By Anthony Diosdi
The policy behind creating tax advantage qualified retirement plans and Individual Retirement Accounts or “IRAs” under the Internal Revenue Code is to provide income to employees when they retire from employment. This goal would not be satisfied if employees could infinitely defer the receipt of income from these plans. The regulations under Internal Revenue Code Section 401(a)(9) provides guidance to plan participants, IRA owners and beneficiaries as to the amounts which must be distributed from a qualified plan or IRA on an annual basis and be subjected to income tax. All qualified retirement plans and individual retirement accounts are subject to the minimum distribution rules. The minimum distribution rules also apply to SEPS, tax sheltered annuities, and certain deferred compensation plans for employees of tax-exempt organizations or state and local governments under Internal Revenue Code Section 457. The lifetime required minimum distribution rules do not apply to Roth IRAs; however, Roth IRAs are subject to the minimum distribution rules after the death of the IRA owner.
Rules During the Participant’s Lifetime
Minimum Distribution Penalty
The minimum distribution requirement provides that the entire interest of the participant must be distributed in installments not later than the participant’s required beginning date. The participant obtains a divisor for each distribution calendar year from the Uniform Lifetime Table based on the age the participant will attain on his or her birthday which occurs in that distribution calendar year. Under Internal Revenue Code Section 401(a)(9), participants in qualified retirement plans begin taking their distributions by their required beginning date. Originally, the required beginning date was April 1 of the year following the participant’s 70 1/2 birthday. The tax law now extends this age to 72.
If the participant fails to take a required minimum distribution or if after the participant’s death, a participant’s beneficiary fails to take a required minimum distribution, then an excise tax will be imposed which is equal to 50 percent of the amount by which such required minimum distribution exceeded the actual amount distributed during the calendar year. This tax is imposed on the participant if living, or if not, on the beneficiary. See IRC Section 4975. The Internal Revenue Service (“IRS”) may waive this excise tax if the participant or beneficiary can establish that the shortfall was due to reasonable error and the reasonable steps are being taken to remedy the shortfall.
Penalty for Early Distribution Prior to Age 50 ½
Distributions before the participant reaches the age of 50 ½ are subject to a 10 percent penalty tax in addition to the income tax due, unless an exception applies. Some of these exceptions include: distributions made to a beneficiary after the death of the participant, disability; IRS levy, medical expenses; medical expenses; distributions to alternate payees pursuant to qualified domestic relations orders in divorce or child support matters; certain qualified higher education expenses; certain first time home buyers; and if distributions are made as part of a series of substantially equal periodic payments made not less frequently than annually for the life expectancy of the participant or the joint life expectancy of the participant and his or her beneficiary.
Substantially equal periodic payments are calculated under Revenue Ruling 2002-62. The United States Tax Court held in Charlotte Gee, et vir. v. Commissioner., 127 T.C. No. 1, that once a surviving spouse rolled her deceased husband’s IRA into her own IRA (and in this case commingled it with her own IRA funds) the funds became subject to the 10 percent additional penalty tax when distributed to her, even though the distribution would have been exempt from the early distribution penalty had the distribution been made directly to her from the deceased husband’s IRA. When the beneficiary has not attained age 59 ½, it is important to determine whether the beneficiary will need to take withdrawals. If so, and substantially equal periodic payments will not suffice and no other exception applies, it will be advisable for the spouse to leave the funds in the participant’s IRA and not roll them over.
Rules After the Participant’s Death
Spouse as Beneficiary
If the spouse is the participant’s designated beneficiary, then the spouse can roll over the participant’s account or treat the account as the spouse’s own, in which case the spouse then becomes the participant for purposes the the minimum distribution rules, and may delay distributions until the spouse’s required beginning date. See IRC Section 401(a)(9)(B)(iii).
A designated beneficiary is named as a beneficiary on an IRA account.
As the result of the Setting Every Community Up for Retirement Enhancement or “SECURE” Act of 2019, designated non-spouse beneficiaries inheriting an IRA, inherited IRA funds cannot be rolled over into an existing IRA. Instead, designated beneficiaries will need to transfer funds into a new IRA that is formally named as an inherited IRA; for example (Name of the deceased IRA owner) for the benefit of (the name of the beneficiary). The designated beneficiary cannot make additional contributions to the inherited IRA account. Most designated beneficiaries must deplete an inherited IRA within 10 years of the original participant’s death. However, each withdrawal will be subject to income tax. The ten year rule does not apply to minors and chronically ill or disabled non spouse beneficiaries.
Rules for Nondesgnated Beneficiaries
If the participant did not name a designated beneficiary, the amount of required distribution will depend on whether the decedent began taking required distributions during his lifetime. If the decedent has begun taking distributions from the IRA, his or her remaining is used to determine the beneficiary’s distribution period. The minimum distribution rule of Internal Revenue Code Section 401(a)(9) mandates when beneficiaries must start withdrawing benefits from the IRA. The beneficiary is always welcome to withdraw more than the minimum required distribution, but of course must pay income tax on the entire amount withdrawn. Withdrawing more than the minimum in any year does not reduce the minimum distribution which must be taken in later years. See Treas. Reg. Section 1.401(a)(9)-5, A-2. Many qualified plans provide that the beneficiaries must withdraw the entire benefit in a lump sum and do not allow for distributions over time. This is particularly the case with 401K plans. If the participant died before taking required distributions, annual distributions are not required and the entire benefit may be distributed in the fifth year. See IRC Section 401(a)(9)(B)(ii), Treas. Reg. Section 1.401(a)(4)-3, A-2.
Listing a Trust as an IRA Beneficiary
It is possible to list a trust as a beneficiary of an IRA. This is often done in second marriage situations, in situations where IRAs are not creditor protected and the spouse has or may have creditors, or in situations where the spouse needs the assistance of a trustee for investment management or otherwise. The participant or owner of an IRA may choose to name a trust for the spouse as the beneficiary of the IRA. Before naming a trust for the spouse as beneficiary, it is best to determine how much income and assets that the spouse needs. In larger estates, it may be possible to leave part or all of the IRA to the children and grandchildren within the estate tax and generation-skipping tax exemption limits and leave the rest outright to the spouse, creating a more favorable income tax result. A QTIP trust may be used in these situations.
With QTIP trusts, it is essential to comply with the requirements of Internal Revenue Code Section 2056(b)(7) by providing a qualified income interest for life to the spouse whereby the surviving spouse is entitled to all of the income from the trust, payable annually or at more frequent intervals, and by providing that no person has the power to appoint any part of the property to any person other than the surviving spouse. The IRS has issued guidance over time relating to designating QTIP trust as beneficiaries of IRAs. Revenue Ruling 2006-26 provides guidance clarifying the circumstances under which the surviving spouse is considered to have a qualifying income interest for life in an IRA where the trust is designated as an IRA beneficiary.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. He has more than 20 years of experience with tax-related matters, focusing on federal and state tax disputes. His experience covers a broad range of engagements at all stages of the IRS administrative process, including assisting with audits and litigation in the federal courts. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in domestic and international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.