Secure Act 2.0: RMD Start Age Pushed Back to 73 Starting in 2023

On December 23, 2022, Congress passed the Secure Act 2.0, which moved the required minimum distribution (RMD) age from the current age of 72 out to age 73 starting in 2023.  They also went one step further and included in the new law bill an automatic increase in the RMD beginning in 2033, extending the RMD start age to 75.

This is the second time within the past 3 years that Congress has changed the start date for required minimum distributions from IRAs and employer-sponsored retirement plans.  Here is the history and the future timeline of the RMD start dates:

1986 – 2019:     Age 70½

2020 – 2022:     Age 72

2023 – 2032:     Age 73

2033+:               Age 75 

You can also determine your RMD start age based on your birth year:

1950 or Earlier:   RMD starts at age 72

1951 – 1959:      RMD starts at age 73

1960 or later:      RMD starts at age 75   

What Is An RMD?

An RMD is a required minimum distribution.   Once you hit a certain age, the IRS requires you to start taking a distribution each year from your various retirement accounts (IRA, 401(K), 403(b), Simple IRA, etc.) because they want you to begin paying tax on a portion of your tax-deferred assets whether you need them or not. 

What If You Turned Age 72 In 2022?

If you turned age 72 anytime in 2022, the new Secure Act 2.0 does not change the fact that you would have been required to take an RMD for 2022.  This is true even if you decided to delay your first RMD until April 1, 2023, for the 2022 tax year.    

If you are turning 72 in 2023, under the old rules, you would have been required to take an RMD for 2023; under the new rules, you will not have to take your first RMD until 2024, when you turn age 73.

Planning Opportunities

By pushing the RMD start date from age 72 out to 73, and eventually to 75 in 2033, it creates more tax planning opportunities for individuals that do need to take distributions out of their IRAs to supplement this income.  Since these distributions from your retirement account represent taxable income, by delaying that mandatory income could allow individuals the opportunity to process larger Roth conversions during the retirement years, which can be an excellent tax and wealth-building strategy. 

Delaying your RMD can also provide you with the following benefits:

• Reduce the amount of your Medicare premiums

• Reduce the percentage of your social security benefit that is taxed

• Make you eligible for tax credits or deductions that you would have phased out of

• Potentially allow you to realize a 0% tax rate on long-term capital gains

• Continue to keep your pre-tax retirement dollars invested and growing

Additional Secure Act 2.0 Articles

• Mandatory Roth Catch-Up Contributions For High Wage Earners

• New Roth Simple IRA Contributions Beginning in 2023

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Pension Income and Retirement Account Withdrawals Can Impact Unemployment Benefits

How Pension Income and Retirement Account Withdrawals Can Impact Unemployment Benefits

As the economy continues to slow, unemployment claims continue to rise at historic rates.  Due to this expected increase in unemployment, the CARES Act included provisions for Coronavirus related distributions which give people access to retirement dollars with more favorable tax treatment.  Details on these distributions can be found here.  With retirement dollars becoming more accessible with the CARES Act, a common question we are receiving is “Will a retirement distribution impact my Unemployment Benefits?”.

Unemployment Benefits vary from state to state and therefore the answer to this question can be different depending on the state you reside in.  This article will focus on New York State Unemployment Benefits, but a lot of the items discussed may be applied similarly in other states.

The answer to this question also depends on the type of retirement account you are receiving money from so we will touch on the most common. 

Note:  Typically, to qualify for unemployment insurance benefits, you must have been paid minimum wage during the “base period”.  Base period is defined as the first four quarters of the last five calendar quarters prior to the calendar quarter which the claim is effective.  “Base period employer” is any employer that paid the claimant during the base period.

Pension Reduction

Money received from a pension that a base period employer contributed to will result in a dollar for dollar reduction in your unemployment benefit.  Even if you partially contributed to the pension, 100% of the amount received will result in an unemployment benefit reduction.

If you were the sole contributor to the pension, then the unemployment benefit should not be impacted.

Even if you are retired from a job and receiving a pension, you may still qualify for unemployment benefits if you are actively seeking employment.

Qualified Retirement Plans (examples; 401(k), 403(b))

If the account you are accessing is from a base period employer, a withdrawal from a qualified retirement plan could result in a reduction in your unemployment benefit.  It is common for retirement plans to include some type of match or profit-sharing element which would qualify as an employer contribution.  Accounts which include employer contributions may result in a reduction of your unemployment benefit.

We recommend you contact the unemployment claims center to determine how these distributions would impact your benefit amount before taking them.

IRA

No unemployment benefit rate reduction will occur if the distribution is from a qualified IRA.Knowing there is no reduction caused by qualified IRA withdrawals, a common practice is rolling money from a qualified retirement plan into an IRA and then accessing it as needed.  Once you are no longer at the employer, you are often able to take a distribution from the plan.  Rolling it into an IRA and accessing the money from that account rather than directly from the retirement plan could result in a higher unemployment benefit. 

NYS Unemployment Home Page

National Unemployment Resource Finder - careeronestop

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

$5,000 Penalty Free Distribution From An IRA or 401(k) After The Birth Of A Child or Adoption

New parents have even more to be excited about in 2020.  On December 19, 2019, Congress passed the SECURE Act, which now allows parents to withdraw up to $5,000 out of their IRA’s or 401(k) plans following the birth of their child without having to pay the 10% early withdrawal penalty.  To take advantage of this new distribution option, parents will need to know: 

• Effective date of the change

• Taxes on the distribution

• Deadline to make the withdrawal

• Is it $5,000 for each parent or a total per couple?

• Do all 401(k) plans allow these types of distributions?

• Is it a per child or is it a one-time event?

• Can you repay the money to your retirement account at a future date?

• How does it apply to adoptions?

This article will provide you with answers to these questions and also provide families with advanced tax strategies to reduce the tax impact of these distributions. 

SECURE Act

The SECURE Act was passed in December 2019 and Section 113 of the Act added a new exception to the 10% early withdrawal penalty for taking distributions from retirement accounts called the “Qualified Birth or Adoption Distribution.”

Prior to the SECURE Act, if you were under the age of 59½ and you distributed pre-tax money from an IRA or 401(k) plan, in addition to having to pay ordinary income tax on the amount distributed, you were also hit with a 10% early withdrawal penalty from the IRS.   The IRS prior to the SECURE Act did have a list of exceptions to the 10% penalty but having a child or adopting a child was not on that list.  Now it is.

How It Works

After the birth of a child, a parent is allowed to distribute up to $5,000 out of either an IRA or a 401(k) plan.  Notice the word “after”.  You are not allowed to withdraw the money prior to the child being born.  New parents have up to 12 months following the date of birth to process the distribution from their retirement accounts and avoid the 10% early withdrawal penalty.

Example: Jim and Sarah have their first child on May 5, 2020.  To help with some of the additional costs of a larger family, Jim decides to withdraw $5,000 out of his rollover IRA.  Jim’s window to process that distribution is between May 5, 2020 – May 4, 2021.

The Tax Hit

Assuming Jim is 30 years old, he would avoid having to pay the 10% early withdrawal penalty on the $5,000 but that $5,000 still represents taxable income to him in the year that the distribution takes place.  If Jim and Sarah live in New York and make a combined income of $100,000, in 2020, that $5,000 would be subject to federal income tax of 22% and state income tax of 6.45%, resulting in a tax liability of $1,423.

Luckily under the current tax laws, there is a $2,000 federal tax credit for dependent children under the age of 17, which would more than offset the total 22% in fed tax liability ($1,100) created by the $5,000 distribution from the IRA.  Essentially reducing the tax bill to $323 which is just the state tax portion.

TAX NOTE: While the $2,000 fed tax credit can be used to offset the federal tax liability in this example, if the IRA distribution was not taken, that $2,000 would have reduced Jim & Sarah’s existing tax liability dollar for dollar.

For more info on the “The Child Tax Credit” see our article:  More Taxpayers Will Qualify For The Child Tax Credit

$5,000 Per Parent

But it gets better. The $5,000 limit is available to EACH parent meaning if both parents have a pre-tax IRA or 401(k) plan, they can each distribute up to $5,000 from their retirement accounts within 12 months following the birth of their child and avoid the 10% early withdrawal penalty.

ADVANCED TAX STRATEGY:  If both parents are planning to distribute the full $5,000 out of their retirement accounts and they are in a medium to high tax bracket, it may make sense to split the two distributions between separate tax years.

Example:  Scott and Linda have a child on October 3, 2020 and they both plan to take the full $5,000 out of their IRA accounts.  If they are in a 24% federal tax bracket and they process both distributions prior to December 31, 2020, the full $10,000 would be taxable to them in 2020.  This would create a $2,400 federal tax liability.  Since this amount is over the $2,000 child tax credit, they will have to be prepared to pay the additional $400 federal income tax when they file their taxes since it was not fully offset by the $2,000 tax credit.

In addition, by taking the full $10,000 in the same tax year, Scott and Linda also run the risk of making that income subject to a higher tax rate.  If instead, Linda processes her distribution in November 2020 and Scott waits until January 2021 to process his $5,000 IRA distribution, it could result in a lower tax liability and less out of pocket expense come tax time.

Remember, you have 12 months following the date of birth to process the distribution and qualify for the 10% early withdrawal exemption.

$5,000 For Each Child

This 10% early withdrawal exemption is available for each child that is born.  It does not have a lifetime limit.

Example: Building on the Scott and Linda example above, they have their first child October 2020, and both of them process a $5,000 distribution from their IRA’s avoiding the 10% penalty.  They then have their second child in November 2021.  Both Scott and Linda would be eligible to withdraw another $5,000 each out of their IRA or 401(k) within 12 months after the birth of their second child and again avoid having to pay the 10% early withdrawal penalty.

IRS Audit

One question that we have received is “Do I need to keep track of what I spend the money on in case I’m ever audited by the IRS?” The short answer is “No”. The new law does not require you to keep track of what the money was spent on.  The birth of your child is the “qualifying event” which makes you eligible to distribute the $5,000 penalty free. 

Not All 401(k) Plans Will Allow These Distributions

Starting in 2020, this 10% early withdrawal exception will apply to all pre-tax IRA accounts but it does not automatically apply to all 401(k), 403(b), or other types of qualified employer sponsored retirement plans.

While the SECURE Act “allows” these penalty free distributions to be made, companies can decide whether or not they want to provide this special distribution option to their employees.  For employers that have existing 401(k) or 403(b) plans, if they want to allow these penalty free distributions to employees after the birth of a child, they will need to contact their third-party administrator and request that the plan be amended.

For companies that intend to add this distribution option to their plan, they may need to be patient with the timeline for the change. 401(k) providers will most likely need to update their distribution forms, tax codes on their 1099R forms, and update their recordkeeping system to accommodate this new type of distribution.

Ability To Repay The Distribution

The new law also offers parents the option to repay the amounts to their retirement account that were distributed due to a qualified birth or adoption.   The repayment of the amounts previously distributed from the IRA or 401(k) would be in addition to the annual contribution limits.  There is not a lot of clarity at this point as to how these “repayments” will work so we will have to wait for future guidance from the IRS on this feature. 

Adoptions

The 10% early withdrawal exception also applies to adoptions. An individual is allowed to take a distribution from their retirement account up to $5,000 for any children under the age of 18 that is adopted.  Similar to the timing rules of the birth of a child, the distribution must take place AFTER the adoption is finalized, but within 12 months following that date.  Any money distributed from retirement accounts prior to the adoption date will be subject to the 10% penalty for individuals under the age of 59½. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

IRA RMD Start Date Changed From Age 70 ½ to Age 72 Starting In 2020

The SECURE Act was passed into law on December 19, 2019 and with it came some big changes to the required minimum distribution (“RMD”) requirements from IRA’s and retirement plans.  Prior to December 31, 2019, individuals were required to begin taking mandatory distributions from their IRA’s, 401(k), 403(b), and other pre-tax retirement accounts starting in the year that they turned age 70 ½.  The SECURE Act delayed the start date of the RMD’s to age 72.   But like most new laws, it’s not just a simple and straightforward change. In this article we will review: 

• Old Rules vs New Rules surrounding RMD’s

• New rules surrounding Qualified Charitable Distributions from IRA’s

• Who is still subject to the 70 ½ RMD requirement?

• The April 1st delay rule

Required Minimum Distributions

A quick background on required minimum distributions, also referred to as RMD’s.  Prior to the SECURE Act, when you turned age 70 ½ the IRS required you to take small distributions from your pre-tax IRA’s and retirement accounts each year.  For individuals that did not need the money, they did not have a choice. They were forced to withdraw the money out of their retirement accounts and pay tax on the distributions.   Under the current life expectancy tables, in the year that you turned age 70 ½ you were required to take a distribution equaling 3.6% of the account balance as of the previous year end. 

With the passing of the SECURE Act, the start age from these RMD’s is now delayed until the calendar year that an individual turns age 72. 

OLD RULE: Age 70 ½ RMD Begin Date

NEW RULE: Age 72 RMD Begin Date 

Still Subject To The Old 70 ½ Rule

If you turned age 70 ½ prior to December 31, 2019, you will still be required to take RMD’s from your retirement accounts under the old 70 ½ RMD rule.  You are not able to delay the RMD’s until age 72.

Example: Sarah was born May 15, 1949.  She turned 70 on May 15, 2019 making her age 70 ½ on November 15, 2019.  Even though she technically could have delayed her first RMD to April 1, 2020, she will not be able to avoid taking the RMD’s for 2019 and 2020 even though she will be under that age of 72 during those tax years.

Here is a quick date of birth reference to determine if you will be subject to the old 70 ½ start date or the new age 72 start date:

• Date of Birth Prior to July 1, 1949: Subject to Age 70 ½ start date for RMD

• Date of Birth On or After July 1, 1949: Subject to Age 72 start date for RMD

April 1 Exception Retained

OLD RULE:  In the the year that an individual turned age 70 ½, they had the option to delay their first RMD until April 1st of the following year.  This is a tax strategy that individuals engaged in to push that additional taxable income associated with the RMD into the next tax year. However, in year 2, the individual was then required to take two RMD’s in that calendar year: One prior to April 1st for the previous tax year and the second prior to December 31st for the current tax year. 

NEW RULE:  Unchanged. The April 1st exception for the first RMD year was retained by the SECURE Act as well as the requirement that if the RMD was voluntarily delayed until the following year that two RMD’s would need be taken in the second year. 

Qualified Charitable Distributions (QCD)

OLD RULES: Individuals that had reached the RMD age of 70 ½ had the option to distribute all or a portion of their RMD directly to a charitable organization to avoid having to pay tax on the distribution.  This option was reserved only for individuals that had reached age 70 ½.  In conjunction with tax reform that took place a few years ago, this has become a very popular option for individuals that make charitable contributions because most individual taxpayers are no longer able to deduct their charitable contributions under the new tax laws.

 

NEW RULES: With the delay of the RMD start date to age 72, do individuals now have to wait until age 72 to be eligible to make qualified charitable distributions?  The answer is thankfully no.  Even though the RMD start date is delayed until age 72, individuals will still be able to make tax free charitable distributions from their IRA’s in the calendar year that they turn age 70 ½. The limit on QCDs is still $100,000 for each calendar year.

 

NOTE: If you plan to process a qualified charitable distributions from your IRA after age 70 ½, you have to be well aware of the procedures for completing those special distributions otherwise it could cause those distributions to be taxable to the owner of the IRA.  See the article below for more on this topic:

 Article: Lower Your Tax Bill By Directing Your Mandatory IRA Distributions To Charity

ANOTHER NEW RULE: There is a second new rule associated with the SECURE Act that will impact this Qualified Charitable Distribution strategy.  Under the old tax law, individuals were unable to contribute to Traditional IRA’s past the age of 70 ½.  The SECURE Act eliminated that rule so individuals that have earned income past age 70 ½ will be eligible to make contributions to Traditional IRAs and take a tax deduction for those contributions.

As an anti-abuse provision, any contributions made to a Traditional IRA past the age of 70 ½ will, in aggregate, dollar for dollar, reduce the amount of your qualified charitable distribution that is tax free.

Example:  A 75 year old retiree was working part-time making $20,000 per year for the past 3 years. To reduce her tax bill, she contributed $7,000 per year to a traditional IRA which is allowed under the new tax laws.  This year she is required to take a $30,000 required minimum distribution (RMD) from her retirement accounts and she wants to direct that all to charity to avoid having to pay tax on the $30,000. Because she contributed $21,000 to a traditional IRA past the age of 70 ½,  $21,000 of the qualified charitable distribution would be taxable income to her, while the remaining $9,000 would be a tax free distribution to the charity.

$30,000 QCD  –  $21,000 IRA Contribution After Age 70 ½ =  $9,000 tax free QCD

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How To Use Your Retirement Accounts To Start A Business

One of the most challenging aspects of starting a new business is finding the capital that is needed to support your expenses as you begin to build up a revenue stream since it’s not always easy to ask friends and family for money to invest in a startup business.  Luckily, for new entrepreneurs, there are some little-known ways on how you can use retirement accounts as a funding source for your new business. However, before you cash out your 401(k) account to start a business, you have to fully understand the pros and cons of each option. 

ROBS Plans

ROBS stands for “Rollover for Business Startups”.   ROBS is a special program that allows you to use the balance in your 401(k) or IRA account to fund your new business while avoiding having to pay taxes and the 10% early withdrawal penalty for business owners under age 59.5.  Unlike a 401(k) loan that has limits, loan payments, and interest, ROBS plans allow you to use your full retirement account balance without having to enter into a repayment plan. 

Why do business owners use ROBS plans?

The benefits are fairly obvious.  First off, by using your own retirement assets to fund your new business, you don’t have to ask friends and family for money.  Secondly, if you were to embark on the traditional lending route from a bank for your start-up, most would require you to pledge personal assets, such as your house, as collateral for the loan. Doing this puts an added pressure on the new entrepreneur because if the business fails you not only lose the business, but potentially your house as well.  By using the ROBS plan, you are only risking your own assets, you have quick and easy access to those funds, and if the business fails, worst case scenario, you just have to work longer than you expected. 

Is this too good to be true?

When I explain this funding strategy to new business owners, the question I usually get is, “Why haven’t I heard of these plans before?”, and here are a few reasons why.  To begin, you are using retirement plan dollars and accessing the tax benefits, and in doing so there are a lot of complex rules surrounding these types of plans. It’s not uncommon for accountants, third-party administrators, and financial advisors to not know what a ROBS plan is, let alone understand the compliance rules surrounding these plans; thus, it’s rarely presented as a viable option. Over the course of this article we will cover the pros and cons of this funding mechanism. 

How do ROBS plans work?

The concept is fairly simple, your retirement account essentially buys shares of stock in your new business which provides the business with the cash needed to grow. You do not have to be a publicly traded company for your retirement account to buy shares, however, you are required to establish your new company as a C-Corp in order for this plan to work.

This process entails incorporating your new business, as well as establishing a new 401(k) plan within that business, that contains the special ROBS features. Then, you can transfer assets from your various retirement accounts into the new 401(k) plan allowing the 401(k) plan to then buy shares in your new company.  While this sounds easy, I cannot stress enough that you must work with a firm that fully understands these types of plans and the funding strategy.   These plans are perfectly legal, but there are a lot of rules to follow. Since this funding strategy allows you to access retirement account dollars without having to pay tax to the IRS, the IRS will sometimes audit these plans hoping that you did not fully understand or comply with the rules surrounding the establishment and operations of these ROBS plans.

The steps to set up a ROBS plan

Here are the steps for setting up the plan:

1) Establish your new business as a C-Corp.

2) Establish a new 401(k) plan for your new business

3) Process direct rollovers from your 401(k) accounts and IRA accounts into your new 401(k) plan

4) Use the balance in your 401(k) account to purchase shares of the corporation

5) Now you have cash in your business checking account to pay expenses

You must be a C-Corp

The only type of corporate structure that works for a ROBS plan is a C-Corp because only a C-Corp can sell shares of the business to a retirement account legally.  That means that LLCs, sole proprietorships, partnerships or even S-Corps will not work for this funding option. 

Establishing the new 401(k) plan

ROBS plans have all the same features and benefits of a traditional 401(k) plan, profit-sharing plan, or defined benefit plan, except they also have special features that allow the plan to invest plan assets in the privately held C-Corp.

You need to work with a firm that knows these plans well because not all custodians will allow you to hold shares of a privately held corporation in a qualified retirement account. For many investment firms and custodians, this is considered either a “private placement” or an “alternative investment”.  There is typically a special approval process that you must go through with the custodian before they allow your 401(k) account to purchase the shares of stock in your new company. Be ready, there are a lot of mainstream 401(k) providers that will not only not know what a ROBS plan is, but they often times limit the plan investment options to mutual funds; to avoid this, make sure you are aligning yourself with the right provider. 

Transferring funds from your retirement accounts to your new 401(k) plan

Your new investment provider should assist you with coordinating the rollovers into your 401(k) account to avoid paying taxes and penalties.  Also, if you have 401(K) Roth or after-tax money in your retirement accounts, special preparations need to be made prior to the rollover occurring for those sources. 

Purchasing stock in the business

It’s not as easy as simply transferring money into the business checking account since you have to go through the process of issuing shares to the 401(k) account. In most cases, the percentage of ownership attributed to the 401(k) plan is based upon your total funding picture to start up the company. If your retirement accounts are the sole resource to fund the business, then technically your 401(k) plan owns 100% of the company. It’s not uncommon for new business owners to use multiple funding sources including personal savings, funding from friends and family, or a home-equity loan.  In these instances, a ROBS plan is still allowed but the plan will own less than 100% of the business.

I don’t want to get too deep in the weeds with this point, but it’s usually advisable not to issue 100% of the shares of the business to your 401(k) plan. This could limit your ability to raise additional capital down the road because you don’t have any additional shares to issue to new investors or to share equity with a new partner.

Using the capital to grow your business

Once the share purchase is complete, the cash will be transferred from your retirement account into the business checking account allowing use those funds to start growing the business.

There is a very important rule when it comes to what you can use these funds for within the new business. First and foremost, you cannot use these funds to pay yourself compensation as the business owner. This is probably the biggest ‘no-no’ associated with these types of plans. The IRS does not want you circumnavigating income taxes and penalties just to pay yourself under a ROBS plan.  In order to pay yourself as the business owner, you have to be able to generate revenue from the business.  The assets from the stock purchase can be used to pay all of your expenses but before you’re able to take any money out of the business to pay yourself compensation you have to be showing revenue.

Once new business owners hear this, it’s often disheartening. It’s great that they have access to capital to build their business, but how do they pay their bills while they’re building up the revenue stream? Luckily, I have good news on this front. We have additional strategies that we can implement using your retirement accounts outside of the ROBS plan that will allow you to pay yourself compensation as the owner and it can work out better tax wise than paying yourself as a W2 income through the C-corp.

Requirements for ROBS plans

There are a few requirements you have to meet for this funding strategy to work.

1) The funds have to be held in a pre-tax retirement account. This means that money in Roth IRA’s and Roth 401(k)’s are not eligible for this funding strategy.

2) You typically need at least $50,000 in your new 401(k) account for the ROBS plan to make sense since there are special costs associated with establishing and maintaining a ROBS 401(k) plan.  If your balance is less than $50,000, the cost to establish and maintain the plan begins to outweigh the benefit of executing this funding strategy.

3) If you’re rolling over a 401(k) plan to fund your ROBS 401(k) plan, it cannot be from a current employer. In other words, if you are still working for a company and you’re running this new business on the side, you are not able to rollover your 401(k) balance into your newly established 401(k) plan and implement this ROBS strategy. The 401(k) account must be coming from a former employer that you no longer work for.

4) You have to be an active employee in the business

There are special IRS rules that define if an employee is actively or materially participating in a business. Since ROBS plans do not work for passive business owners, it is difficult to use these plans for real estate investments unless you can prove that you are an active employee of that real estate corporation. If your new business is your only employer, you work over 1000 hours per year, and it’s your primary source of revenue, then you should not have a problem qualifying as an active employee.  If you have multiple businesses however, you really need to consult your accountant and ROBS provider to make sure you satisfy the IRS definition of materially participating.

A ROBS plan can be used for more than just start-ups

While we have talked a lot about using ROBS plans to start up a business, they can also be used for other purposes. These plans can be a funding source to:

1) Buy an existing business

2) Recapitalize a business

3) Build a franchise

These plans can offer fast access to large amounts of capital without having to go through the traditional lending channels.

Cost of setting up and maintaining a ROBS plan

It typically costs $4,000 – $5,000 to set up a ROBS plan and you cannot use the balance in your retirement account to pay this fee. It must be paid with outside funds.

As for ongoing fees, you will have the regular administrative, recordkeeping, and investment advisory fees associated with sponsoring a 401(k) plan which vary from provider to provider. You may also have additional fees charged each year by the custodian for holding the privately held C-Corp shares in your retirement account.  Make sure you clearly understand what the custodian will require from you each year to value those shares.  If you wind up with a custodian that requires audited financial statements, this could easily run you an additional $8,000+ per year to obtain those audited financial statements from an accounting firm.  If you are sponsoring one of these plans, you probably want to try to avoid this large additional cost.

Complications if you have employees

For start-up companies or established companies that have employees that would otherwise be eligible for the 401(k) plan, there are special issues that need to be addressed. The rules within the 401(k) world state that all investment options available within the plan must be made available to all eligible employees.  That means if the business owner is able to purchase shares of the company within the retirement plan, the other eligible employees must also be given the same investment opportunity. You can see immediately where this would pose a challenge to the ROBS plan if you have eligible employees.

However, investment options can be changed which is why ROBS plans are the most common in start-ups where there are no employees yet, allowing the 401(k) plan to setup the only eligible plan participant, the business owner, allowing them to buy shares of the company.  Once the share purchases are complete, the business owner can then remove those shares as an investment option in the plan going forward.

The Cons of a ROBS plan

Up until now we have presented the advantages of the ROBS plan but there are some disadvantages.

1)  The first one is pretty obvious. You are risking your retirement account dollars in a start-up business. If the business fails, not only will you be looking for a new job, but you’ve depleted your retirement assets.

2)  You are required to sponsor a C-Corp which may not be the most advantageous corporate structure.

3) You are required to sponsor a 401(k) plan.  When running a start-up business, it’s sometimes more advantageous to sponsor a Simple IRA or SEP IRA which requires less cost and time to maintain, but you don’t have that option using this funding strategy.

4)  The business owners can’t pay themselves compensation from the stock purchase

5) The cost to setup and maintain the plan. Paying $5,000 just to establish the plan isn’t exactly cheap.  Plus, you’re looking at $2,000+ in annual maintenance costs for the plan.  Other options like taking a home-equity loan or establishing a Solo 401(K) plan and taking a $50,000 401(k) loan from the plan may be the better funding option.

6) Audit risk.  While it’s not the case that all these plans are audited, they do present an audit opportunity for the IRS given the compliance rules surrounding the operation of these plans. However, this risk can be managed with knowledgeable providers.

7) Asset sale of the business becomes complex.  If 10 years from now you sell your company, there are two ways to sell it. An asset sale or a stock sale. While a stock sale jives very easily with this ROBS funding strategy, an asset sale becomes more complex.

Summary

Finding the capital to start up a business is never easy.  Each funding option comes with its own set of pros and cons.  The ROBS plan is just another option for consideration. While I have greatly simplified how these plans work and how they operate, if you are strongly considering using this plan as a funding vehicle for your new business, please reach out to us so we can have an open discussion about what you are trying to accomplish, and how the ROBS plan stacks up against other funding options that you may have available. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Advanced Tax Strategies For Inherited IRA's

 Inherited IRA’s can be tricky.  There are a lot of rules surrounding; 

• Establishment and required minimum distribution (“RMD”) deadlines

• Options available to spouse and non-spouse beneficiaries

• Strategies for deferring required minimum distributions

• Special 60 day rollover rules for inherited IRA’s

Establishment Deadline

If the decedent passed away prior to December 31, 2019, as a non-spouse beneficiary you have until December 31st of the year following the decedent’s death to establish an inherited IRA, rollover the balance into that IRA, and begin taking RMD’s based your life expectancy. If you miss that deadline, you are locked into distribution the full balance with a 10 year period.

If the decedent passed away January 1, 2020 or later, with limited exceptions, the inherited IRA rollover option with the stretch option is no longer available to non-spouse beneficiaries.

RMD Deadline - Decedent Passed Away Prior to 12/31/19

If you successfully establish an inherited IRA by the December 31st deadline, if you are non-spouse beneficiary, you will be required to start taking a “required minimum distribution” based on your own life expectancy in the calendar year following the decedent’s date of death.

Here is the most common RMD mistake that is made.  The beneficiary forgets to take an RMD from the IRA in the year that the decedent passes away.  If someone passes away toward the beginning of the year, there is a high likelihood that they did not take the RMD out of their IRA for that year. They are required to do so and the RMD amount is based on what the decedent was required to take for that calendar year, not based on the life expectancy of the beneficiary.  A lot of investment providers miss this and a lot of beneficiaries don’t know to ask this question.  The penalty?  A lovely 50% excise tax by the IRS on the amount that should have been taken.

Distribution Options Available To A Spouse

If you are the spouse of the decedent you have three distribution options available to you: 

• Take a cash distribution

• Rollover the balance to your own IRA

• Rollover the balance to an Inherited IRA

Cash distributions are treated the same whether you are a spouse or non-spouse beneficiary. You incur income tax on the amounts distributed but you do not incur the 10% early withdrawal penalty regardless of age because it’s considered a “death distribution”.  For example, if the beneficiary is 50, normally if distributions are taken from a retirement account, they get hit with a 10% early withdrawal penalty for not being over the age of 59½.  For death distributions to beneficiaries, that 10% penalty is waived. 

#1 Mistake Made By Spouse Beneficiaries

This exemption of the 10% early withdrawal penalty leads me to the number one mistake that we see spouses make when choosing from the three distribution options listed above.   The spouse has a distribution option that is not available to non-spouse beneficiaries which is the ability to rollover the balance to their own IRA.  While this is typically viewed as the easiest option, in many cases, it is not the most ideal option.  If the spouse is under 59½, they rollover the balance to their own IRA, if for whatever reason they need to access the funds in that IRA, they will get hit with income taxes AND the 10% early withdrawal penalty because it’s now considered an “early distribution” from their own IRA. 

Myth: Spouse Beneficiaries Have To Take RMD’s From Inherited IRA’s

Most spouse beneficiaries make the mistake of thinking that by rolling over the balance to their own IRA instead of an Inherited IRA they can avoid the annual RMD requirement.  However, unlike non-spouse beneficiaries which are required to take taxable distributions each year, if you are the spouse of the decedent you do not have to take RMD’s from the inherited IRA unless your spouse would have been age 70 ½ if they were still alive.  Wait…..what?

Let me explain.  Let’s say there is a husband age 50 and a wife age 45. The husband passes away and the wife is the sole beneficiary of his retirement accounts.  If the wife rolls over the balance to an Inherited IRA, she will avoid taxes and penalties on the distribution, and she will not be required to take RMD’s from the inherited IRA for 20 years, which is the year that their deceased spouse would have turned age 70 ½.   This gives the wife access to the IRA if needed prior to age 59 ½ without incurring the 10% penalty.

Wait, It Gets Better......

But wait, since the wife was 5 years young than the husband, wouldn’t she have to start taking RMD’s 5 years sooner than if she just rolled over the balance to her own IRA?  If she keeps the balance in the Inherited IRA the answer is “Yes” but here is an IRA secret. At any time, a spouse beneficiary is allowed to rollover the balance in their inherited IRA to their own IRA.   So in the example above, the wife in year 19 could rollover the balance in the inherited IRA to her own IRA and avoid having to take RMD’s until she reaches age 70½.  The best of both worlds. 

Spouse Beneficiary Over Age 59½

If the spouse beneficiary is over the age of 59½ or you know with 100% certainty that the spouse will not need to access the IRA assets prior to age 59 ½ then you can simplify this process and just have them rollover the balance to their own IRA.  The 10% early withdrawal penalty will never be an issue. 

Non-Spouse Beneficiary Options

As mentioned above, the distribution options available to non-spouse beneficiaries were greatly limited after the passing of the SECURE ACT by Congress on December 19, 2019.  For most individuals that inherit retirement accounts after December 31, 2019, they will now be subject to the new "10 Year Rule" which requires non-spouse beneficiary to completely deplete the retirement account 10 years following the year of the decedents death.

For more on the this change and the options available to Non-Spouse beneficiaries in years 2020 and beyond, please read the article below: 

https://www.greenbushfinancial.com/new-rules-for-non-spouse-beneficiaries-of-retirement-accounts-starting-in-2020/ 

60 Day Rollover Mistake

There is a 60 day rollover rule that allows the owner of an IRA to take a distribution from an IRA and if the money is deposited back into the IRA within 60 days, it’s like the distribution never happened. Each taxpayer is allowed one 60 day rollover in a 12 month period.  Think of it as a 60 day interest free loan to yourself. 

Inherited IRA’s are not eligible for 60 day rollovers.  If money is distributed from the Inherited IRA, the rollover back into the IRA will be disallowed, and the individual will have to pay taxes on the amount distributed. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Beware of the 5 Year Rule for Your Roth Assets

Beware of the 5 Year Rule for Your Roth Assets

Being able to save money in a Roth account, whether in a company retirement plan or an IRA, has great benefits. You invest money and when you use it during retirement you don't pay taxes on your distributions. But is that always the case? The answer is no. There is an IRS rule that you must take note of known as the "5 Year Rule". There are a number of scenarios where this rule could impact you and rather than getting too much into the weeds, this post is meant to serve as a public service announcement so you are aware it exists.

Advantages of a Roth

As previously mentioned, the benefit of Roth assets is that the account grows tax deferred and if the distributions are "qualified" you don't have to pay taxes. This is compared to a Traditional IRA/401(k) where the full distribution is taxed at ordinary income tax rates and regular investment accounts where you pay taxes on dividends/interest each year and capital gains taxes when you sell holdings. A quick example of Roth vs. Traditional below:

Roth Traditional

Original Investment $ 10,000.00 $ 10,000.00

Earnings $ 10,000.00 $ 10,000.00

Total Account Balance $ 20,000.00 $ 20,000.00

Taxes (Assume 25%) $ - $ 5,000.00

Account Value at Distribution $ 20,000.00 $ 15,000.00

This all seems great, and it is, but there are benefits of both Roth and Traditional (Pre-Tax) accounts so don’t think you have to start moving everything to Roth now. This article gives more detail on the two different types of accounts and may help you decide which is best for you Traditional vs. Roth IRA’s: Differences, Pros, and Cons.

Qualified Disbursements

Note the “occurs at least five years after the year of the employee’s first designated Roth contribution”. This is the “5 Year Rule”. The other qualifications are the same for Traditional IRA’s, but the “5 Year Rule” is special for Roth money. Not always good to be special.

It seems pretty straight forward and in most cases it is. Open a Roth IRA, let it grow at least 5 years, and as long as I’m 59.5 my distributions are qualified. Someone who has Roth money in a 401(k) or other employer sponsored plan may think it is just as easy. That isn’t always the case. Typically, an employee retires, and they roll their retirement savings into a Traditional or a Roth IRA. Say I worked at the company for 10 years, and I now retire and want to use all the savings I’ve created for myself throughout the years. I can start taking qualified distributions from my Roth IRA because I started contributing 10 years ago, correct? Wrong! The time you we’re contributing to the Roth 401(k) is not transferred to the new Roth IRA. If you took distributions directly from the 401(k) and we’re at least 59.5 they would be qualified. In most cases however, people don’t start using their 401(k) money until retirement and most plans only allow for lump sum distributions once you are no longer with the company.

So what do you do?

Open a Roth IRA outside of the plan with a small balance well before you plan to use the money. If I fund a Roth IRA with $100, 10 years from now I retire and roll my Roth 401(k) into that Roth IRA, I have satisfied the 5 year rule because I opened that Roth IRA account 10 years ago. The clock starts on the date the Roth IRA was opened, not the date the assets are transferred in.

About Rob.........

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

Should I Rollover My Pension To An IRA?

Whether you are about to retire or if you were just notified that your company is terminating their pension plan, making the right decision with regard to your pension plan payout is extremely important. It's important to get this decision right because you only get one shot at it. There are a lot of variables that factor into choosing the right option. While selecting the monthly payment option may be the right choice for your fellow co-worker, it could be the wrong choice for you. Here is a quick list of the items that you should consider before making the decision.

• Financial health of the plan sponsor

• Your age

• Your health

• Flexibility

• Monthly benefit vs lump sum amount

• Inflation

• Your overall retirement picture

Financial Health Of The Plan Sponsor

The plan sponsor is the company, organization, union, municipality, state agency, or government entity that is in charge of the pension plan. The financial health of the plan sponsor should weigh heavily on your decision in many cases. After all what good is a monthly pension payment if five years from now the company or entity that sponsors the plan goes bankrupt?

Pension Benefit Guarantee Corporation

But wait……..isn’t there some type of organization that guarantees the pension payments? The answer, there may or may not be. The Pension Benefit Guarantee Corporation (PBGC) is an organization that was established to protect your pension benefit. But PBGC protection only applies if your company participates in the PBGC. Not all pension plans have this protection.

Large companies will typically have PBGC protection. The pension plan is required to pay premiums to the PBGC each year. Those premiums are used to subsidize the cost of bankrupt pension plans if the PBGC has to step in to pay benefits. But it’s very important to understand that even through a pension plan may have PBGC protection that does not mean that 100% of the employee’s pension benefits are protected if the company goes bankrupt.

There is a dollar limited placed on the monthly pension benefit that the PBGC will pay if it has to step in. It’s a sliding scale based on your age and the type of pension benefit that you elected. If your pension payment is greater that the cap, the excess amount is not insured. Here is the PBGC 2021 Maximum Monthly Guarantee Table:

Another important note, if you have not reached age 65, your full pension benefit may not be insured even if it is less than the cap listed in the table.

Again, not all pension plans are afforded this protection by the PBGC. Pension plans offered by states and local government agencies typically do not have PBGC protection.

If you are worried about the financial health of the plan sponsor, that scenario may favor electing the lump sum payment option and then rolling over the funds into your rollover IRA. Once the money is in your IRA, the plan sponsor insolvency risk is eliminated.

Your Age

Your age definitely factors into the decision. If you have 10+ years to retirement and your company decides to terminate their pension plan, it may make sense to rollover your balance in the pension plan into an IRA or your current employer’s 401(k) plan. Primarily because you have the benefit of time on your side and you have full control over the asset allocation of the account.

Pension plans typically maintain a conservative to moderate growth investment object. You will rarely ever find a pension plan that has 80%+ in equity exposure. Why? It’s a pooled account for all of the employees of all ages. Since the assets are required to meet current pension payments, pension plans cannot be subject to high levels of volatility.

If your personal balance in the pension plan is moved into our own IRA, you have the option of selecting an investment objective that matches your personal time horizon to retirement. If you have a long time horizon to retirement, it allows you the freedom to be more aggressive with the investment allocation of the account.

If you are within 5 years to retirement, it does not necessarily mean that selecting the monthly pension payment is the right choice but the decision is less cut and dry. You really have to compare the monthly pension payment versus the return that you would have to achieve in your IRA to replicate that income stream in retirement.

Your Health

Your health is a big factor as well. If you are in poor health, it may favor electing the lump sum option and rolling over the balance into an IRA. Whatever amount is left in your IRA account will be distributed to your beneficiaries. With a straight life pension option, the benefit just stops when you pass away. However, if you are worried about your spouse's spending habits and your spouse is either in good health or is much younger than you, you may want to consider the pension option with a 100% survivor benefit.

Flexibility

While some retirees like the security of a monthly pension payment that will not change for the rest of their life, other retirees prefer to have more flexibility. If you rollover you balance to an IRA, you can decide how much you want to take or not take out of the account in a given year.

Some retirees prefer to spend more in their early years in retirement because that is when their health is the best. Walking around Europe when you are 65 is usually not the same experience as walking around Europe when you are 80. If you want to take $10,000 out of your IRA to take that big trip to Europe or to spend a few months in Florida, it provides you with the flexibility to do so. By making sure that you have sufficient funds in your savings at the time of retirement can help to make things like this possible.

Working Because I Want To

The other category of retirees that tend to favor the IRA rollover option is the "I'm working because I want to" category. It has becoming more common for individuals to retire from their primary career and want to still work doing something else for two or three days a week just to keep their mind fresh. If the income from your part-time employment and your social security are enough to meet your expenses, having a fixed pension payment may just create more taxable income for you when you don't necessarily need it. Rolling over your pension plan to an IRA allows you to defer the receipt of that income until at least age 70½. That is the age that distributions are required from IRA accounts.

Monthly Pension vs Lump Sum

It’s important to determine the rate of return that you would need to achieve in your IRA account to replicate the pension benefit based on your life expectancy. With the monthly pension payment option, you do not have to worry about market fluctuations because the onus is on the plan sponsor to produce the returns necessary to make the pension payments. With the IRA, you or your investment advisor are responsible for producing the investment return in the account.

Example 1: You are 65 and you have the option of either taking a monthly pension payment of $3,000 per month or taking a lump sum in the amount of $500,000. If your life expectancy is age 85, what is the rate of return that you would need to achieve in your IRA to replicate the pension payment?

The answer: 4%

If your IRA account performs better than 4% per year, you are ahead of the game. If your IRA produces a return below 4%, you run the risk of running out of money prior to reaching age 85.

Part of this analysis is to determining whether or not the rate of return threshold is a reasonable rate of return to replicate. If the required rate of return calculation results in a return of 6% or higher, outside of any special circumstances, you may be inclined to select the pension payments and put the responsibility of producing that 6% rate of return each year on the plan sponsor.

Low Interest Rate Environment

A low interest rate environment tends to favor the lump sum option because it lowers the “discount rate” that actuaries can use when they are running the present value calculation. Wait……what?

The actuaries are the mathletes that produce the numbers that you see on your pension statement. They have to determine how much they would have to hand you today in a lump sum payment to equal the amount that you would have received if you elected the monthly pension option.

This is called a “present value” calculation. This amount is not the exact amount that you would have received if you elected the monthly pension payments because they get to assume that they money in the pension plan will earn interest over your life expectancy. For example, if the pension plan is supposed to pay you $10,000 per year for the next 30 years, that would equal $300,000 paid out over that 30 year period. But the present value may only be $140,000 because they get to assume that you will earn interest off of that money over the next 30 years for the amount that is not distributed until a later date.

In lower interest rate environments, the actuaries have to use a lower assume rate of return or a lower “discount rate”. Since they have to assume that you will make less interest on the money in your IRA, they have to provide you with a larger lump sum payment to replicate the monthly pension payments over your life expectancy.

Inflation

Inflation can be one of the largest enemies to a monthly pension payment. Inflation, in its simplest form is “the price of everything that you buy today goes up in price over time”. It’s why your grandparents have told you that they remember when a gallon of milk cost a nickel. If you are 65 today and your lock into receiving $2,000 per month for the rest of your life, inflation will erode the spending power of that $2,000 over time.

Historically, inflation increases by about 3% per year. As an example, if your monthly car payment is $400 today, the payment for that same exact car 20 years from now will be $722 per month. Now use this multiplier against everything that you buy each month and it begins to add up quickly.

If you have the money in an IRA, higher inflation typically leads to higher interest rate, which can lead to higher interest rates on bonds. Again, having control over the investment allocation of your IRA account may help you to mitigate the negative impact of inflation compared to a fixed pension payment.

A special note, some pension plans have a cost of living adjustment (“COLA”) built into the pension payment. Having this feature available in your pension plan will help to manage the inflation risk associated with selecting the monthly pension payment option. The plan basically has an inflation measuring stick built into your pension payment. If inflation increases, the plan is allowed to increase the amount of your monthly pension payment to help protect the benefit.

Your Overall Financial Picture

While I have highlighted a number of key variables that you will need to consider before selecting the payout option for your pension benefit, at the end of the day, you have to determine how each option factors into your own personal financial situation. It’s usually wise to run financial projections that identify both the opportunities and risks associated with each payment option.

Don’t be afraid to seek professional help with this decision. They will help you consider what you might need to pay for in the future.  Are you going to need money spare for holidays, transportation, even funeral costs should be considered. Where people get into trouble is when they guess or they choose an option based on what most of their co-workers selected. Remember, those co-workers are not going to be there to help you financially if you make the wrong decision.

As an investment advisor, I will also say this, if you meet with a financial planner or investment advisor to assist you with this decision, make sure they are providing you with a non-bias analysis of your options. Depending on how they are compensation, they may have a vested interest in getting you to rollover you pension benefit to an IRA. Even though electing the lump sum payment and rolling the balance over to an IRA may very well be the right decision, they should walk you through a thorough analysis of the month pension payments versus the lump sum rollover option to assist you with your decision.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Spouse Inherited IRA Options

If your spouse passes away and they had either an IRA, 401(k), 403(b), or some other type of employer sponsored retirement account, you will have to determine which distribution option is the right one for you.   There are deadlines that you will need to be aware of, different tax implications based on the option that you choose, forms that need to be completed, and accounts that may need to be established. 

Spouse Distribution Options

As the spouse, if you are listed as primary beneficiary on a retirement account or IRA, you have more options available to you than a non-spouse beneficiary.  Non-spouse beneficiaries that inherited retirement accounts after December 31, 2019 are required to fully distribution the account 10 years following the year that the decedent passed away. But as the spouse of the decedent, you have the following options: 

• Fulling distribute the retirement account with 10 years

• Rollover the balance to an inherited IRA

• Rollover the balance to your own IRA

To determine which option is the right choice, you will need to take the following factors into consideration: 

• Your age

• The age of your spouse

• Will you need to take money from the IRA to supplement your income?

• Taxes

Cash Distributions

We will start with the most basic option which is to take a cash distribution directly from your spouse’s retirement account.    Be very careful with this option.  When you take a cash distribution from a pre-tax retirement account, you will have to pay income tax on the amount that is distributed to you.  For example, if your spouse had $50,000 in a 401(k), and you decide to take the full amount out in the form of a lump sum distribution, the full $50,000 will be counted as taxable income to you in the year that the distribution takes place. It’s like receiving a paycheck from your employer for $50,000 with no taxes taken out.   When you go to file your taxes the following year, a big tax bill will probably be waiting for you.

In most cases, if you need some or all of the cash from a 401(k) account or an IRA, it usually makes more sense to first rollover the entire balance into an inherited IRA, and then take the cash that you need from there.   This strategy gives you more control over the timing of the distributions which may help you to save some money in taxes.  If as the spouse, you need the $50,000, but you really need $30,000 now and $20,000 in 6 months, you can rollover the full $50,000 balance to the inherited IRA, take $30,000 from the IRA this year, and take the additional $20,000 on January 2nd the following year so it spreads the tax liability between two tax years.

10% Early Withdrawal Penalty

Typically, if you are under the age of 59½, and you take a distribution from a retirement account, you incur not only taxes but also a 10% early withdrawal penalty on the amount this is distributed from the account.  This is not the case when you take a cash distribution, as a beneficiary, directly from the decedents retirement account.  You have to report the distribution as taxable income but you do not incur the 10% early withdrawal penalty, regardless of your age. 

IRA Options

Let's move onto the two IRA options that are available to spouse beneficiaries.  The spouse has the decide whether to: 

• Rollover the balance into their own IRA

• Rollover the balance into an inherited IRA

By processing a direct rollover to an IRA in either case, the beneficiary is able to avoid immediate taxation on the balance in the account.  However, it’s very important to understand the difference between these two options because all too often this is where the surviving spouse makes the wrong decision.  In most cases, once this decision is made, it cannot be reversed. 

Spouse IRA vs Inherited IRA

There are some big differences comparing the spouse IRA and inherited IRA option.

There is common misunderstanding of the RMD rules when it comes to inherited IRA’s.  The spouse often assumes that if they select the inherited IRA option, they will be forced to take a required minimum distribution from the account just like non-spouse beneficiaries had to under the old inherited IRA rules prior to the passing of the SECURE Act in 2019. That is not necessarily true.  When the spouses establishes an inherited IRA, a RMD is only required when the deceases spouse would have reached age 70½.  This determination is based on the age that your spouse would have been if they were still alive.  If they are under that “would be” age, the surviving spouse is not required to take an RMD from the inherited IRA for that tax year.

For example, if you are 39 and your spouse passed away last year at the age of 41, if you establish an inherited IRA, you would not be required to take an RMD from your inherited IRA for 29 years which is when your spouse would have turned age 70½.   In the next section, I will explain why this matters.

Surviving Spouse Under The Age of 59½

As the surviving spouse, if you are under that age of 59½, the decision between either establishing an inherited IRA or rolling over the balance into your own IRA is extremely important.  Here’s why .

If you rollover the balance to your own IRA and you need to take a distribution from that account prior to reaching age 59½, you will incur both taxes and the 10% early withdrawal penalty on the amount of the distribution.

But wait…….I thought you said the 10% early withdrawal penalty does not apply?

The 10% early withdrawal penalty does not apply for distributions from an “inherited IRA” or for distributions to a beneficiary directly from the decedents retirement account.  However, since you moved the balance into your own IRA,  you have essentially forfeited the ability to avoid the 10% early withdrawal penalty for distributions taken before age 59½.

The Switch Strategy

There is also a little know “switch strategy” for the surviving spouse.  Even if you initially elect to rollover the balance to an inherited IRA to maintain the ability to take penalty free withdrawals prior to age 59½, at any time, you can elect to rollover that inherited IRA balance into your own IRA.

Why would you do this?  If there is a big age gap between you and your spouse, you may decide to transition your inherited IRA to your own IRA prior to age 59½.  Example, let’s assume the age gap between you and your spouse was 15 years.  In the year that you turn age 55, your spouse would have turned age 70½.  If the balance remains in the inherited IRA, as the spouse, you would have to take an RMD for that tax year.   If you do not need the additional income, you can choose to rollover the balance from your inherited IRA to your own IRA and you will avoid the RMD requirement.   However, in doing so, you also lose the ability to take withdrawals from the IRA without the 10% early withdrawal penalty between ages 55 to 59½.  Based on your financial situation, you will have to determine whether or not the “switch strategy” makes sense for you.

The Spousal IRA

So when does it make sense to rollover your spouse’s IRA or retirement account into your own IRA?  There are two scenarios where this may be the right solution:

• The surviving spouse is already age 59½ or older

• The surviving spouse is under the age of 59½ but they know with 100% certainty that they will not have to access the IRA assets prior to reaching age 59½

If the surviving spouse is already 59½ or older, they do not have to worry about the 10% early withdrawal penalty.

For the second scenarios, even though this may be a valid reason, it begs the question:  “If you are under the age of 59½ and you have the option of changing the inherited IRA to your own IRA at any time, why take the risk?”

As the spouse you can switch from inherited IRA to your own IRA but you are not allowed to switch from your own IRA to an inherited IRA down the road.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Changes To 529 Accounts & Coverdell IRA's

Included in the new tab bill were some changes to the tax treatment of 529 accounts and Coverdell IRA's. Traditionally, if you used the balance in the 529 account to pay for a "qualified expense", the earnings portion of the account was tax and penalty free which is the largest benefit to using a 529 account as a savings vehicle for college.So what's the change? Prior to the Tax Cuts and Jobs Act (tax reform), qualified distributions were only allowed for certain expenses associated with the account beneficiary's college education. Starting in 2018, 529 plans can also be used to pay for qualified expenses for elementary, middle school, and high school.

Kindergarten – 12th Grade Expenses

Tax reform included a provision that will allow owners of 529 account to take tax-free distributions from 529 accounts for K – 12 expenses for the beneficiary named on the account. This is new for 529 accounts. Prior to this provision, 529 accounts could only be used for college expenses. Now 529 account holders can distribute up to $10,000 per student per year for K – 12 qualified expenses. Another important note, this is not limited to expenses associated with private schools. K – 12 qualified expense will be allowed for:

• Private School

• Public School

• Religious Schools

• Homeschooling

529 Accounts Will Largely Replace Coverdell IRA's

Prior to this rule change, the only option that parents had to save and accumulate money tax-free to K – 12 expenses for their children were Coverdell IRA's. But Coverdell IRA's had a lot of hang ups

• Contributions were limited to $2,000 per year

• You could only contribute to a Coverdell IRA if your income was below certain limits

• You could not contribution to the Coverdell IRA after your child turned 18

• Account balance had to be spend by the time the student was age 30

By contrast, 529 accounts offer a lot more flexibility and higher contributions limits. For example, 529 accounts have no contribution limits. The only limits that account owners need to be aware of are the "gifting limits" since contributions to 529 accounts are considered a "gift" to the beneficiary listed on the account. In 2018, the annual gift exclusion will be $15,000. However, 529 accounts have a provision that allow account owners to make a "5 year election". This election allows account owners to make an upfront contribution of up to 5 times the annual gift exclusion for each beneficiary without trigger the need to file a gift tax return. In 2018, a married couple could contribution up to $150,000 for each child to a 529 account without trigger a gift tax return.If I have a child in private school, they are in 6th grade, and I'm paying $20,000 in tuition each year, that means I have $140,000 that I'm going to spend in tuition between 6th grade – 12th grade and then I have college tuition to pile on top of that amount. Instead of saving that money in an after-tax investment account which is not tax sheltered and I pay capital gains tax when I liquidate the account to pay those expenses, why not setup a 529 account and shelter that huge dollar amount from income tax? It will probably saves me thousands, if not tens of thousands of dollars in taxes, in taxes over the long run. Plus, if I live in a state that allows tax deductions for 529 contributions, I get that benefit as well.

Income Limits and Tax Deductions

Unlike Coverdell IRA's, 529 accounts do not have income restrictions for making contributions. Plus, some states have a state tax deduction for contributions to 529 account. In New York, a married couple filing joint, receive a state tax deduction for up to $10,000 for contribution to 529 account. A quick note, that is $10,000 in aggregate, not $10,000 per child or per account.

Rollovers Count Toward State Tax Deductions

Here is a fun fact. If you live in New York and you have a 529 account established in another state for your child, if you rollover the balance into a NYS 529 account, the rollover balance counts toward your $10,000 annual NYS state tax deduction. Also, you can rollover balances in Coverdell IRA's into 529 accounts and my guess is many people will elect to do so now that 529 account can be used for K – 12 expenses.

Contributions Beyond Age 18

Unlike Coverdell IRA's which restrict contributions once the child reaches age 18, 529 accounts have no age restriction for contributions. We will often encourage clients to continue to contribute their child's 529 account while they are attending college for the sole purpose of continuing to capture the state tax deduction. If you receive the tuition bill in the mail today for $10,000, you can send in a $10,000 check to your 529 account provider as a current year contribution, as soon as the check clears the account you can turn around and request a qualified withdrawal from the account for the tuition bill, and pay the bill with the cash that was distributed from the 529 account. A little extra work but if you live in NYS and you are in a high tax bracket that $10,000 deduction could save you $600 - $700 in state taxes.

What Happens If There Is Money Left In The 529 Account?

If there is money left over in a 529 account after the child has graduated from college, there are a number of options available. For more on this, see our article "5 Options For Money Left Over In College 529 Plans"

Qualified Expenses

The most frequent question that I get is "what is considered a qualified expense for purposes of tax-free withdrawals from a 529 account?" Here is a list of the most common:

• Tuition

• Room & Board

• Technology Items: Computers, Printers, Required Software

• Supplies: Books, Notebooks, Pens, Etc.

Just as important, here are a list of expense that are NOT considered a "qualified expense" for purposes of tax free withdrawals from a 529 account:

• Transportation & Travel: Expense of going back and forth from school / college

• Student Loan Repayment

• General Electronics and Cell Phone Plans

• Sports and Fitness Club Memberships

• Insurance

If there is ever a question as to where or not an expense is a qualified expense or not, I would recommend that you contact the provider of your 529 account before making the withdrawal form your 529 account. If you take a withdrawal for an expense that is not a "qualified expenses" you will pay income taxes and a 10% penalty on the earnings portion of the withdrawal.

Do I Have To Close My Coverdell IRA?

While 529 accounts have a number of advantages compared to Coverdell IRA's, current owners of Coverdell IRAs will not be required to close their accounts. They will continue to operate as they were intended. Like 529 accounts, Coverdell IRA withdrawals will also qualify for the tax-free distributions for K – 12 expenses including the provision for expenses associated with homeschooling.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.