By Rebecca W. Geyer, Rebecca W. Geyer & Associates PC
According to the United States Department of Labor, more than 46 million workers are currently covered by employer-provided retirement plans, and such plans often represent some of the most significant assets an individual owns. Almost every client estate planning attorneys encounter has a retirement plan which makes up part of his or her estate. As a result, it is important to understand the rules which govern retirement plans and the income tax consequences which may affect both clients and beneficiaries.
Roth IRA Conversions May No Longer Be Undone
The Tax Cuts and Jobs Act of 2017 eliminates the taxpayer’s right to recharacterize or undo a Roth IRA Conversion. When assets are converted, the taxable amount of the conversion is the value at the time the amount is initially converted, even if the assets have declined in value. For instance, if an individual converted assets valued at $100,000 and the assets declined in value to $50,000, the individual must pay tax on $100,000. As a result, prior to 2018 many individuals chose to recharacterize conversions that dropped in value, thus removing any tax liability associated with the conversion. For any Roth IRA Conversions made in taxable year 2018 and going forward, the taxpayer will no longer be able to undo the conversion. The provision governing this issue says that it “shall apply to taxable years beginning after December 31, 2017.”
Making Roth IRA Contributions Through the "Back Door"
Although the Tax Cuts and Jobs Act is silent on this issue, the Conference Committee’s statement explaining the law confirms that an individual who is under 70 ½ years of age and who has current compensation income may make an annual contribution to a Traditional IRA and then convert that Traditional IRA to a Roth IRA, with no income limit on the amount being converted. This allows an individual whose adjusted gross income is above the limit permitting an annual contribution to a Roth IRA to still accomplish a Roth IRA. In addition to allowing for the tax-free growth, Roth IRA assets do not require minimum distributions during the participant’s lifetime, reducing the amount of income tax due for the participant in retirement.
Reduce RMDs Through a Qualified Longevity Annuity Contract
A relatively new IRS rule allows an owner of a traditional IRA to use a portion of his or her IRA or 401K funds to purchase a longevity annuity without the need to comply with the required minimum distribution (RMD) rules. Previously, RMD rules required that an annuity purchased inside a traditional IRA or 401K had to start distributions when the owner turned 70 1/2, even if the owner did not need the money at that time. There was no real option to defer the annuity start date, so as to allow the annuity to grow in value inside the IRA and begin larger payouts at a later date. In short, the RMD rules previously clashed with the goal of planning for lifetime income. Thus, for those who wanted to defer the annuity start date, often the only option was to purchase an annuity outside the traditional IRA with after-tax dollars or use after-tax dollars inside a Roth IRA.
The rule, which can be found in IRS Notice 2014-66, allows owners of traditional IRAs the ability to put a portion of their portfolio into a longevity annuity to provide for guaranteed income beginning at a future date, which can begin as late as age 85. By permitting this deferred start date, the rule allows for the interim growth of the annuity contract, and hence higher payouts beginning at a future date. The longer payouts are deferred, the more money the owner receives. In short, the rule allows retirees to insure themselves against the risk of outliving their money because they can provide lifetime income for themselves starting later in life.
There are some requirements of the rule, including the following: (1) Only up to 25% of the IRA account value, capped at $125,000, can be used to purchase a Qualifying Longevity Annuity Contract (“QLAC”); (2) the annuity must begin payout by age 85; and (3) the annuity must be irrevocable once purchased. The rule also permits the contract to have a “return of premium” feature: if the IRA owner dies before receiving back all of the annuity premium payment, the difference will be paid back to his or her beneficiary. Also, the $125,000 cap will be subject to cost of living adjustments. Retirees who choose to take advantage of this new option can still invest the remaining 75% of their IRA or 401(k) account balance in other assets, as before, with the understanding that only these assets will be used to calculate the RMD’s with the mandatory start date at age 701/2. This rule is especially significant for those persons who are not yet ready to retire or who do not need to begin drawing on their traditional IRA or 401K at age 70 ½.
Roll Funds into IRAs After Retirement for Greater Flexibility
Employer-provided retirement plans, such as 401(k)s, are governed by ERISA. While the required distribution rules for employer-provided retirement plans are the same as those which apply to traditional IRAs, employer-sponsored plans can often be less flexible for participants. For example, under ERISA rules a married participant may not designate a non-spousal beneficiary to receive more than 50% of his or her retirement plan without the consent of his or her spouse (unless a premarital agreement is in place specifically addressing such issue). Spousal waivers, however, are not required for IRA rollovers.
Another drawback of employer-provided retirement plans is that they are limited to the investments offered by the specific plan. Moving the plan to a rollover IRA allows the participant to choose his or her investment choices from all those offered by the company with whom the account is held.
Clients with large retirement plans who do not need their annual RMD for living expenses may wish to avoid income tax on the RMD by donating the money directly to a qualifying charity. This concept is discussed in more detail in the fifth tip below, but charitable contributions can only be made from IRAs, not 401(k)s or similar types of retirement accounts. Clients wishing to reduce their income tax liability in retirement may wish to rollover their employer-provided plan to an IRA to allow this type of charitable planning.
Donating Required Minimum Distribution to Charity
After years of contributing to tax-deferred 401(k)s and IRAs, income tax is due when a participant takes withdrawals in retirement. Annual withdrawals from traditional retirement accounts are required after age 70 ½, and the penalty for skipping a required minimum distribution is 50 percent of the amount that should have been withdrawn. However, if a participant is in the fortunate position of not needing his or her required minimum distribution for living expenses and is charitably inclined, he or she can avoid income tax on the required withdrawal by donating the money directly to a qualifying charity.
IRA owners must be age 70 ½ or older to make a tax-free charitable contribution. Those who meet the age requirement can transfer up to $100,000 per year directly to an eligible charity without paying income tax on the transaction. If the participant files a joint tax return, the participant’s spouse can also make a charitable contribution of up to $100,000, meaning couples can exclude up to $200,000 of their retirement savings from income tax if they donate it to charity. If a participant donates more than the maximum allowable amount it is considered income and could be subject to income tax. Qualified charitable contributions must be made by December 31 each year in order to exclude that amount from taxable income.
Charitable contributions can only be made from IRAs, not 401(k)s or similar types of retirement accounts. A participant might need to roll funds over from a 401(k) to an IRA to make tax-free charitable contributions from a retirement plan. The participant does not need to itemize taxes in order to make an IRA charitable distribution. However, the participant cannot additionally claim a charitable contribution tax deduction on a charitable distribution from the IRA. Because the participant is not getting taxed on the distribution from the IRA, the participant doesn’t get to count the transfer to the charity as a charitable deduction as well. The participant should still request an acknowledgment of the donation from the charity for tax purposes to prove the RMD should not be included in the participant’s gross income.
A $100,000 charitable contribution from an IRA could save the participant tens of thousands of dollars in taxes, depending on the participant’s tax rate. For a retiree in the 25 percent tax bracket, an IRA charitable contribution of $5,000 could reduce the retiree’s income tax bill by $1,250. Even a $1,000 donation would save the retiree $250 in taxes. The benefits of making a charitable contribution from the participant’s IRA are even bigger for those in higher tax brackets. Because the participant is not receiving the distribution, he or she is not getting taxed on the distribution; it goes straight to the charity.
Funds must be transferred directly from the IRA to an eligible charity by the IRA trustee in order to qualify for the tax break. If the participant withdraws the money from his or her IRA and later donates it, it won't qualify as a tax-free qualified charitable distribution. The charity must also be a 501(c)(3) organization in order to receive the tax-free IRA charitable contributions. Charities that do not qualify include private foundations and donor-advised funds. A participant can also distribute his or her required minimum distribution to multiple charities in the same year.