How to Maximize IRA Accumulations

A longer distribution period can help increase the funds available.
BY LINDA M. JOHNSON

  

EXECUTIVE SUMMARY
  • TAX LAW REQUIRES IRA OWNERS TO BEGIN TAKING minimum distributions from traditional IRAs starting in the year they turn age 70 12 . Since the balances in these accounts can be quite sizable, some owners prefer to continue generating tax-deferred earnings as long as possible. CPAs can help clients prolong the distribution period by recommending certain techniques.
  • NAMING A DESIGNATED IRA BENEFICIARY ALLOWS the IRA owner to use joint life expectancy tables to compute required distributions based on the joint life expectancy of the owner and the beneficiary. Since this is longer than the owner’s life expectancy alone, the account will be paid out over a longer period of time. Generally, only individuals qualify as designated beneficiaries.
  • RECALCULATING THE OWNER’S LIFE EXPECTANCY is another way to extend the life expectancy used in computing required IRA distributions. As a general rule, however, CPAs should not recommend recalculation. The method only marginally increases the life expectancy used during the owner’s lifetime, but accelerates required distributions at the owner’s death.
  • DISTRIBUTION RULES FOR INHERITED IRAs DEPEND on whether the owner dies before the required beginning date for distributions. If the owner dies before this date, an IRA must generally be distributed within five years. An exception allows the designated beneficiaries to take distributions over their life expectancy. If the owner dies after the RBD, the remaining IRA balance must be distributed at least as fast as the owner was taking distributions.
  • BY PLANNING AHEAD, AN IRA OWNER CAN EXTEND the period for IRA distributions, allowing additional tax-deferred earnings to accrue.
LINDA M. JOHNSON, CPA, PhD, is associate professor of accounting at Kennesaw State University in Kennesaw, Georgia. Her e-mail address is Linda_Johnson@coles2.kennesaw.edu .

RAs have long been a popular retirement savings vehicle. In addition to making individual contributions, employees who change jobs often roll over employer-provided retirement benefits into self-directed IRAs to gain greater control over how the funds are invested. Because the balances in these accounts can be quite sizable, some IRA owners, especially those with other sources of retirement income, might want to continue generating tax-deferred earnings indefinitely.

America’s Retirement Savings in Arrears

More than half (56%) of American households are behind where they should be in saving for a comfortable retirement. A majority—59%—say they expect their standard of living in old age will be lower than it is now.

Only 23% of households with income between $10,000 and $25,000 will have adequate retirement savings. However, 54% of those with incomes between $50,000 and $100,000 will be able to retire with adequate savings. For those with incomes over $100,000, the number rises to 69%.

Only 26% of Americans with income between $15,000 and $25,000 expect to retire at age 65 with the same or a higher standard of living. By comparison, 44% of those with incomes above $50,000 expect to retire comfortably at 65.

Fully 45% of survey respondents said they had developed a financial plan to ensure adequate retirement income. Nearly half of those with a plan said they expected to retire with the same or higher standard of living. Of those without a plan, only 23% had this expectation.

An estimated 55% of those who participate in an employer-sponsored retirement plan will have enough retirement savings, while only 24% of those who don’t will have adequate retirement assets.

Source: Consumer Federation of America, Washington, D.C. Additional survey information and a retirement savings toolkit are available at www.consumerfed.org.

Unfortunately, the tax laws require IRA owners to begin taking minimum distributions from traditional IRAs (the rules for Roth IRAs are different) starting with the year they turn age 7012. (Taxpayers can delay the first required distribution until April 1 of the following year.) If they withdraw less than the required amount, the IRS assesses a 50% excise tax on the difference. The required minimum distribution in any year equals the IRA balance on December 31 of the previous year divided by the appropriate life expectancy. Taking distributions toward the end of the year allows IRA owners to accrue additional tax-deferred earnings for that year. However, more important to maximizing the tax-deferred benefits associated with traditional IRAs is using the longest life expectancy possible to compute required distributions. This article provides guidance on how CPAs can help some IRA owners prolong the distribution period by naming a designated beneficiary, establishing multiple IRAs or recalculating the owner’s life expectancy.

USING LIFE EXPECTANCY TABLES

To compute required IRA distributions for an account with no designated beneficiary, an owner uses the single life expectancy tables to determine his or her life expectancy. Having a designated beneficiary allows the owner to use the joint life expectancy tables to compute required distributions based on the joint life expectancy of the owner and the designated beneficiary. This joint life expectancy is always longer than the owner’s single life expectancy. The tables in the exhibit on page belw show that the single life expectancy of a 70-year-old IRA owner is 16 years, whereas the joint life expectancy of the same person and another 70-year-old is 20.6 years—an increase of 4.6 years. If the designated beneficiary is younger than the owner, the joint life expectancy is even longer. For example, if the designated beneficiary is 60 instead of 70, the joint life expectancy is 26.2 years. Thus, IRA owners can substantially lengthen the life expectancy used in computing required distributions (thereby maximizing the amount remaining in the IRA) by naming a designated beneficiary.

Single and Joint Life Expectancy Tables*

*Life expectancy tables are available online at www.irs.ustreas.gov/plain/forms_pubs/pubs/p5909901.htm.

**The full text of this table can be found in Treasury regulations section 1.72-9, table V.

***The full text of this table can be found in Treasury regulations section 1.72-9, table VI.

RULES FOR NAMING A BENEFICIARY

Although any individual or entity can be named as an IRA beneficiary, generally, only individuals qualify as so-called designated beneficiaries. If a charity or the owner’s estate, for example, is a beneficiary or co-beneficiary, the IRA is treated as having no designated beneficiary and the owner must compute required distributions using his or her single life expectancy. When the IRA owner wants both individual and other beneficiaries, establishing separate IRAs for each beneficiary can lengthen the life expectancy used to compute required distributions.

Example. Diane names her brother and a charity as the beneficiaries of her IRA. Because the charity cannot be a designated beneficiary, required distributions must be made over Diane’s single life expectancy. If Diane established two IRAs with her brother as the beneficiary of one and the charity as the beneficiary of the other, she could receive distributions from the first account over her and her brother’s joint life expectancy. Required distributions from the second IRA would be made over her single life expectancy.

The designated beneficiary is determined as of the owner’s required beginning date (RBD) for taking distributions—April 1 of the year after the year in which the owner turns age 70 12 . Thus, an IRA owner who turns 70 on February 15, 2000, turns 70 12 on August 15, 2000, and accordingly, would have an April 1, 2001 RBD. However, an owner who turns 70 on August 5, 2000, does not turn 70 12 until February 5, 2001, and therefore would have until the April 1, 2002 RBD to name a designated beneficiary. If there is more than one designated beneficiary on the RBD, the one with the shortest life expectancy is used to determine joint life expectancy. If an owner has multiple beneficiaries in mind, establishing a separate IRA for each one ensures the smallest possible distribution each year.

Example. Ginny’s brother and sister are the beneficiaries of her IRA. Ginny turns 70 12 on November 14, 2000; her brother and sister that year are 62 and 66, respectively. The 2000 required distribution is based on the joint life expectancy for 70 and 66, or 22.5 years. Had Ginny established separate IRAs before her April 1, 2001 RBD, she would still use the 22.5-year joint life expectancy for the IRA of which her sister is the beneficiary. However, she would use the longer joint life expectancy of 24.9 years (ages 70 and 62) for the IRA of which her brother is the beneficiary.

When the designated beneficiary is not the owner’s spouse, the age of the designated beneficiary used in determining the joint life expectancy can be no more than 10 years younger than the IRA owner, regardless of the designated beneficiary’s actual age.

Example. Susan turns 70 12 on April 16, 2000. Her 39-year-old daughter is the beneficiary of her IRA. In computing her 2000 required distribution, Susan uses the joint life expectancy of 25.3 years (ages 71—Susan’s age in 2000—and 61, the maximum 10 years younger than her age).

If after the RBD the owner adds a beneficiary with a shorter life expectancy, minimum required distributions starting with the following distribution year are computed by replacing the existing designated beneficiary with a new one, thereby shortening the life expectancy used to compute required distributions. However, adding a beneficiary with a longer life expectancy has no effect on the required distributions.

DISTRIBUTIONS FROM MULTIPLE IRAs

Owners with several IRAs compute the minimum distributions using the appropriate life expectancy for each account. The aggregate of the required distributions from all traditional IRAs must be made during the year, but distributions can be made from any of the owner’s traditional IRAs. The decision regarding which account to take distributions from can affect the future earnings and distributions from the various accounts.

Example. Curt turns 70 12 on March 8, 2001. On December 31, 2000, the balances in his traditional IRAs were $40,000 and $10,000. As of Curt’s RBD, his wife and a charity are the respective beneficiaries of these accounts. His wife turns 58 in 2001. Therefore, Curt uses the joint life expectancy of 27.5 years (ages 71 and 58) to compute the 2001 required distribution from the first IRA; a life expectancy of 15.3 years (age 71 from the single life table) applies to the second IRA. The aggregate required distribution is $2,109 ($1,455 for the first account; $654 for the second). Curt can withdraw the entire $2,109 from the second IRA, thereby maximizing both the balance and future earnings in the IRA with the longer distribution period.

Recalculating Life Expectancies

B efore deciding whether to recommend the recalculation method, CPAs should consider the adverse effects the owner’s death may have on subsequent distributions. When recalculation is used, the owner’s life expectancy becomes zero in the year after he or she dies. All subsequent distributions use the single life expectancy of the designated beneficiary. If the IRA does not have one, the balance must be distributed by December 31 of that year. For this reason, CPAs should not recommend recalculation in most instances.

One exception might be when the beneficiary is a charitable organization and when deferral of income after the owner’s death is not an issue since tax-exempt organizations are not taxed on distributions from traditional IRAs. A second exception might be when the owner’s spouse is the sole beneficiary and the spouse intends to treat the owner’s IRA as his or her own after the owner’s death. However, distributions accelerate after the owner dies when the spouse predeceases the owner, as illustrated in the following examples.

Example. Arnie’s spouse Judy is the beneficiary of his IRA. Arnie turned 70 12 on June 4, 1999; Judy turned 64 that year. In computing the 1999 required distribution, Arnie used the joint life expectancy for 71 and 64 (23.4 years from the joint life expectancy table in the exhibit). If both life expectancies are recalculated, in computing the 2000 required distribution Arnie would use the joint life expectancy for 72 and 65—22.5 years.

Judy dies in 2001, but her life expectancy does not become zero until 2002. Therefore, the 2001 required distribution will use the (recalculated) joint life expectancy of ages 73 and 66. Starting in 2002, required distributions are computed using Arnie’s actual age from the single life expectancy table. Thus, the 2002 required distribution will use his single life expectancy at age 74. When Arnie dies, the beneficiaries of his IRA must receive the remaining account balance by December 31 of the following year.

Example. Same information as above, except neither Arnie nor Judy recalculates their life expectancy. The 1999 required distribution does not change, but the 2000 distribution calculation uses the joint life expectancy of 22.4 years (23.4 minus 1), instead of 22.5. The life expectancies used in computing the 2001 and 2002 distributions are 21.4 and 20.4 years, respectively. Following Arnie’s death, his IRA beneficiaries will continue to use the reduce- by-one-year method in each distribution year until the IRA is fully distributed in 2022.

TO RECALCULATE OR NOT?

Another way to extend the life expectancy used in computing required distributions is to recalculate the owner’s life expectancy each distribution year. Under this method, the life expectancy is based on the owner’s actual age at the end of each distribution year. Without recalculation, the owner’s life expectancy is one year less than the life expectancy used in the previous year.

Example. Joann turned 70 12 on December 2, 1999. Her IRA has no designated beneficiary. From table 1 in the exhibit, the single life expectancy for age 70 is 16 years. In 2000, Joann will use the remaining life expectancy of 15 years if she does not recalculate her life expectancy. If she does elect to recalculate, she uses the slightly longer 15.3 years—the single life expectancy for age 71.

As a general rule, CPAs should not recommend recalculation. Although the method marginally increases the life expectancy used during the owner’s lifetime, distributions accelerate after the owner dies because the owner’s life expectancy is zero beginning with the year after his or her death. When the spouse is the sole beneficiary, the owner also must decide whether to recalculate the spouse’s life expectancy. (Recalculation is not an option for non-spouse beneficiaries.) The sidebar, “Recalculating Life Expectancies,” above, describes the recalculation method more fully, including a discussion of when it might be advantageous.

Whether an IRA owner uses the recalculation method also depends on the IRA plan documents. Some plans don’t allow it unless the owner elects to recalculate the life expectancy of either the owner or the spouse. The owner must make such an election by his or her RBD; once made, it cannot be revoked. Some plans are silent on recalculation, in which case the owner’s (and spouse’s, if applicable) life expectancy must be recalculated each year. Consequently, when establishing an IRA the owners should be aware of the plan’s recalculation policy and make sure they make any required distribution elections before the RBD.

INHERITED IRAs

Although extending the distribution period during the IRA owner’s lifetime is advisable, it is equally important that CPAs recommend clients take the necessary steps to ensure that after the owner dies, the beneficiaries are entitled to the longest distribution period possible. The distribution rules for beneficiaries depend on whether or not the owner died before the RBD.

Before RBD. When the IRA owner dies before reaching the RBD, the five-year rule requires that all amounts in the IRA be distributed to the beneficiaries no later than December 31 of the calendar year that includes the fifth anniversary of the owner’s death. The exception to the five-year rule allows designated beneficiaries to receive distributions over the beneficiary’s life expectancy, as long as they begin by December 31 of the year after the owner dies. When the beneficiary is not an individual, there is no designated beneficiary and distributions must be made under the five-year rule. Thus, as long as the IRA owner establishes separate accounts for each beneficiary before his or her death, the exception to the five-year rule will be available for accounts that have a designated beneficiary.

The IRA agreement can specify whether distributions will be made using the five-year rule or the exception. The agreement also can allow the owner or beneficiary to decide which method to use. When the plan is silent, in the case of a non-spouse beneficiary, distributions must be made under the five-year rule. When the owner’s spouse is the designated beneficiary, distributions must be made in accordance with the exception to the five-year rule. Other special rules that apply when the owner’s spouse is the sole beneficiary are discussed in the sidebar, “Special Rules for a Spouse,” below.

Example. Kathy dies on June 22, 2001, before reaching her RBD. Kathy’s son, Bruce, is her designated beneficiary. If the agreement allows Bruce to decide which distribution method to use, he has the following options:

  • Begin receiving distributions by December 31, 2002, over a period not to exceed his life expectancy.

  • Take distribution of the entire IRA balance no later than December 31, 2006.

On or after RBD. When the IRA owner dies on or after the RBD, the remaining balance must be distributed to the beneficiaries at least as fast as the method the owner was using to take distributions. (This rule does not apply to surviving spouses who elect to treat the decedent’s IRA as their own; see the sidebar on page 37). Also, the rule requiring that the age of a non-spouse designated beneficiary when determining the joint life expectancy be no more than 10 years younger than the owner’s age applies only during the IRA owner’s lifetime. When the owner’s life expectancy is not recalculated, the joint life expectancy used in computing required distributions starting the year after the owner dies is based on the actual ages of the IRA owner and the designated beneficiary in the year distributions first begin, reduced by 1 for each distribution year that has lapsed.

Example. Todd turned 70 12 on May 10, 1994. His son, Carlos, is the designated beneficiary of his IRA. Carlos turned 40 during 1994 and Todd does not recalculate his life expectancy. Todd uses the joint life expectancy of ages 71 and 61 (no more than 10 years younger than Todd’s age) to compute his required distribution for the first distribution year.

Todd dies in 2000. Had Carlos’ actual age been used in 1994, the required distribution for that year would have been computed using a joint life expectancy of 42.8 (ages 71 and 40); and 7 years later (in 2001, the year after Todd dies), 35.8 years of the joint life expectancy would remain. Therefore, at least 135.8 of the amount in the IRA as of December 31, 2000, must be distributed to Carlos by December 31, 2001, and at least 134.8 of the December 31, 2001 balance must be distributed during 2002.

PLAN AHEAD

With proper planning before the owner’s RBD (or before the owner dies), CPAs can help clients extend distributions from a traditional IRA significantly, thereby allowing additional tax-deferred earnings to accrue. There are three situations where establishing multiple IRAs may be advantageous: when the IRA owner wants both individual and entity beneficiaries, when one of the beneficiaries is the owner’s spouse or when the beneficiaries are different ages. Establishing a separate IRA for each beneficiary allows for computation of required distributions using the joint life expectancy table for IRAs that have a designated beneficiary and can provide the heirs with more options after the owner dies. It is imperative when establishing an IRA that the owner be aware of the plan provisions regarding use of the recalculation method and the distribution options available to beneficiaries who eventually inherit the owner’s IRA.

Special Rules for a Spouse

W hen the IRA owner’s spouse is the sole beneficiary, the surviving spouse can elect to treat the decedent’s IRA as his or her own. This election is assumed to have been made if: (1) the spouse does not take any required distributions from the decedent’s IRA, or (2) the spouse makes an additional contribution to the account.

When the surviving spouse makes this election, he or she becomes the owner of the IRA. Distributions are made in accordance with the spouse’s RBD, provided the spouse had not reached his or her RBD before the owner died. In addition, the spouse will have until his or her RBD to identify a new designated beneficiary so minimum required distributions can be computed using the joint life expectancy of the spouse and the new beneficiary. Moreover, when the spouse dies, distributions to the beneficiaries will depend on whether the spouse died before his or her RBD using the rules in the “Inherited IRA” section of this article.

Example. Bart was the sole beneficiary of his wife’s IRA when she died on July 14, 2000. Bart elects to treat the IRA as his own. He will turn age 70 12 on March 25, 2004. Therefore, Bart has until April 1, 2005, to name a new beneficiary (or beneficiaries) and he must begin taking distributions on or before that date. After Bart dies, IRA distributions to the beneficiaries will depend on whether Bart died before reaching his April 1, 2005 RBD.

If the surviving spouse’s RBD has passed when the IRA owner dies and the spouse elects to treat the decedent’s IRA as his or her own, the spouse has at least until December 31 of the year following the year the owner died to name a designated beneficiary

If the spouse does not elect to treat the decedent’s IRA as his or her own, a spousal exception to the five-year rule allows the spouse to delay receiving annual required distributions from the decedent’s IRA until the later of, (1) December 31 of the year after the decedent’s death or (2) December 31 of the year in which the IRA owner would have turned 70 12 .

Example. Henry dies on June 4, 2000. He would have turned 70 12 in 2007. Henry’s wife, Mary, the sole beneficiary of his IRA, will be 70 12 on October 25, 2010. Accordingly, Mary has the following options for taking distributions from the IRA.

  • Elect to treat Henry’s IRA as her own and begin receiving distributions no later than her April 1, 2011 RBD.
  • Distribute the entire balance by December 31, 2005, under the five-year rule.
  • Receive the balance in the IRA over her life expectancy but wait until December 31, 2007, to receive her first distribution under the spousal exception to the five-year rule.

Only the owner’s spouse can roll over the decedent’s IRA into his or her own IRA. A non-spouse beneficiary cannot make a rollover contribution from an inherited IRA. However, trustee-to-trustee transfers of funds from one traditional IRA to another are permitted. Thus, a non-spouse beneficiary can achieve greater control and flexibility over the way the IRA funds are invested by transferring the funds to a new IRA in a trustee-to-trustee transfer. The tax laws require that the new IRA be established in the decedent’s name.

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