May, 2009:

As you are likely well aware, once you reach age 70½ you’re required to begin taking a minimum distribution from your IRA and/or qualified retirement plans.  There are several things you need to know about these distributions, so that you don’t make any mistakes.  Listed below are some of the more important rules – but keep in mind that these RMD rules are only for the original owner of the account, not for a beneficiary of an inherited account.

Required Minimum Distribution Rules

Special Exception for 2009 – for calendar year 2009, Required Minimum Distribution (RMD) rules are waived, so no distribution is required in 2009.  If your 70½ year was during 2008 you are still required to take your distribution for 2008 calendar year before April 1, 2009.  If you turn age 70½ during 2009 you will not be required to take a distribution before April 1, 2010, however, your first RMD will be required by December 31, 2010.

Calculation of RMD -

1. You must have your account balance from the end of the calendar year prior to the year for which the distribution is being calculated.  Any additions or withdrawals after December 31 of the previous year are not included in this balance, even if an addition is for the previous calendar year.  Also, any “in flight” rollovers or recharacterizations that effectively would impact the end of year balance are included (or excluded) in the balance as applicable.
2. You must learn your distribution period, which can be found in Table III, using your age at the end of the current year (not the previous year).
3. Divide the balance from #1 by the distribution period found in #2.  This is your RMD for the current year.
4. For each subsequent year, go back through #1 for a new balance at the end of the prior year, then go to the table from #2 to get a new distribution period, and do the math.

More Than Minimum – for any year in which you withdraw more than the RMD amount you are NOT allowed a credit against future year RMD.  The result is that your balance at the end of the current year would be less, so future RMD would be resultingly a little less, but not by the amount of extra you received.

No Rollovers or Conversions of RMD Amounts – Although you’re allowed to rollover or convert IRA funds after age 70½, you can not rollover or convert the amount attributable to your RMD for the year.

Multiple Accounts – For the purposes of calculating RMD, the IRS considers all traditional IRAs owned by one individual as one aggregate IRA.  This means that you can determine your RMD by adding together the balances of all your trad IRA accounts at the end of the prior year, and then taking your RMD from any one account (or as many accounts as you wish) as long as it totals at least the RMD for that year.  Other qualified retirement plans such as a 401(k) must be treated separately – that is, RMD must be calculated only on that account and distribution received from only that account.

Multiple Payments – You are allowed to take from as little as one to as many payments as you wish from your IRAs, as long as they add up to the RMD for the year.

Photo by Mr. Kris

In this day and age with bankruptcies on the rise, quite often this question comes up:  are my retirement plan assets protected from creditors? And of course, there are two ways you can take this – are the assets protected from creditors of my employer; and are the assets protected from my personal creditors?

Employer Creditors

Your qualified retirement plans (401(k), 403(b), etc.) are always protected from creditors, in the event that your company should declare bankruptcy.  The same is true for traditional qualified pension plans.  However, with certain nonqualified retirement plans, there is a strong possibility that these assets could be accessed by your employer’s creditors in the event of a bankruptcy.

These plans are often called executive compensation, rabbi trust, deferred compensation, or supplemental retirement savings (among many other terms).  The key here is that these accounts are “non-qualified”, and as such are not protected by the ERISA law.  These accounts are very often open to access by creditors, so be aware of this if you’re a participant in such an account.  Check with your HR department if you’re unsure if your retirement account(s) are qualified (and thus protected by ERISA) or not.

IRAs, being individual accounts totally separate from your employer (unless you’re self-employed) are not considered in any way the assets of your employer.  If you are self-employed and are not incorporated in some fashion, depending upon your state law, some of your IRA assets could be at risk, depending upon the state that you live in, and the balance of the account (see below).

Personal Creditors

In general, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) provides that both traditional and Roth IRAs derived from contributions are protected from creditors up to $1 million.  This protection only applies to bankruptcy, not to other judgments, and as such state law applies for all other situations.  The level of creditor protection varies widely by state.  For more up-to-date information on the protection within your state, click this link.  Rollover (including, if you’ve been paying attention, trustee-to-trustee transfer) amounts from employer plans, SEP or SIMPLE IRAs have unlimited protection from creditors.

There are cases, as illustrated recently in a case that was decided in 2007, where an inherited IRA with a revocable trust as the beneficiary became available to the decedent’s creditors.  This case was in the state of Kansas, so other states may have differing laws, this was just an example.  The way to resolve or avoid this is to use an irrevocable trust as the beneficiary and use discretionary and spendthrift clauses within the trust as protection.  Otherwise, naming an individual (or individuals) as the IRA beneficiary(s) would avoid this problem as well.

Further problems develop in the inherited IRA spectrum due to the fact that most state courts do not consider an inherited IRA to be a “retirement account”, since the owner (the beneficiary of the decedent) is currently receiving an income from the account.  This is important because retirement accounts are specifically protected from creditors (due to BAPCPA).

Closing

So, even though the IRA has somewhat fewer protections against creditors versus the employer plans, if you’ve left the employer this shouldn’t be the reason to leave funds in the old account.  An IRA account can be considerably more flexible, easier to access, and (likely) lower in cost overall.  If protection against creditors is a great concern, umbrella liability and/or malpractice insurance could be used as a low-cost alternative.

Photo by Hryck.

The stretch IRA, when implemented properly, can be one of the great vehicles for transferring wealth to your heirs, maintaining the tax-deferred status until much later.  The problem is that there are some very specific terms that must be met in order to achieve the stretch – and if you screw it up, there’s definitely not a do over in most of these cases.

Ground Rules

First, let’s run through the specifics that make up a stretch IRA situation.  When an IRA account owner dies, the beneficiary(s) are eligible to re-title the account(s) as inherited IRAs in the name of the deceased owner, and then begin taking Required Minimum Distributions based upon the beneficiary’s age – rather than having to take the entire sum all at once and pay tax on it, or the onerous five-year distribution rule that can come into effect if things aren’t done properly. (more on the specifics of the Stretch IRA can be found in this article.)

Keep in mind that these stretch rules apply to both Traditional and Roth IRAs – even though Roth IRA owners are not subject to RMD, their beneficiaries are.

7 Mistakes

What we’re here to discuss are the some of the common mistakes that can be made when attempting to stretch an IRA.

1. Not properly titling the account – if the account is set up in the name of the non-spouse beneficiary, the funds would be immediately taxable and the IRA would be distributed.  There’s no remedy to this one, the account has to be titled as “John Doe IRA (Deceased January 1, 2009) FBO Janie Brown” or something very similar.
2. Doing a “rollover” – while it may seem like an issue of semantics, there is a technical difference between a direct trustee-to-trustee transfer and a rollover.  The trustee-to-trustee transfer is self-describing; a rollover is when the beneficiary receives a payment made out in his own name, which he then deposits into an IRA.  A rollover is disallowed in attempting to set up a stretch IRA – you must always do a direct trustee-to-trustee transfer.
3. Neglecting timely transfer – sometimes estates can be tied up for years getting everything sorted out.  IRAs and 401(k) plans should not have this sort of problem, as generally there is a specific beneficiary or beneficiaries designated on the account documentation.  It is critical that the funds are transferred into a properly titled account before the end of the year following the year of the deceased owner’s death – otherwise the stretch IRA option is lost, and the funds will have to be paid out via the five year rule.
4. Failing to take RMD for year of death – if the IRA owner dies after his RBD, a Required Minimum Distribution must be taken for the year of his death, and can not be included in a transfer to an inherited IRA.  This one can cause some hiccups, but in general can be resolved if caught in a timely fashion by taking the distribution in the name of the decedent and paying the applicable penalties for excess accumulation.  If the amount is transferred to the inherited IRA and isn’t caught quickly, it could negate the stretch altogether, causing big tax bills.
5. Missing or neglecting RMD payments – if the beneficiary forgets to take the Required Minimum Distribution payment in a timely fashion, technically the five-year rule could kick in, requiring that the entire balance is paid out within five years, rather than the beneficiary’s lifetime.  However, it is possible to recover from this mistake, according to the outcome of a Private Letter Ruling (PLR 200811028, 3/14/2008).  What happened in this case was that the beneficiary neglected to take two years’ worth of RMD, and then corrected her mistake in the third year, taking all three years’ worth of RMD, followed by paying the penalty (50%) on the missed two years.  The IRS ruled that the failure to make these distributions in a timely fashion does not require that the five year rule apply – and since she maintained the appropriate distributions, caught up on the “misses” and paid the penalties, she is allowed to continue stretching the IRA over her lifetime. Interestingly, this particular PLR is the first place where the stretch IRA was determined as the default rather than the five-year rule, breaking ground for this to be the case across the board, unless the plan’s provisions require the five-year rule.
6. Not properly designating the beneficiary(s) – IRS regulations state that the beneficiary must be identifiable in order to be eligible for the stretch provision.  This means naming an individual or individuals as specific beneficiaries on the account forms, or designating a proper “see through” trust (with specific beneficiaries named) as the beneficiary.  The account form can not have something ambiguous like “as stated in will” – since this does not name an identifiable beneficiary.  In addition, if the original IRA beneficiary is a trust and any beneficiary of the trust is not a person, then the stretch IRA provision is lost for all beneficiaries.
7. Transferring the balance to a trust – if a qualified “see-through” trust is the beneficiary of the IRA, the balance of the funds in the IRA are NOT transferred to the trust – but rather the IRA is transferred directly to a properly-titled inherited IRA, and then RMDs are taken from the IRA and paid to the trust.  According to the trust’s provisions, the payments are then made to the trust beneficiary(s).  If the payments are simply passed through the trust to the trust beneficiary(s), then each beneficiary will be responsible for any tax on the distribution.  If the funds are accumulated in the trust, they are taxable to the trust (to the extent that they exceed $10,700 in income).

Obviously this isn’t an exhaustive list, but rather a sampling of some of the more common sorts of errors that folks make when attempting to set up a stretch IRA. Done properly, this sort of arrangement can turn an IRA of a sizeable amount in your lifetime into a very significant legacy to your heirs.  Proper setup is very important – get a professional to help you with it if you are confused by how this works!

Photo by filtran