year of death is withdrawn before doing anything else. When nonspouse beneficiaries take their own payouts, they should be aware of two quirks. First, if the estate paid estate tax, they may be able to take an itemized deduction to offset some IRA income. Second, the minimum is calculated differently than for your own IRA. You take the balance on Dec. 31 of the previous year and divide it by your life expectancy listed in the IRS’ “single life expectancy” table, rather than the table used by IRA owners. The next year you use the same life expectancy, minus a year. (With your own IRA, you take a new life expectancy from a table each year.)