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Should You Take or Postpone Your First RMD?

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In the first year that you’re required to start taking Required Minimum Distributions (RMDs) from your IRAs and other retirement plans, you have a decision to make:  Should you take the RMD during the first year, or should you delay it to the following year?

The Rule

This decision comes about because of the special rule regarding your first RMD:  In the year that you achieve age 72 (used to be 70½), you don’t have to take the first distribution until April 1 of the following year. For each subsequent year thereafter, you’re required to take your RMD by December 31 of the year… so this first year provides you with the opportunity to plan your income just a bit.

Generally it’s a better idea to take the distribution in the first year, with just a few reasons that you might reconsider:

  • If your income is considerably higher in the first year than it will be in the following year, you might want to delay the distribution, recognizing the income the following year when your tax bracket is lower. This situation might come about if you’ve delayed retirement until age 72, so you’d potentially have much more income in that year than the following year.
  • If taking the distribution would have an adverse impact on your Social Security, causing a higher amount to be taxed in the first year (versus the second year), you might want to delay the distribution. Again, this might be due to retiring during the year you reach age 72 making your income higher during that year.
  • Other MAGI limited provisions may impact your decision as well – but these are too varied and specific to the individual to list here.

Reasons to NOT Delay

The downsides to delaying receipt of the first year’s RMD: delaying the distribution to the following year will cause a double-shot of RMD to be recognized as income in the second year. In addition, the two RMDs in one year will be unnecessarily complicated: Each has a different deadline (April 1 for the delayed RMD, December 31 for the regular RMD); each is calculated on different account balances (the delayed one is based upon the balance of December 31 of the year before you turned age 72, the regular RMD is based upon the balance one year later); and each is calculated based upon your Table I value for different ages (the first is based on age 72, the second on age 73).

All of these differences increase complexity which increases the possibility of confusion and opportunity for making an error, so unless you have a very compelling reason (such as those listed above) it’s probably in your best interest to go ahead and take the first distribution in the first year – when you reach age 72.

Note:  Bear in mind that this planning doesn’t apply to inherited IRAs and the RMDs – only to your own regular distributions from your own IRA. 

In addition, if you have a 401(k), 403(b) or other employer-oriented retirement plan instead of an IRA, your first year for distribution might be later than age 72. This occurs if you were still working for the company and are not a 5% or more owner of the company. This only applies to current employers’ 401(k) plans – if you’ve left a company your 401(k) plan will follow the age 72 start rules.

Roth Conversion Timing Where After-Tax Contributions Are Involved

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Yet another point that you need to keep in mind as you plan your Roth IRA conversion strategy is the timing of the activities. This is especially true when you have after-tax contributions to your IRAs in addition to the growth on those contributions and the typical deductible contributions. As you’ll see below, in some circumstances it can make a big difference in how much tax you’ll have to pay…

Timing Examples

Example 1. You have an IRA worth $100,000, of which $50,000 is after-tax contributions, $20,000 is deductible contributions, and $30,000 is growth on your contributions. This is the only IRA that you own (which is a key fact, since the IRS considers all IRAs together when determining the taxability of distributions).

You have decided that you’d like to convert $40,000 to a Roth IRA. When you do so, half of the amount converted ($20,000) will be taxable and the other half non-taxed, since you have after-tax contributions amounting to $50,000 of the total account value of $100,000.

Simple enough, right? Okay, let’s complicate it…

Example 2. Same circumstances as in Example 1, except that you also have a 401(k) plan worth $100,000, all deductible contributions – and you’ve just retired. You decide at your retirement that you’d like to rollover the 401(k) to an IRA – you never liked the restrictive investment options available in that old 401(k) plan anyhow.

As in the first example, you want to convert $40,000 to a Roth IRA this year. (Here comes the timing part)

IF you convert the $40,000 to your IRA BEFORE (not during the same tax year) you rollover the 401(k), you will only be taxed on $20,000 of the conversion, just like example 1.

HOWEVER (and there’s always a however in life, don’t ya know) – if you rollover the 401(k) first (or during the same tax year) and then convert the $40,000 to Roth, you will be taxed on $30,000 of the conversion. This is because, now that you’ve rolled over the 401(k) plan, you have IRAs worth $200,000, of which only 25% ($50,000) is after-tax contributions… therefore, only 25% of the conversion distribution is tax-free, and the remaining 75%, or $30,000, is taxable.

To avoid this situation, you should wait until after the tax year of the conversion before doing the rollover of the 401(k) plan.

So – there you have it.  Timing is very important indeed…

401(k) – Good For Many, But Not Necessarily the Employee

401(k)

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Okay, the title might be a little misleading in regards to how I really feel about 401(k) plans… I do think that these plans are (or can be) good for a lot of folks, as long as they use them correctly and follow sound investing principles. But that’s not what this post is all about.

The 401(k) plan is one of the places that the average Joe Employee is not well-served – in ways you don’t realize.

The 401(k) Dirty Little Secrets

Without getting too technical about all this, one problem is that most 401(k) providers are able to get away with supplying a plan that is high in cost when compared to the rest of the marketplace, with no one but the plan participants (read that “employees”) bearing the brunt of the cost. And furthermore, the plan participants have little to no say in making changes to the plan in their favor.

It doesn’t have to be as nefarious as the employer choosing to stick the employees with high fees – it likely is a given fact that costs are higher for smaller employers’ retirement plans because they can’t achieve an economy of scale to keep costs low.

At any rate, most individuals can do much better (cost-wise) than 401(k) plans by looking to the low-cost alternative investing options, such as no load mutual fund companies and low-cost brokerages.

Since there is no legislation to make true fiduciary responsibility a requirement – meaning that the plan provider must act in the best interests of the plan participants – most often the plan and the investment choices are among the highest internal cost investing options available. And because the fees are charged totally at the back end (at the mutual fund company, usually) and the employer sees little or no up-front costs, the employer is happy with the plan.

In addition, the mutual fund company is thrilled to have a captive audience with only their funds available to be invested in – which translates into new deposits for the company for nearly zero marketing cost. Of course the agent who sold the plan is ecstatic: for virtually no ongoing effort, he is able to rake in a percentage from each and every dollar that goes into the plan.

On top of the higher costs and limited choices, 401(k) plans are the most restrictive of all contribution-oriented retirement savings options available. Typically, the only way you can touch the money in the plan is to leave employment at the company. 401(k) plans, as a concession, do allow loans against a portion of the holdings, which is unheard of for IRA plans.

Health Savings Accounts – The Basics, Part 1

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A Health Savings Account (HSA) is a tax-exempt trust or custodial account that you set up with a bank or other US financial institution which allows you to pay or be reimbursed for qualified medical expenses. The HSA must be used in conjunction with a High Deductible Health Plan (HDHP). The HSA can be established using a qualified trustee or custodian that is separate from the HDHP provider. Contributions to an HSA must be made in cash or through a cafeteria plan. Contributions of stock or property are not allowed.

Benefits of an HSA

There are quite a few benefits to an HSA:

  1. Contributions to an HSA are deductible from income – even if you don’t itemize deductions;
  2. If your employer makes contributions to an HSA on your behalf (such as via a cafeteria plan) the contributions can be excluded from your gross income;
  3. Your account contributions can remain in the account year-after-year until you use them – there is no annual “use it or lose it” clause;
  4. Growth in the account (via interest, dividends, or capital gains) is tax-free;
  5. Distributions from the account are tax-free if used for qualified medical expenses; and
  6. Your HSA is portable – not tied in any way to your employment with a particular employer. You take the account with you if you change employers or leave the workforce.

Qualifications for an HSA

In order for you to qualify for an HSA, the following conditions must be met:

  1. You have an HDHP;
  2. You (and your spouse, if married) cannot have any other health plan beyond the HDHP, with the exception of another plan that is limited to the following coverages:
    1. accidents,
    2. disability,
    3. dental care,
    4. vision care,
    5. long-term care,
    6. benefits related to worker’s compensation laws, tort liabilities, or ownership or use of property,
    7. specific disease or illness, or
    8. a fixed amount per day (or other period) of hospitalization.
  3. You are not entitled to Medicare benefits (i.e., beginning with the first month that you are eligible for benefits under Medicare, you can no longer contribute to an HSA. You are still allowed to take distributions from your existing HSA plan, however.); and
  4. You cannot be claimed as a dependent on someone else’s tax return.

If you meet these qualifications, you are eligible to participate in an HSA, even if your spouse has a non-HDHP family plan, provided the spouse’s plan doesn’t cover you.

Qualified Medical Expenses

Qualified medical expenses are those that qualify for the medical and dental expenses deduction under §213. Examples include amounts paid for doctors’  fees, prescription and non-prescription medicines, and necessary hospital services not paid for by insurance. Qualified medical expenses must be incurred after the HSA has been established.

You cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are used to offset the tax-free amount of the distribution from your HSA.

In Part 2 we’ll cover the contribution limits as well as some of the other special considerations for the HSA.

5 Tactics for Required Minimum Distributions

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So – you’ve reached that magic age, 72 (used to be 70½), and now you’ve got to begin taking the dreaded Required Minimum Distributions (RMDs) from your various retirement accounts. Listed below are a few tactics that you might want to employ as you go through this process. Perhaps one or another will make the process a little less onerous on you.

5 Tactics for Required Minimum Distributions

1.  Take all of your RMDs from your smallest IRA account. If you have several IRA accounts, you can aggregate the amount of your RMD for the year and take it all out of one (in this tactic, the smallest) account. This way you’ll eventually eliminate that account by draining it completely. This will reduce paperwork, time and error in calculating RMD amounts, as well as limit complications in estate planning.

The same can be done for your 403(b) accounts. You can’t use IRA distributions to make up your 403(b) RMDs or vice versa, however. Each type of account must have its own distributions. This only applies to 403(b) accounts, and not to 401(k) accounts, though: each 401(k) has its own separate RMD, they can’t be aggregated.

Keep in mind though, that distributions from an inherited IRA or inherited 403(b) cannot be used to satisfy the RMD for your other, regular IRAs or 403(b)s, and these inherited accounts can’t be aggregated for RMDs.

2.  Take distributions in kind, rather than in cash. There is no requirement that your RMD must be in cash – so if the situation is advantageous to you, you might consider taking the distribution in stocks, bonds, or any other investments to fulfill the RMD requirement. When the distribution occurs, the value of the investment is considered taxable income to you – and therefore becomes the new basis of that investment.

There are three situations when this type of distribution is particularly useful:

a) If you wish to remain “fully invested”, you will save on commissions since you don’t have to sell the investment inside the IRA, remove the cash, and the re-purchase the same investment in your taxable account.

b) If you hold a stock that you believe is undervalued and expect it to appreciate in value, transferring it outside the IRA gives you the ability to receive capital gains treatment on the appreciation. Even better, once outside the IRA, if you hold the stock until your death, your heirs will receive the stepped up basis of the stock as of the date of your death, bypassing tax altogether (depending upon the size of your estate, of course).

c) If you hold an investment that is particularly difficult to value, such as a thinly-traded stock or a limited partnership, you can take a portion of the distribution from this holding (e.g., if you’re required to take 5% of the account as an RMD, you could take 5% from the LP ownership and the rest in cash or whatever else the account holds). This way you don’t have to come up with a value of the difficult to value holding each year when taking distributions.

3.  Take your distribution early in the year. No wait, take it late in the year. There are arguments on either side of the issue, but in general I agree more with the benefit of the latter statement, which I’ll explain in a moment.

Taking the distribution early in the year is most helpful for your heirs.  If you happen to pass away during the year and have not yet taken the RMD, your heirs will need to make certain that the RMD is taken before the end of the year – at a time when they aren’t necessarily thinking about this sort of thing.

On the other hand, taking the distribution later in the year provides you with the opportunity to take advantage of any rule changes that Congress tosses your way through the year. For example, in 2020 you didn’t have to take an RMD at all, and if you did you got to roll the distribution back into your IRA. Similarly, in 2006, 2008, and 2009 there were late-in-the-game rule changes that allowed the IRA holder to make distributions directly to a Qualified Charity, so that the income was never factored into the tax return at all (an advantageous thing, especially with regard to Social Security taxation calculations, for example).

So, all in all, I think it’s better to wait – at least until the first half of the year is over – before taking the RMD. Besides, your heirs will get over it.

4.  Take extra distributions (more than the RMD) when your income is lower. This is similar to the “Fill Out The Bracket” strategy that I’ve written about before. Essentially you look at your available tax bracket (especially if you are in the lower brackets) and take out extra distributions up to the maximum in your applicable bracket. This will reduce your RMDs in future years, allowing you to either convert those funds over to Roth IRA accounts or a taxable account subject to the much lower capital gains rates.

5.  Take extra distributions when subject to AMT. This is mostly useful if you are normally subject to the highest tax brackets (37% these days), but for other reasons you find yourself subject to AMT. You can take additional distributions from your IRA up to the limit that keeps you in the AMT tax, and these funds will only be taxed at a 26-28% rate. These distributions could either be taken as income or converted to a Roth IRA. (Note:  bear in mind that if the final calculation shows that you’ve taken too much from the IRA and kicked yourself back into a higher bracket, you’ll have to work quickly to get the excess rolled back into the IRA account. The Service doesn’t have any sense of humor about allowing extensions of the 60-day rollover period in cases like this. For this reason it would be prudent to not try to maximize this benefit.)

Level payment pension plan option

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When you approach retirement, if you’re fortunate enough to have worked in a job that provides a pension plan, you are faced with a decision: what type of payout should you choose? There are generally several – the first choice is between a lump sum versus an annuitized payout

The lump sum works just like it sounds – you get the equivalent of your account in the pension system in one big lump – and you can rollover this lump sum into an IRA or other tax-deferred vehicle, taking distributions as you see fit over your lifetime. At some point (age 72 for most cases) you’ll be required to take distributions from your account.

On the other hand, an annuitized payout is where the money comes to you in a (generally) set amount over your lifetime, rather than all at once. And with the annuitized option you often have several choices to consider – such as an annuity based solely on your life, or one based on your life and the life of a potential survivor of yours, most often your spouse.

There’s also often an option to receive the pension payments over a specified period of time, regardless of whether you live that long or not. These options are generally either 10-year payments or 20-year payments. With this plan you (and your survivor if you don’t live that long) will receive payments for either 10 or 20 years in a set amount, after which the payments cease.

Another, less common, type of pension payment option is known as the level payment option, which is the topic of this post.

Level payment pension plan option

With most of the annuity payment options, once your benefit payment amount is determined, unless there is an inflation adjustment factor built in, your payment remains the same during your lifetime. For the survivor options, the payment might change after you pass away – such as with the joint-and-50% survivor option, where you receive one payment amount during your lifetime, and your surviving beneficiary receives 50% of that amount once you die.

With the level payment pension plan, the idea is to incorporate your pension payment along with your Social Security payment. The way it works, if you’ve retired and wish to begin receiving the pension at some point before you start receiving Social Security benefits, a level payment plan will provide you with approximately the same month-to-month income for the entire period of time, including before and after you’ve started receiving Social Security benefits.

In practice, an estimate is made of the amount of Social Security benefits that you’ll be eligible to receive at a specified age. Sometimes the age is set at 62 (the earliest age you can start Social Security retirement benefits), or at Full Retirement Age (which could be between ages 66 and 67, depending on you date of birth). Some plans arbitrarily set the age at 65, which is known in the retirement planning world as “normal” retirement age.

(This is a throwback to the olden times when 65 was the Social Security Full Retirement Age, or FRA. FRA hasn’t been 65 for quite a while, but it’s still the triggering age for Medicare. Many plans simply haven’t updated the feature.)

Once you have the estimate of the amount of your Social Security benefit, the pension plan is adjusted to coordinate with it. 

For example, let’s say you have a pension plan that would commonly have a single-life annuity monthly payment of $1,000. You’ve gotten an estimate of your Social Security benefit at age 62, and the amount at that age is $750 per month. Your level payment pension plan might provide you with $1,550 per month up to your age 62, and then drop to $800 per month. When you add in the anticipated $750 from Social Security, you maintain the same retirement income level of $1,550 both before and after you’ve filed for Social Security benefits.

Practical application of the level payment option

Of course, like all choices in life, there can be problems to deal with for the level payment option. 

For example, what happens if you’re not ready to start receiving Social Security benefits at 62? Once you’ve chosen the level payment option, you can’t change it – so regardless of whether you take your Social Security benefit at the prescribed age, your pension payment will reduce at that time. So you could wind up with a shortfall if you decide to delay starting your Social Security benefit to a later date.

On the other hand, let’s say your level payment plan indicates a Full Retirement Age starting date for your Social Security payment. There’s no requirement for you to wait that long – if you wanted to, you could start receiving Social Security benefits at age 62, with no impact to your pension amount. The reduction to the pension would still occur at FRA as planned, and since you started your Social Security benefit earlier (and therefore it is at a reduced amount), your ending total of pension plus Social Security will be less than was originally calculated.

For example, let’s say you expect a $1,000 Social Security benefit at Full Retirement Age. Your level payment pension (pre-Social Security) is set at $1,550, dropping to $550 after you’ve reached FRA (age 67 for our purposes). You could start your Social Security benefit at 62 instead, at a benefit amount of $700. This would give you a total retirement monthly income of $2,250 (your $1,550 level payment pension plus $700 in Social Security benefits) up to your age 67, FRA. At FRA, your level payment pension plan drops to $550, and so now your total retirement monthly income is down to $1,250.

That seems pretty harsh, but if you crunch the numbers, you’ll realize that you’ve received $700 a month for five years (60 months), for a total of $42,000 (no COLAs are included in this calculation to reduce complexity). So if you had saved the extra, you could use that $42,000 to augment your other monthly income, making up the $300 reduction for a long time to come. ($300 is the difference between your original level payment and your post-leveling payment after you’ve reached FRA. This assumes that you “banked” the $700 Social Security benefit payment during the intervening 5 years.)

Considerations with the level payment option

No matter what you decide to do about the timing of your Social Security benefit, if you’re considering the level payment option you need to run the numbers against all of your other choices to help you figure out what’s the best way to go.

Keep in mind that the level payment option is front-loaded, giving you more pension benefits early in your life, and far less later. There also is no survivor component built in to the level payment option. Your surviving spouse will have to get by on Social Security benefits alone, along with your other retirement savings, and forego the pension after your death.

Not many folks choose the level payment plan from my experience, in part because it’s complicated and sort of locks you into choices early on in your retirement. But for some, this is exactly what is needed to bridge the gap between an early(ish) retirement and the start of Social Security benefits.

Consult your favorite advisor to help you best understand your options and what might work best for you.

Restoring Social Security benefit level after early filing

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There’s at least one circumstance in the Social Security retirement benefits world where it seems you can have your cake and eat it too. For whatever reason, this one has completely slipped past me up to this point, but I assure you, it’s legitimate and a very real part of Social Security’s rules. 

Not long ago, I was looking over some information on Social Security audits (Hey, some people collect stamps, I read audits. Sue me!), when I came across an audit that caught my eye. This particular audit, done by the Office of the Inspector General of the Social Security Administration, was titled Social Security Beneficiaries Financial Advantaged by Electing to Convert from Disability Benefits to Reduced Retirement Benefits. Naturally with a seductive title like that, I had to know more!

The audit explains how certain Social Security disability recipients may achieve an advantage if they make a change from disability benefits to retirement benefits, at some point at or after age 62. This might work in your favor, for example, if you were on Social Security disability benefits and you had a work opportunity available to you. The restrictions on working while collecting disability are pretty harsh, especially when compared to the restrictions on working when you’re receiving Social Security retirement benefits.

While on disability, the Substantial Gainful Activity rule only allows you to earn $1,310 in a month. If you earn more than that amount, your benefit will cease completely, and you’ll need to request a reinstatement of benefits if your income falls below that level in the future (and you’re still disabled).

On the other hand, your earnings while receiving Social Security retirement benefits become limited once you’ve earned $18,960 in a year (works out to $1,580/month), so you’ve got a bit more headroom to work with. Plus, when your income goes over the $18,960 limit, your retirement benefit doesn’t completely cease – for every $2 over the limit, $1 in benefits are withheld. Aaaannnnddd – you get credit for those withheld months later when you reach Full Retirement Age. 

So right there, you’ve got two advantages when you switch over from disability benefits to retirement benefits, if you happen to be over age 62.

  1. Higher monthly earnings limit (it’s actually an annual limit, so each month of overage might be mitigated by a lower month in the same year)
  2. Going over the limit only reduces your benefit, instead of eliminating the benefit, as with disability.

(Of course, once you’re at FRA your disability benefit automatically switches over to retirement benefits, so that’s not a factor here.)

When you reach Full Retirement Age, if you’ve had any months of benefits withheld because your earnings were above the limit, these months are removed from your early retirement factor, thus increasing your future benefit amount.

For example, if you started benefits at age 62 and your FRA was 67, this means your initial reduction factor calculates to 30% (more details on reductions here). Let’s say your unreduced benefit (your PIA) is $2,000. By starting benefits at age 62, it is reduced by 30% to $1,400/month. If you earned too much over the years between age 62 and your FRA and subsequently 10 months’ worth of your benefits were withheld, this means that at FRA, your benefit is recalculated as if you had filed at the age of 62 years and 10 months. This results in a new benefit reduction of 25.83%. So your new benefit from here forward is $1,483.

But the real kicker is what happens at Full Retirement Age when you were originally entitled to disability benefits.

What happens at Full Retirement Age?

In a curious twist to the rules – if you fit the circumstances described within the audit – that is:

  1. You are currently receiving Social Security Disability benefits
  2. You are at or older than age 62
  3. You are otherwise eligible for Social Security Retirement benefits

If you switch over and begin receiving Social Security Retirement benefits while you’re still entitled to the Disability benefit, of course your Social Security Retirement benefit will be reduced from your Primary Insurance Amount since you started benefits prior to Full Retirement Age.

BUT! When you reach Full Retirement Age, when under normal circumstances your benefit might be recalculated to add back those months where your benefit was withheld due to exceeding the earnings limit – another factor is added back as well. 

If you were also entitled to Disability benefits at the same time as when you were receiving the Retirement benefits prior to Full Retirement Age, every month that you were entitled to Disability benefits is added back to your record as well. 

In other words, if you were otherwise eligible and were originally entitled to the disability benefit but you switched over to a reduced Retirement benefit, for every month that you continued to be eligible for the disability benefit while under Full Retirement Age you will get a credit month added to your record.

So let’s say you’re receiving disability benefits, and you’re 63 years old. Your FRA is 67. But you have an opportunity to take on a job that will pay just over the Substantial Gainful Activity amount. It’s a job that you can do, even in your disabled condition. So you switch over to Retirement benefits, although this will result in a lower benefit (by 25% at this point), but you won’t have the onerous SGA rule hanging over your head.

When you reach FRA, assuming that you have continued to be otherwise eligible for the disability benefit throughout the intervening 4 years, your Social Security retirement benefit will be increased to equal your Primary Insurance Amount. That’s right – no reduction for the early filing!

If you want to dig into the details, you can find out all about this particular wrinkle in the rules by looking at the law behind the Social Security Act – in particular, § 402(q)(7)(F) – it takes some digging and reading/re-reading (it’s the Social Security Act, after all) but it’s well worth the effort to understand this odd but advantageous rule.

While you’re at it, if you find something more in 402(q) that makes your eyes pop, let me know! I’m always interested in picking up new tidbits.

What income is used for the Annual Earnings Test?

Annual Earnings Test

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If you’re receiving Social Security retirement benefits and you’re under Full Retirement Age (FRA), you may be subject to the Annual Earnings Test. This is a test to see if you’re actually retired enough (per the Social Security Administration’s rules) to receive your Social Security retirement benefit.

You can read up on the rules about the Annual Earnings Test by clicking the link. Effectively, if you earn more than $18,960 (for 2021), then for each $2 over that amount in earnings, your Social Security retirement benefit is reduced by $1. If this is the year that you’ll reach FRA, for every $3 over the limit of $50,520 (for 2021), the reduction in your benefit is $1. Above FRA, there is no Annual Earnings Test.

But what earnings are counted toward the Annual Earnings Test? Read on, you may be surprised by at least one category of earnings that is counted.

Earnings counted toward Annual Earnings Test

As you might expect, any earnings that you have from a regular job that is covered by Social Security taxation is definitely included toward the Annual Earnings Test. In addition, your Net Earnings from Self Employment (NESE), upon which you are assessed the Self Employment tax, is included as well.

Added to the above are any earnings that have not been included for coverage purposes – specifically smaller amounts that are below the limits for Social Security coverage in the agricultural or domestic employment (and others). These amounts, however small, are included as earnings toward the Annual Earnings Test.

If you happen to have earnings that are above the covered amount – that is, if in 2021 your earnings are above $142,800 – then these amounts are also included toward the Annual Earnings Test. (I always thought this was a weird item to include, since even just including the full covered amount would put you over the Annual Earnings Test, but I suppose SSA is just covering all possible circumstances.)

After those excluded items have been added, we come to (what I consider) the surprising part: Also included for the Annual Earnings Test are earnings from a job that is not covered by Social Security. That’s right, even if your earnings are outside the system, they’re still counted toward the Annual Earnings Test and can possibly reduce your Social Security retirement benefit.

So, for example, let’s say you’ve worked for 40 years (between ages 22 and 62) in Social Security covered jobs, and then you decide to make a change to your career – now you’d like to go into teaching. You decide to take your Social Security retirement benefit at the same time. But hold on!

Even though your earnings from the teaching position are not included to possibly increase your Social Security benefit (and the truth is that they may have a downward impact on your benefit due to the WEP, but that’s another story), those earnings are counted toward your Annual Earnings Test. Therefore, if your only earnings at this point are from the teaching position, if it pays you more than $18,960 (2021 figure) and you’re under Full Retirement Age, you’ll experience withheld Social Security benefits due to the Annual Earnings Test.

It’s important to know that the non-covered earnings are only counted toward the Annual Earnings Test if they come from a US-based source. Earnings from a non-covered job that is not based in the US are not counted toward the Annual Earnings Test. Those earnings are subject to a more stringent (for most folks) test called the Foreign Work Test. In this test, essentially if you have any earnings from a foreign source that is not covered by Social Security, your Social Security retirement benefit is withheld for those months when you have earnings (if you’re under FRA).

Avoiding the Underpayment Penalty with Form 2210 – Annualized Income

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In another article I covered a few ways that you might avoid an underpayment penalty in certain circumstances. Specifically, when you had not had the right amount of money withheld throughout the year or had not made timely estimated payments. But what if your income was uneven, sporadic throughout the year, and you received a good deal of your income in the last month? There’s a potential for an underpayment penalty with this sort of income, but there’s also a systematic way to avoid it. (H/T to reader P.D. for the suggestion!)

Self employment income

Generally this situation comes about when you’re either self-employed or work on a contract basis, and you’re generally responsible for making regular estimated tax payments on your income. You might also have sporadic income if you have a side-hustle or you sell some appreciated item (where the income from the sale becomes taxable). In other words, your income, or at least part of it, is not coming to you in the form of a paycheck from an employer, where the employer is withholding taxes for you.

When you’re in this position, typically you’ll make estimated tax payments throughout the year – one by April 15, for income earned through March; one by June 15 for income earned through May; one by September 15 for income earned through August; and lastly one by January 15 for the income earned through December. 

When it comes time to file your taxes (by April 15 of the following year), if the four payments you made through the year are not roughly equivalent to 1/4, 5/12, 8/12 and 100% (respectively) of your annualized income throughout the year, the IRS might say that you’ve underpaid estimated taxes. However, if you made these payments based on the actual net income that you received during the period, you have no reason to be concerned, as long as the payments were adequate for the income received.

Form 2210

There’s an IRS form, Form 2210, that is ostensibly used to determine the amount of underpayment penalty that applies to you, if any. In addition, Form 2210 provides you with a way to show that your income was not received evenly through the year, and that you made payments based on the actual taxable income during each period, if that’s the case.

At the bottom of Form 2210 is Schedule AI – Annualized Income Installment Method. This Schedule provides you with the format to report your actual income during those four periods mentioned previously: through the end of March, then May, then August, and December. In addition, you’ll report in Schedule AI the amounts that you have paid in estimated taxes.

You’ll also need detail information about your other income throughout the year, such as if you had a “regular” job with a paycheck and withheld taxes, plus interest and dividends from investments, and any other income that you earned (rent, royalties, side-hustles, etc.).

Filling out Schedule AI provides a way to show the IRS that you did make the payments correctly (assuming that you did) in correspondence with the income as you earned it. You’ll then work your results from Schedule AI into Part IV of Form 2210, and complete the process to determine if you have an underpayment penalty. This form, if necessary, is filed along with your Form 1040 for the year.

But what if you didn’t make the payments correctly?

Here’s another way that Schedule AI can help you out, especially if you haven’t been very accurate in your estimated tax payments. Let’s say, for example, you miscalculated (or just out-right didn’t pay the necessary amount) for the first payment in April, but then you corrected it and “caught up” with the June payment. Using Schedule AI can ensure that your penalty for underpayment only applies until you made the “catch up” payment. 

Then, if you made the appropriate payments through the rest of the year to correspond with your income during those periods, no further underpayment penalty would apply.

Otherwise, you might get stuck with underpayment penalties that could apply across the entire year, resulting in a considerably higher penalty.

If you didn’t make the proper payments throughout the year and you’re looking at a big underpayment penalty, you might look at the options presented in the article Understanding the Underpayment Penalty and How to Avoid It, as mentioned earlier.

Understanding the Underpayment Penalty and How to Avoid It

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Photo credit: coop

While filling out your tax return this year, maybe you discovered a nasty little surprise:  you’re being hit with an Underpayment Penalty, an extra little whack on the nose that means the IRS would like to hear from you more often throughout the year. Why?

Understanding the Underpayment Penalty

When you calculate the amount of tax that you owe, along with however much you’ve had withheld or paid in estimated tax throughout the year, if you haven’t had enough withheld, the IRS will assess a penalty for underpayment. How much is enough? The penalty is based upon the lesser of two amounts:

  • 90% of the amount of tax you will pay in total for the current year; or
  • 100% of the amount of tax you paid for the previous year.

Note: These amounts are different if you are a farmer or fisherman by trade – in that case you use 66 2/3% of the tax you’ll pay instead of 90%. In addition, if you are not a farmer or fisherman by trade, and your income is greater than $150,000  or $75,000 for Married Filing Separately, the factor you use is 110% of the amount of tax you paid the previous year, rather than 100%. For the purpose of this article, we’ll just use the “regular” figures.

If the amount of withholding and estimated payments that you’ve made throughout the year is at least $1,000 less than the smaller of those two factors, you’re in a position to receive an underpayment penalty.

Calculating Your Estimated Tax

The IRS has Form 1040ES to help you determine the amount of tax that you should be withholding or making in estimated payments. It’s a little complicated and daunting, but if you bear with it you can come up with the proper numbers to make sure you’re covering the tax throughout the year.

With the information that you get from Form 1040ES, you will have calculated the amount of under-withholding – if it turns out that you’re over-withholding, you might make adjustments to your W4’s or estimated payments as well, but that’s another topic altogether. No action is necessary if the calculated under-withholding is less than $1,000.

How To Avoid The Underpayment Penalty

Assuming that the figure you come up with is more than $1,000 in under-withholding, to pay the absolute minimum in withholding or estimated payments, subtract $1,000 from your underpayment estimate. (Note:  you don’t have to reduce the amount of your withholding by $1,000, you can have more withheld if you wish.) Then you have three options:

Make estimated payments – on April 15, June 15, September 15, and January 15, pay 25% of the excess amount that you’ve calculated. Postmark these amounts on or before the due dates to avoid late payment penalties.

Adjust W4 withholding – for regular wages, the form is W4; for pensions, W4P; and for Social Security benefits, it’s form W4V. Adjust the amount being withheld via this form to match your required withholding. Make sure that if there is already tax being withheld from a particular source that you’re increasing the amount being withheld! Too often, trying to make an adjustment to have additional money withheld, we inadvertently replace the current withholding, rather than increasing it.

Take an IRA distribution and have tax withheld from it – if you’re otherwise eligible to take an IRA distribution (either you’re age 59½ or older, or one of the other exceptions applies), when you take the distribution you have the option of having tax withheld. By doing this, you can avoid the hassle of quarterly estimated payments, if you like. See the article “IRA Trick – Eliminate Quarterly Estimated Tax Payments” for all the details.

Rolling Your IRA into a 401(k) – to Avoid RMD

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Photo credit: jb

In another article I pointed out a few additional reasons that might make you want to rollover your old 401(k) plan into an IRA – but there are also good reasons, in particular circumstances, that it might make sense to move your IRA funds into a 401(k) plan. One of those reasons might be to avoid having to take Required Minimum Distributions (RMDs) if you’re over age 72 and are still working.

Rolling IRA Money into a 401(k) to Avoid RMD

This is a somewhat narrow slice of folks, but as the population and workforce ages, there are bound to be people that this will be available to. Here’s how it works:

If you are age 72 or older (it used to be 70½) and you have an IRA, you will be required to take a distribution from your IRA each year. However, if you are still working and have a 401(k) plan available to you, you can avoid having to take these RMDs from the 401(k) until the year that you retire. If your 401(k) plan allows it (and today most plans do), you can rollover your existing IRA account into your 401(k) plan.

This is possible because 401(k) plans (and other Qualified Retirement Plans such as a 403(b) or a 457) don’t require you to start RMDs while you are still working, even if you’re over age 72.

So, if you don’t need the RMDs to live off of, you can eliminate the requirement by rolling over those funds into your 401(k) plan – and then begin taking RMDs upon your retirement. At that point you can also roll the funds back into an IRA as you see fit.

Of course, this shouldn’t be the only factor that you consider – you should also look at the inherent costs in your 401(k) plan, along with your investment choices and any plan-specific issues that may cause a problem for you with the rollover. In general though, this is a pretty good move for folks who happen to fit the criteria.

One last thing – if you happen to own the company that you work for (or own at least 5% or more of it), you can’t roll your IRA money into that company’s 401(k) plan to avoid RMDs. It’s just one of those IRS things… You only get to avoid RMDs if you’re not a 5% or more owner.

Year-End Planning

As the year comes to an end there are some things you may want to consider before 2021 arrives in just a few weeks.

  1. Increase your retirement savings. The maximum amounts allowed to 401k and IRA retirement plans remains unchanged for 2021 at $19,500 ($26,000 if over 50) and $6,000 ($7,000 if over 50) respectively. Consider saving as a percentage versus a dollar amount. Some 401k plans allow you to increase your percentage savings automatically every year.
  2. Replenish your emergency fund if necessary. Three to six months of living expenses is a good idea. If you found yourself using more during the pandemic, consider an emergency fund of six to nine months.
  3. Consider lowering your debt. Reducing and eliminating debt could mean making extra payments on your mortgage or vehicles. It may also necessitate refinancing your mortgage. With current rates as low as they are, it may be wise to refinance from a 30-year mortgage to a 15-year or even 10-year mortgage.
  4. Review your estate. Make sure your beneficiary designations are up to date on all of your retirement plans, life insurance, and other accounts. Review your will to make sure it’s up to date and still reflects your wishes. You may also want to discuss and consider powers of attorney and advanced medical directives.
  5. Review your insurance. Review your auto insurance policies to make sure you carry enough coverage, and if deductibles should be changed. The same is true for your home insurance. Don’t have an umbrella policy? Get at least $1 million in coverage. It’s dirt cheap. Review your life, disability, health insurance to see if any changes or additions are necessary.
  6. Commit to learning or improving on one area that interests you. Read up on the subject, take a class, practice what you’re learning. While financial improvement and stability is important, don’t let your self-improvement atrophy.

IRA Trick – Eliminate Estimated Tax Payments

ira trick

Photo credit: diedoe

Retirees: don’t you get tired of making those estimated tax payments? January, April, June and September, like clockwork, you have to hand over tax money, just because you’re receiving a pension, retirement funds, and/or Social Security benefits. What if there was a way to send this money off one time, and then you wouldn’t have to remember it every few months?

There is.

IRA Trick – Eliminating Estimated Tax Payments

When you receive money throughout the year, the IRS expects withholding payments or estimated payments to coincide with your receipt of the money. So when you receive a monthly pension check, you should either have some tax withheld out of each payment. On the other hand, you could send in an estimated tax payment, at four intervals throughout the year, which is treated equivalent to check-deducted withholding.

These estimated payments, often wrongly referred to as quarterly payments, are due each year on April 15, June 15, September 15, and January 15 of the following year. If you don’t make these payments in a timely fashion and you don’t have other withholding occurring with your receipt of money, the IRS may penalize you for underpayment of tax when you file your tax return.

A little-known fact about IRA distributions is that when you have taxes withheld from the distribution (which are then sent directly to the IRS), the withheld money is considered to have been received throughout the year – even if it is received late in December. Using this fact to your advantage, you could figure out how much your total estimated tax payments should be for the year sometime in early December, and then take a distribution from your IRA in that amount. Here’s the trick:  Instead of taking the distribution yourself, fill out a form W-4P (or use your custodian’s form) to direct the total amount of the withdrawal to be withheld and sent to the IRS. Voila! You’ve now made even payments to the IRS for each of the four quarters, on time with no penalties!

The downside to this plan is that, in the event of the taxpayer’s untimely death before the annual distribution is made, the estimated payments will be considered as unpaid up to the date of death, and therefore the estate will be responsible for paying the underpayment penalty. Other than that shortcoming, this trick could provide you with several months’ additional interest/return on your money, plus remove the hassle of the quarterly filings.

But Jim, what if I’m retired and under age 59½? Won’t there be a penalty?

There doesn’t have to be, although I’d place this particular move into the “higher degree of difficulty” category of tricks – not to be taken lightly.

Why does this work? IRC Sec 6654(g)(1)

There is a section in the Internal Revenue Code related to income tax withholding from paychecks and other sources, specifically Section 6654(g)(1). Turns out that any withholding through the year at any time is credited as though they were paid evenly throughout the year. IRC Sec 6654(g)(1) states verbatim:

(g) Application of section in case of tax withheld on wages

   (1) In general

For purposes of applying this section, the amount of the credit allowed under section 31 for the taxable year shall be deemed a payment of estimated tax, and an equal part of such amount shall be deemed paid on each due date for such taxable year, unless the taxpayer establishes the dates on which all amounts were actually withheld, in which case the amounts so withheld shall be deemed payments of estimated tax on the dates on which such amounts were actually withheld.

   (2) Separate application
 
The taxpayer may apply paragraph (1) separately with respect to—
      (A) wage withholding, and
      (B) all other amounts withheld for which credit is allowed under section 31.

Therefore, by default, withholding from a paycheck, pension or other tax withholding source is considered to have been paid in ratably during the tax year, rather than credited when they were actually withheld. That doesn’t mean the taxpayer couldn’t specify timeliness of a particular withholding (if it was to the taxpayer’s advantage), this is an election the taxpayer can choose if they wish.

Pre-59½ Retiree: How to Avoid Penalty?

Same situation as before, but now you must take another step:  once you’ve taken the distribution and properly filed the W-4P (or custodian form) to have the distribution withheld as tax – execute a 60-day rollover, placing the same amount of money either into the same IRA or another IRA… effectively, you’ve pulled the old switcheroo with the IRS on this: you’ve paid tax with a distribution that didn’t happen!

How can this be?  Well, the IRS allows you to replace (or rollover) money from any source back into your IRA, so it doesn’t matter that your original distribution was used for withholding. So you have made up for missing all those quarterly estimated payments (no underpayment penalty now) plus by rolling over the funds you’ve avoided the 10% early withdrawal penalty as well.

Caveat

I mentioned that this last trick fits into the “higher degree of difficulty” category of tricks. The reason I say this is because using your account in this fashion (essentially a 60-day loan) can be hazardous – the primary reason is that 60 days is all you have, and 60 days can be a relatively short period of time. Plus, the IRS HAS NO SENSE OF HUMOR ABOUT THIS. If you miss the rollover period by one day, you’re outta luck.

In addition to the 60-day period, there is also the limitation of only one 60-day rollover per 12-month period. Again, remember: no sense of humor at the IRS. It is for these reasons that this rollover trick should only be used in the most dire of circumstances – such as if you completely forgot to make quarterly payments and are facing a stiff underpayment penalty, for example. Otherwise, I’d suggest leaving this one alone. By all means, you should not try this trick year after year. It shouldn’t be a problem if you’re over age 59½, though.

How Remarriage Affects Widow(er)s and Ex-Spouses Differently

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Photo credit: jb

The Social Security Administration has a special way to treat former spouses (ex-spouses) differently from widows and widowers with regard to benefits when the person in question remarries. This special rule only affects ex-Spouses while the other partner from the former marriage is still living. When the former spouse dies, the surviving spouse is treated effectively the same as a widow or widower.

Remarriage Rules for Widows and Widowers

(For brevity I’m going to refer only to widows, but everything applies as well to widowers.)

If a widow is under age 60 and remarries (and stays married), she is no longer eligible for her Survivor Benefit based upon her late husband’s record. After age 60, the widow can remarry and retain access to Survivor Benefits. This rule applies the same way for a widow who was divorced from the decedent, as long as she was married to the ex-spouse for at least ten years.

Remarriage Rules for Ex-Spouses

If a couple was married for at least 10 years and has been divorced for at least 2 years, an ex-spouse can be eligible for Spousal Benefits based upon her former husband’s record – as long as she remains unmarried. (As with other examples, the roles could be reversed.) Her ex-husband must be eligible for benefits (doesn’t have to be taking them) and she must be at least age 62 for early benefits. The same rules apply as if they were still married, except that he doesn’t have to apply for her to be eligible for the Spousal Benefit. If he does apply for benefits, the two-year waiting period is eliminated.

However – if she remarries at any time while he is still alive, she will become ineligible for the spousal benefit while married. If there is a subsequent divorce or the new spouse dies, her eligibility for Spousal Benefits from the earlier marriage is restored. If/When the first husband (or any earlier husband) dies, she becomes eligible for a Survivor’s Benefit as a Widow (see above for remarriage rules for Widows). She can choose the earlier husband (if she was married more than once) with the highest available benefit for her Spousal and/or Survivor benefit – as long as she met the eligibility (length of marriage) to that former spouse.

2021 Retirement Plan Limits

No changes in contributions limits for employees to their employer-sponsored plans and IRAs.

Charitable Contribution Deductions

George would like to speak to a manager about identity theft. – photo credit – jb

On your Schedule A, you have the ability to itemize and deduct contributions that you have made to various charities during the tax year. There are some specific rules that we have to follow when listing these contributions as deductions.

Ten Tips for Deducting Charitable Contributions

  1. Contributions must be made to qualified organizations to be deductible. You cannot deduct contributions made to specific individuals or to political organizations and candidates.
  2. You cannot deduct the value of your time or services. Nor can you deduct the cost of raffles, bingo or other games of chance.
  3. If your contributions entitle you to merchandise, goods or services, including admission to a charity ball, banquet, theatrical performance or sporting event, you can deduct only the amount that exceeds the fair market value of the benefit received. Usually your charitable organization will itemize the FMV of the benefit received on your gift receipt.
  4. Donations of stock or other property are usually valued at the fair market value of the property. Special rules apply to donation of vehicles.
  5. Clothing and household items donated must generally be in good used condition or better to be deductible. The value of these items is generally far less than what you originally paid for the item. Imagine if the item were for sale on a garage sale to value it.
  6. Regardless of the amount, to deduct a contribution of cash, check, or other monetary gift, you must maintain a bank record, payroll deduction records or a written communication from the organization containing the name of the organization, the date of the contribution and amount of the contribution. For donations by text message, a telephone bill will meet the record-keeping requirement if it shows the name of the organization receiving your donation, the date of the contribution, and the amount given. Often the charitable organization will send you an electronic receipt for such donations.
  7. To claim a deduction for contributions of cash or property equaling $250 or more you must have a bank record, payroll deduction records or a written acknowledgment from the qualified organization showing the amount of the cash and a description of any property contributed, and whether the organization provided any goods or services in exchange for the gift. One document may satisfy both the written communication requirement for monetary gifts and the written acknowledgment requirement for all contributions of $250 or more.
  8. If your total deduction for all noncash contributions (merchandise or other property) for the year is over $500, you must complete and attach IRS Form 8283, Noncash Charitable Contributions, to your return.
  9. Taxpayers donating an item or a group of similar items valued at more than $5,000 must also complete Section B of Form 8283, which requires an appraisal by a qualified appraiser.
  10. To deduct a charitable contribution, you must file Form 1040 and itemize deductions on Schedule A.

For more information on charitable contributions, refer to Form 8283 and its instructions, as well as Publication 526, Charitable Contributions.  For information on determining value, refer to Publication 561, Determining the Value of Donated Property.

What to do When You Receive a Notice From the IRS

IRS-Envelope-edited-300x142You’re cruising along with everyday life, dealing with this, that and the other thing… then you go to the mailbox and there it is: A Notice From The IRS. <queue scary music here>

It’s a simple enough little envelope, much the same as a lot of other mail you might receive… but look at the return address.  IT’S. FROM. THE. IRS.

ohmygoshohmygoshohmygoshohmygoshohmygosh!!!!!!!!!!!!!!!!!!!!

What should you do? (Other than sit down, of course, before you fall down)

Steps To Take

First and foremost: calm down. The IRS sends out literally millions of these notices, often for clarification of a minor item that was either entered incorrectly, or inadvertently omitted from your return. The point is, it’s not the end of the world. But there are some very important steps you need to take when you receive such a notice.

Read. It may sound like a ridiculous thing to say, but you’ve got to read what they’re telling you. You’d be surprised how many folks are terrified to even open the letter! Quite often all they’re asking for is clarification on your return, something didn’t match up in their records. It could be quite simple! Or it could be something more complicated, but you need to read and understand what the notice is about so you know what to do next.

Take action – don’t ignore it. The IRS has these wonderful computer systems in place that keep track of your situation, even when you’re not. Ignoring the situation will not make it go away – if they’re asking for more information, provide what they ask for. Start with the letter, and get figured out what you need to do to straighten things up.

Call the number. On your notice there should be a number to call if you don’t understand the notice, or if you have questions. Bear in mind that this first line of defense at the Service is mostly interested in collecting money – and if that’s what your notice is about, you need to be prepared to hold your ground if you disagree with the notice. Also, know that calling the number is not a five-minute affair. Especially in these days of reduced staffing, you should expect the phone call to take at least an hour if not more time to just get someone to talk to. You need to do this when you have plenty of time on your hands.

Keep records. Every notice you receive, every time you call, every time you write, keep a record of the interaction. When you talk to the IRS office, every person you speak with will give you his or her name and badge number. Write it down – along with everything you say, and everything the IRS agent says. This can be critical if something changes along the line, and you need to justify why you did one thing or another. You don’t need a complete word-by-word transcript, but make sure you have the important parts of the interaction documented – especially deadlines!

Don’t get in over your head. If you’re overwhelmed by the notice, the communication, and the whole process, get help. You can find experienced tax professionals in your area by looking on the National Association of Enrolled Agents (NAEA) website (or you can call me). These folks are ready and willing to help you through the maze of working with the IRS – even if you’ve already started the communications process and found out you’ve bitten off more than you can chew.

Don’t just give in. If the notice indicates that you owe the IRS some amount of money, don’t just pay it to get it over with. The IRS is often wrong – especially when it comes to missing tax forms or miscalculations. It may seem like the safest thing to do: give them whatever they’re asking for and get them off your back! But it can really work against you if you don’t know what you’re doing.

For example, if you had cashed in a bond and forgot to include that information on your return, the IRS is going to assume that you had a zero basis in the bond. If you purchased the bond for $10,000 and later sold it for $10,100, the IRS only knows about the $10,100 that you received when you sold the bond, and in their notice they’ll indicate that you owe tax on $10,100. But in the end, when you file your amended return with your basis properly reported on Schedule D, you end up only owing tax on the $100 gain. Big difference! And if you just gave in, you’d have given them far more than you really owed.

Work it out. If it turns out that you do owe additional money to the IRS and you just can’t swing paying it all at once, ask for a payment plan. It’s not cheap to do this, but it’s a whole lot better than just ignoring the IRS altogether. Because pretty soon after you do that, you start to notice how your entire wardrobe is made up of black and white striped clothes. (Hint: that’s what you get to wear in prison!)

Summing it all up

Okay – you’ve got the notice. It’s not the end of the world. By all means, take action, do something about it, and get help if you need it. (by the way, you can also call me directly if you need help with one of these.) Good luck!

Post-Death Options for Directing a Retirement Plan to a Spouse

pet-camel

Photo credit: diedoe

There are many cases where an IRA or other retirement plan owner has directed his or her account to someone other than his or her spouse – such as the estate, a trust, or other person(s), or – the owner may not have named a beneficiary at all. It could be that the original owner simply forgot to make his or her beneficiary designation…

In a case like this, although the intent of the original owner could still be met by distributing the account as the original beneficiary designation directs, but there may also be cases where the intended heirs think otherwise and would prefer to direct the assets to the surviving spouse. It could be important from a tax standpoint since the surviving spouse has the unique option to transfer the account to his or her own name as owner, potentially allowing for deferral of taxes for many years. Plus, the surviving spouse is one of the few eligible designated beneficiaries that are allowed to stretch inherited IRA distributions over their lifetime. There could be many reasons for this to happen, but the point is that the situation could and often does arise.  How can this be accomplished to the best interest of the surviving spouse?

After Life Actions

If the account is directed to the estate or a trust and the surviving spouse is entitled to an elective share of the estate or the trust, the IRA could be chosen as the surviving spouse’s share – and thereby available to the surviving spouse.

Another option for the account that is now owned by an estate or trust with spousal and non-spouse beneficiaries is that the non-spouse beneficiaries could disclaim their portion(s) of the estate or trust, leaving the spouse as the only beneficiary.

While there are ways around the issue, this definitely doesn’t take the place of proper estate planning, by any means. You’re always better off if you make the proper moves before death, so that there is no question about your intent and who your beneficiary should be.

Important Notes

It is important to note that the IRS doesn’t have an official position on these matters with regard to how and when the surviving spouse who wasn’t specifically named as the beneficiary may be able to utilize the inherited IRA as an owned IRA (in his or her own name).

There are many Private Letter Rulings (PLRs) that address these situations – and the consensus from those PLRs seems to be this: if the circumstance is that the surviving spouse has sole ownership and rights to assign the account and/or distributions to himself or herself, then usually the IRS allows transfer to an owned IRA (rather than an inherited IRA). If the anyone other than the surviving spouse has rights or control ownership, then the IRA is considered to have been transferred from the entity (the trust or the estate) and is not available to him or her as an owned IRA, only as an inherited IRA.

As with all PLRs, these cannot be used to support your own position with regard to an action you might take, only as guidance in determining a course to consider. You will need to get your own PLR if your situation is unusual and not covered by the IRS in any other way.

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