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
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:
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.
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.
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.
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
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.
