Mini-Course Series - Income (Part 6) by Institute of Business & Finance

MINI-COURSE SERIES

RETIREMENT INCOME Part VI

RETIREMENT INCOME

INDIVIDUAL RETIREMENT ARRANGEMENTS (IRAS) There are two types of individual retirement arrangements, individual retirement accounts and individual retirement annuities. Each is often referred to as an “IRA,” or a “traditional IRA.” Generally, an account is set up as a trust or custodial account with a bank, a federally insured credit union or a savings and loan association. An individual retirement annuity is established by purchasing an annuity contract from a life insurer. The IRA may not hold life insurance. Contributions may be made up to the time when the individual’s tax return is due (excluding extensions). In order to deduct contributions an individual must: (1) have compensation (earned income or alimony) and (2) not have attained age 70 1/2 during the taxable year for of the contribution. In 2011, a deduction may be taken for amounts contributed up to the lesser of $5,000 or 100% of compensation includable in gross income. An additional “catch-up” contribution of $1,000 is allowed for individuals who attain age 50 before the close of the taxable year. Deductions may be reduced or eliminated if the individual is an “active participant” in a qualified plan. In the case of traditional IRAs, contributions are full deductible, regardless of the taxpayer’s level of income, provided he or she is not an active participant in a qualified retirement plan. For 2012, if the taxpayer is single and is an active participant, a traditional IRA contribution (plus any “catch-up”) is also deductible if AGI is $58,000 or less. Contributions are partially deductible if AGI is between $58,000 and $68,000. Active single participants cannot deduct IRA contributions if their AGI is over $68,000. In the case of someone married who files a joint tax return, deductibility of a traditional IRA depends on whether or not the taxpayer or spouse is an active participant in a qualified retirement plan. For 2012, if the married taxpayer is an active participant: [a] 100% deductibility if AGI is up to $92,000, [b] if AGI is $92,000 up to $112,000, contributions are partially deductible (pro rata within this range) and [c] if AGI is over $112,000, contributions can still be made but are not deductible.

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RETIREMENT INCOME

If the taxpayer is married, files a joint return and has a spouse who is an active participant in a qualified retirement plan then: [a] any traditional IRA contribution is 100% deductible if AGI is less than $173,000, [b] partial deductibility if AGI is between $173,000 and $183,000 and [c] if AGI is over $183,000, contributions can still be made but are not deductible (all figures are for the 2012 calendar year). Generally, funds accumulated in a plan are not taxable until they are actually distributed. However, amounts distributed prior to age 59 ½ are considered premature distributions and are subject to a 10% penalty tax. Exceptions to the penalty tax include distributions: (1) made on or after death; (2) attributable to disability; (3) as part of a series of substantially equal periodic payments made (at least annually) for the life or life expectancy of the individual or the joint lives or joint life expectancy of the individual and a designated beneficiary (e.g., an annuity payout); (4) for medical expenses in excess of 7.5% of AGI; (5) for health insurance premiums for those receiving unemployment compensation; (6) used to pay for a first home or (7) to pay for qualified higher education expenses. Distributions from a plan must usually begin by April 1st of the year after year in which the individual reaches age 70 ½.

ROTH IRA In 2012, the Roth IRA permits individuals to make nondeductible contributions to an IRA of up to the lesser of 100% of compensation or $5,000 per year. An additional “catch-up” contribution of $1,000 is allowed for individuals who attain age 50 before the close of the taxable year. Unlike traditional IRAs, contributions may be made after age 70 ½ and husband and wife may contribute amounts without regard to whether either of them is a participant in another qualified plan as long as there is sufficient compensation. The annual contribution limit is reduced dollar-for-dollar by contributions to a traditional IRA. Also, the maximum yearly contribution is subject to a pro rata phase-out for taxpayers filing jointly with modified adjusted gross incomes between $173,000 and $183,000 (for single taxpayers with modified adjusted gross incomes between $110,000 and $125,000). Thus, if someone files a joint return and modified AGI is more than $183,000 (if single, $125,000), no Roth IRA contribution can be made.

PART VI

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RETIREMENT INCOME

As with the traditional IRA, the Roth IRA accumulates tax-deferred. Provided the account has been held for at least five years, distributions are not subject to income taxes if: (1) the owner is at least age 59 1/2; (2) the distribution is made after the owner’s death; (3) the distribution is attributable to the owner being disabled or (4) the distribution is for qualified first-time home buyer expenses (limited to $10,000 for both the owner and specified family members). A 10% penalty tax applies to the taxable portion of withdrawals that are not qualified. Unlike traditional IRAs, there are no requirements that distributions be started or completed by any particular date, unless the owner dies. The following factors might be considered when determining whether for a particular taxpayer the Roth IRA is better than a traditional IRA, or whether to make a taxable rollover to a Roth IRA: (1) the current age of the taxpayer; (2) the taxpayer’s current and anticipated future marginal income tax brackets; (3) the taxpayer’s need for a current income tax deduction; (4) the availability of other funds to pay the taxes on Roth IRA contributions or rollovers and (5) anticipated reduction of taxes on Social Security income caused by receiving untaxed IRA income.

WHICH IRA – ROTH OR TRADITIONAL A Roth IRA offers the following potential advantages: (1) if used for higher education expenses, withdrawals can be made prior to age 59 1/2 without penalty; (2) distributions are not required at age 70 1/2; (3) contributions may continue after reaching age 70 1/2; (4) phase-out limits are higher than those for deductible contributions to a traditional IRA and (5) tax-free retirement distributions will not push modified AGI above the threshold that triggers taxation of Social Security benefits.

IRA DISTRIBUTION PLANNING Monies cannot be kept in a traditional IRA indefinitely. For most, the calculation of required minimum distributions during life is very simple: the account balance as of December 31st of the preceding year is divided by a life expectancy factor based on the account owner’s age in the year distribution is due using the Uniform Lifetime Table (see next table). This method is used regardless of the beneficiary’s age, except when the beneficiary is a spouse more than 10 years younger than the owner—a joint and survivor table set forth in the regulations produces a lower amount.

PART VI

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RETIREMENT INCOME

Lifetime Required Minimum Distributions (RMDs) Age

Distribution Period

Age

Distribution Period

Age

Distribution Period

27.4

18.7

11.4

26.5

17.9

10.8

25.6

17.1

10.2

24.7

16.3

9.6

23.8

15.5

9.1

22.9

14.8

8.6

22.0

14.1

8.1

21.2

13.4

7.6

20.3

12.7

7.1

19.5

12.0

6.7

Application The table above is used in calculating lifetime RMDs from IRAs, qualified plans and TSAs for someone single. For example, a client turned age 74 in 2010, and on December 31st, 2009, his account balance was $325,000. Using this table, his life expectancy is 23.8 years. He must receive a distribution of $13,655 ($325,000 ÷ 23.8 = $13,655) for the 2009 year, no later than December 31st, 2010. If an individual owns more than one IRA, the RMD must be calculated separately for each IRA, but the total RMD may then be taken from any one or more of the IRAs. Failure to take a minimum distribution will subject the payee to a penalty tax of 50%. If an IRA owner dies before her required beginning date, distributions must be made under one of two methods: (1) life expectancy rule–if any portion of the interest is payable to a designated beneficiary, that portion must be distributed over the life (or life expectancy) of the beneficiary, beginning within one year of the owner’s death or (2) five year rule–the entire interest must be distributed within five years after the death of the IRA owner (regardless of who or what entity receives the distribution). If the IRA owner dies on or after his required beginning date, but before his entire interest in the IRA has been distributed, remaining balance is distributed over longer of: (1) the designated beneficiaries single life expectancy or (2) the remaining single life expectancy of the owner, based on his age at death.

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RETIREMENT INCOME

Estate taxes on the IRA will be due at the death of the owner or his spouse, depending upon the beneficiary designation. Incorrectly changing the name on an inherited IRA account can result in the IRA becoming subject to income taxes within a year. When dealing with an inherited IRA the following should be determined: (1) whether distributions have started, (2) whether the required beginning date (RBD) has been reached, (3) whether a beneficiary has been named and (4) whom the beneficiary is. The answers will determine which of the following options are available: IRA inherited by spouse before RBD—A surviving spouse beneficiary may: (1) withdraw the assets within five year; or (2) elect to treat the IRA as her own (or transfer assets to her own IRA), name a new beneficiary and take distributions over her lifetime (beginning either at end of the year following spouse's death or by end of the year she would have turned age 70 1/2). Option (2) also allows for naming a new designated beneficiary and deferral of distributions until surviving spouse's age 70 1/2 (i.e., a so-called "stretch IRA"). IRA inherited by spouse after RBD—A surviving spouse beneficiary may: (1) take distributions over his lifetime, beginning no later than the end of the year following the spouse’s death, (2) treat the IRA as his own or (3) receive distributions over the remaining single life expectancy of the owner based on his age at death. In order to treat the IRA as his own the recipient must be the sole primary beneficiary. IRA inherited by non-spouse before RBD—A non-spouse beneficiary may: (1) withdraw the assets within five years or (2) take distributions over lifetime, beginning no later than the end of the year following the owner’s death (if multiple non-spouse beneficiaries must use life expectancy of oldest beneficiary or create separate accounts before September 30th of the year after death). IRA inherited by non-spouse after RBD—A designated beneficiary may withdraw assets over life (or life expectancy), beginning no later than the end of the year following the owner’s death.

Terminology Designated beneficiary (DB)—The individual or trust designated to receive the IRA proceeds, either by the terms of the IRA document or by an affirmative election by the IRA owner or surviving spouse. Generally, the designated beneficiary will be determined as of September 30th of the year following the year of the owner’s death.

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RETIREMENT INCOME

Required beginning date (RBD)—For traditional IRAs, this is April 1st of the year following the owner’s attaining age 70 1/2. Roth IRA owners are not subject to the lifetime distribution requirements. Required minimum distribution (RMD)—Minimum required payments from an IRA (a penalty tax of 50% is imposed on any RMD not made). Stretch IRA—Uses a combination of beneficiary designations and life expectancy elections to delay receipt of distributions (also referred to as a “multi-generation IRA”). Typically assumes IRA owner and spouse will not need the funds for retirement or for estate taxes. Use of disclaimers may allow post-mortem planning.

THINGS TO DO 

Your Practice

Bypass the debate about the pros and cons of a traditional vs. Roth IRA by having a strategy that includes tax diversification. Using investment vehicles that take advantage of tax deferral, tax free, and taxable means there will be the ultimate flexibility when deciding what accounts should be liquidated during retirement. 

The Next Installment

Your final installment, Part VII, covers equity-indexed annuities (EIAs). Generally, EIAs should be avoided—there are simply better alternatives. Still, there are a few situations wherein this product can make sense. The exclusion ratio for all types of annuities is also detailed. You will receive Part VII in a few days. 

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

PART VI

IBF | MINI-COURSE SERIES