Tax Planning for Retirees

IRA Tax Developments – Part 1

Distributions Taxed to Former Spouse Regardless of Community Property Laws. – A distribution from a qualified retirement plan to a retiree’s former spouse under a court’s “qualified domestic relations order” (a QDRO) is generally taxable to the spouse. The Tax Court has determined that community property laws of a state do not change this result – i.e., do not make the distribution taxable to the retiree. Seidel v. Commissioner, T.C. Memo 2005-67 (2005). See Chapter 2 of the treatise for a discussion of QDROs under qualified retirement plans.

Protection from Bankruptcy for Funds in IRAs and Retirement Plans. – Funds in IRAs and qualified retirement plans are generally exempt from forfeiture in bankruptcy proceedings. However, in the case of IRAs and Roth IRAs, an individual’s bankruptcy exemption is generally limited to the sum of (a) $1,000,000, (b) the amount of funds rolled over from qualified plans (and earnings thereon), and (c) funds in SEPS and Simple IRAs. However, this bankruptcy exemption does not protect inherited IRAs. (Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, § 224; Clark v. Rameker, ___ U.S. ___, 2014-1 U.S.T.C. ¶ 50,317 (inherited IRAs).) See Chapter 5 of the treatise, generally, for a discussion of the taxation of funds in IRAs.

IRS Allows Correction of Overpayment of Required Minimum IRA Distributions. – An IRA must start making minimum distributions by April 1 of the year after the owner reaches age 70 ½. Recipients generally rely on their IRA administrators to compute and distribute the correct amount. Where an administrator erroneously distributed an amount in excess of the required minimum, the IRS ruled that the taxpayer could roll the excess back into his IRA – even though the normal 60-day rollover period had expired. (Ltr. Rul. 200443034 and 200438046.)

For descriptions of other situations where the IRS has waived the 60-day rollover requirement, click here. Also, see Chapter 8 of the treatise for a discussion of minimum distribution requirements; see Chapter 5 of the treatise for a discussion of the requirements for a rollover from an IRA.

Division of an Inherited IRA Held by a Trust. – If a trust is the named beneficiary of an inherited IRA, the beneficiaries of the trust may arrange transfers to new and separate inherited IRAs for each trust beneficiary, provided the trust is a “see through” trust. A see-through trust is a trust with identifiable individual beneficiaries that is irrevocable or that will automatically become irrevocable upon the retiree’s death, and that satisfies certain procedural requirements.

However, the beneficiary of such a newly separated IRA who bases his required minimum distributions on life expectancy must use the life expectancy of the oldest trust beneficiary – unless the use of multiple trusts effectively allows each beneficiary to use his or her own life expectancy. (Reg. § 1.401(a)(9)-4, Q&A 5; Ltr. Rul. 200809042; Ltr. Rul. 200537044.) See Chapters 5 and 8 of the treatise for discussions of divisions of IRAs and trusts and the effect of the divisions on minimum distribution requirements.

Use of Multiple Trusts to Maximize IRA Tax Deferral. – Generally, dividing an inherited IRA (not held in trust) into separate accounts or separate inherited IRAs for each beneficiary will allow the younger beneficiaries to maximize tax deferral on their interests in the IRA by taking distributions over their longer lifetimes. Unfortunately, though, for this purpose, beneficiaries may not treat as separate accounts or separate IRAs those interests of the beneficiaries originally held indirectly through a trust. Nevertheless, a retiree may be able to solve this problem neatly by providing for multiple trusts or sub-trusts, one for each beneficiary – if certain other requirements are satisfied. (Ltr. Rul. 200537044.) See Chapter 8 of the treatise for a discussion of the use of trusts in maximizing tax deferral.

Transfer of Funds from an IRA to a Health Savings Account. – If a retiree does not yet qualify for Medicare, the retiree may be eligible to make tax-deductible contributions to a health savings account (HSA). An HSA is an account that pays medical expenses not otherwise covered by a high deductible health plan.

After 2006, a taxpayer may make a nontaxable trustee-to-trustee transfer of funds to an HSA from an IRA (but not from a “simple retirement account” or a “simplified employee pension”). The transfer is not deductible, and the taxpayer may generally make only one such transfer during his or her lifetime. In addition, the total contributions to HSAs and Archer MSAs for the year (including the IRA transfer) may not exceed the usual annual limitation on such contributions. (Tax Relief and Health Care Act of 2006, Pub. L. No. 109-432, § 307; I.R.C. §§ 223, 408(d)(9)) See Chapter 5 of the treatise for a discussion of the taxation of IRAs.

Division of IRA in Divorce with Consequent Reduction of Distributions. – The transfer of one-half of the funds in an IRA to the taxpayer’s divorcing spouse is not taxable to the taxpayer. Furthermore, if the taxpayer were receiving substantially equal periodic payments to avoid the 10 percent penalty tax on early distributions, a proper reduction in the amount of those payments to account for the division of funds will not trigger the 10 percent penalty tax. (Ltr. Rul. 200717026.) See Chapter 5 of the treatise for a discussion of the 10 percent penalty tax on early distributions.

The IRS Allowed an IRA Loan to a Church Secured by Life Insurance. The IRS allowed a taxpayer’s IRA to loan money to a church, with the loan secured by an insurance policy on the taxpayer’s life. The taxpayer was not a board member or employee of the church and did not own, control, or have a financial interest in the church. In addition, the church was the sole owner of the life insurance policy and enjoyed all the rights under the policy, subject to restrictions imposed by the security agreement. (Ltr. Rul. 200741016.) See Chapter 5 of the treatise for a discussion of prohibited IRA investments and transactions.

Personal Sale of Stock at a Loss and Repurchase by an IRA. – The tax law generally does not allow a taxpayer to deduct a loss on the sale of stock or securities if the taxpayer purchases substantially identical stock or securities within 30 days after the sale (a so-called “wash sale”). The IRS has now held that the loss remains nondeductible even if the taxpayer’s IRA repurchases the substantially identical stock. Furthermore, in such a case, the taxpayer may not increase his or her cost basis in the IRA to account for the excess of the IRA’s repurchase price over the taxpayer’s sales price. (Rev. Rul. 2008-5, 2008-1 C.B. 271.) See Chapter 5 of the treatise for a discussion of the taxation of IRAs.

IRA Distributions Paid Directly to Charities. – A retiree age 70 ½ or older may exclude from taxable income certain distributions paid by his or her IRA directly to a qualified charity. The amount of excludable charitable distributions for a given year is limited to the lesser of (1) $100,000, (2) the amount of the payments to the charity, or (3) the portion of IRA funds otherwise deemed potentially taxable. (I.R.C. § 408(d)(8); Notice 2007-7, 2007-5 I.R.B. 395.) See Chapter 5 of the treatise for a discussion of the taxation of IRAs.

Withdrawal of After-Tax Excess Contributions – A taxpayer may avoid penalties on an excess contribution by withdrawing it before his or her return is due for the year of the contribution. However, if the taxpayer does not make a timely withdrawal, a subsequent withdrawal is taxable as an ordinary distribution. (Ltr. Rul. 200904029; I.R.C. § 408(d)(4).) See Chapters 2, 4, 5, and 6 of the treatise for an explanation of the taxation of distributions from tax-favored plans and arrangements.

IRS Lien Not Extinguished by Rollover to Another Plan or IRA. – If the IRS files a tax lien that attaches to IRA funds, an owner cannot extinguish the lien merely by rolling over the funds from the IRA to a qualified plan. (Miles v. Commissioner, T.C. Memo 2007-208, aff’d by unpublished opinion, 2010-2 U.S.T.C. 50,661 (9th Cir. 2010)). See Chapter 5 of the treatise.

IRA Provisions Placing Restrictions on Distributions. – A retiree may incorporate into an IRA specific distribution restrictions not otherwise required by the tax law, provided the restrictions do not interfere with required minimum distributions. For example, the IRS ruled that a taxpayer suffering from bipolar disorder could incorporate restrictions into her IRA that delayed her requested distributions long enough to allow her attorney to counsel her. (Ltr. Rul. 201150037.) See Chapter 5 of the treatise.

Prohibited Transactions of Self-Directed IRAs. – The tax law prohibits certain transactions involving (1) a retiree’s IRAs and (2) the retiree, a beneficiary, a fiduciary, or certain other related parties (hereafter “disqualified persons”). Unfortunately, a prohibited transaction consummated by an individual retirement account will terminate the account as of the first day of the tax year in which the prohibited transaction occurs. The tax law will then treat the retiree or beneficiary as if he or she received a taxable distribution of all the assets in the account on that first day.

As two recent cases illustrate, the owner of a self-directed IRA may be particularly vulnerable to prohibited transactions since the IRA owner’s power to direct investments generally makes the owner a disqualified person. (Peek v. Commissioner, 140 T.C. No. 12 (2013).) Thus, the payment of compensation for services rendered by the IRA owner to an entity owned by the IRA is a prohibited transaction. (Ellis v. Commissioner, 2015-1 U.S.T.C. ¶ 50,328 (8th Cir.). See Chapter 5 of the treatise for a discussion of prohibited transactions.

Married Individuals and Registered Domestic Partners in Community Property States.– The taxation of distributions from IRAs (and deductions for contributions to IRAs) are generally determined without regard to community property laws. Nevertheless, the IRS and several state courts have held that community property laws continue to apply to IRAs for testamentary and divorce purposes. These rulings and cases may also have some applicability to IRAs held by registered domestic partners in states that apply community property laws to such taxpayers. (I.R.C. §§ 219(f)(2), 408(g); In re Mundell, 124 Idaho 152, 857 P.2d 631, 633 (Idaho 1993); McVay v. McVay, 476 So. 2d 1070, 1073-1074 (La. Ct. App. 1985); Ltr. Rul. 201021048; CCA 201021050; Ltr. Rul. 8040101; FSA 199935055.) See Chapter 5 of the treatise.

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