IRA Accounts and Possible Stretch Reduction.

AuthorMcGeorge, Lorna A.

The current technical federal income tax Individual retirement account (IRA) rules concerning required minimum distribution and post-death payout options are confusing to most attorneys and clients. Despite the complex RMD rules, IRAs are tremendously popular and are frequently one of the primary assets available in retirement and at death. If managed properly, IRAs afford individuals and their family members a powerful wealth accumulation tool; if not managed properly, adverse income tax results and substantial penalties may ensue. Therefore, it is critical to understand the applicable requirements.

In an attempt to update some of these laws and raise revenue, on May 23, 2019, the U.S. House of Representatives passed a bill simplifying the post-death RMD rules and allow, under certain circumstances, such accounts a little more time to grow tax-deferred. The Senate is now considering a similar bill.

This article discusses IRAs in two parts. Part I discusses the basic rules relating to IRAs and Part II briefly considers the proposed changes to the current laws.

IRAs Generally

To encourage retirement savings, Congress created [section] 408(a) of the Internal Revenue Code in 1974 to permit individuals to save for retirement through the use of IRAs without incurring immediate income taxes on the original contributions and subsequent investment gains (traditional IRAs). Specifically, taxpayers are allowed a deduction for amounts contributed to traditional IRAs, but only until age 70W Generally, contributions to IRAs must be in cash unless they involve certain transfers known as "rollovers" of property from one IRA to another IRA.

Currently, individuals must be at least age 59 1/2 to withdraw funds from a traditional IRA without incurring early withdrawal penalties. (1) Taxpayers who take out distributions from traditional IRAs prior to age 593A are required to pay a penalty of 10% on the amount withdrawn in addition to the applicable income tax. There are several exceptions to this rule, however, under certain circumstances, such as incurring large medical bills, disability, a first-time home purchase, and expenses for higher education. (2)

Notably, not everyone can take advantage of traditional IRAs. Congress restricted their use by phasing out the applicable deduction in some cases. In addition to income limitations, there are contribution limits applicable to traditional IRAs. Qualifying taxpayers permitted to make maximum contributions to traditional IRAs can contribute up to the lesser of 100% of earned income or $6,000 in 2019 ($7,000 for those age 50 and older). (3)

The primary benefit of traditional IRAs is the ability to defer income tax on contributions to and accumulate and invest funds within IRAs without being subjected to current income taxation of any income or capital gains when assets within the account are sold. The tax deferral benefit is actually two-fold because the retirement account owner is not merely accumulating and investing his or her own money on a tax-deferred basis, but he or she is also investing and achieving gains on the money, which would have been paid to the Internal Revenue Service (IRS) for income taxes each year. The income tax deferral afforded to traditional IRAs is currently a tremendous boon to most taxpayers who subsequently receive retirement distributions at a time when perhaps they are in a lower tax bracket than they were at the time the contributions were made to their IRAs. Of course, this benefit could change if the income tax rates increase in the future.

Current Minimum Distribution Rules

Unfortunately, assets cannot be held indefinitely in tax-advantaged IRAs. The RMD rules were devised to support the policy of providing retirement funds by mandatory distributions at a "required beginning date," i.e., age 70 1/2, and preventing IRA owners from completely deferring retirement benefits and transferring wealth to subsequent generations. The RMD rules are located in [section] 401(a) (9) of the code, which describes when mandatory distributions from IRAs must begin and how much must be distributed each year. (4)

Traditional IRA distributions generally constitute ordinary income to the recipient. (5) To the extent such interests are not fully distributed, account balances left at account owners' deaths are includible in his or her gross estate under [section] 2039 of the code. (6)

Taxpayers who do not take the prescribed RMD by the applicable IRS deadline may be liable for a 50% penalty on the difference between the actual amount taken, if any, and the mandatory RMD. It is, therefore, critical for attorneys, financial advisors, and taxpayers to clearly comprehend the RMD requirements.

There are two sets of RMD rules: One set is applicable during an IRA owner's life ([section] 401(a)(9)(A) of the code), and one set is applicable after the death of the IRA owner ([section] 401(a)(9)(B) of the code). Individuals may always take out more than the mandatory RMD amount; however, any excess that is taken out does not count toward the RMD amount for future years (i.e., there is no carryover).

While IRA owners may begin receiving distributions from their traditional IRA accounts penalty free upon attaining age 59 1/2, they are not required to take mandatory distributions in required minimum amounts at that time. Permitted...

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