Saturday, June 25, 2022

November 2006 Legal Briefs

Pension Reform: Useful Changes to IRA Provisions

  1. IRA Contribution Limits.
  2. Tax Refunds & Other Transfers to IRA’s.
  3. IRA’s of Guards & Reservists.
  4. IRA Distributions to Charities
  5. Understanding the Tax Advantages:
  6. 50% limit on charitable contributions doesn’t apply.
  7. Deductions and credits don’t phase out. 
  8. Reducing RMD’s in future years. 
  9. Rollover to “Inherited IRA”
  10. Easier Conversion to Roth IRA’s

Pension Reform: Useful Changes to IRA Provisions

The 2006 Pension Protection Act contains several useful changes for IRA accounts.  These more flexible provisions will benefit specific groups of IRA owners.  Improved IRA provisions will also help banks, because IRA’s are the best single source of long-term bank deposits.

Some of the new provisions are effective immediately. A bank needs to have enough details to answer customers’ questions or assist with requested transactions. Other changes will not take effect until 2007, 2008 or 2010.

The more a bank can help in tailoring various IRA transactions and provisions to the particular customer’s situation, the more useful and valuable that IRA will be for the customer, and the more likely it is that the customer will retain and increase his IRA deposits at the bank.

Following are “highlights” of the IRA changes, which are discussed in more detail below:

• IRA contribution limits made permanent and subject to indexing.
• “Catch-up contributions” made permanent.
• Direct-deposit of tax refunds to IRA’s allowed.
• Tax-free, penalty-free IRA withdrawals by reservists on active duty.
• Tax-free transfers from IRA’s to charities, up to $100,000 per year.
• Roll-overs by non-spouse IRA beneficiaries and retirement plan beneficiaries to “inherited IRA’s.”
• Direct conversion of retirement plan balances to Roth IRA’s.

1.  IRA Contribution Limits.

The Pension Protection Act’s most important provision for IRA owners is one that customers may not notice, because nothing seems to “change.”  This provision makes permanent the higher annual IRA contribution limits that have been available since 2002.  

(If Congress had not acted, now or later, to make the last several years’ higher IRA contribution levels permanent, the annual limit on IRA contributions would automatically drop back to $2,000 after 2010.  That possibility has now been avoided.)  

Before 2002, the maximum annual IRA contribution was $2,000.  In the 2001 tax-cut bill, Congress increased the maximum annual IRA contribution to $3,000 for years 2002 through 2005, $4,000 in years 2006 and 2007, and $5,000 in 2008, with inflation adjustments to the contribution limit after 2008.  Because of budget constraints in passing the 2001 bill, Congress did not originally make these provisions permanent.  Instead, these more generous IRA contribution limits approved in 2001 were scheduled to expire at the end of 2010.  The 2006 legislation makes these higher IRA contribution levels permanent, with inflation-indexing of the maximum dollar amount continuing into the future.

In 2001 Congress also authorized a “catch-up” IRA contribution of $500 for years 2002 through 2005 (on top of the regular annual limit) for persons who are 50 or older. For years 2006 and later this “catch-up” contribution was set at $1,000.  (As an example, for tax year 2006 the maximum IRA contribution is $4,000, plus a “catch-up” amount of $1,000 for persons who are 50 or over, for a total of $5,000.)  The “catch-up” provision, also, was originally authorized only on a “temporary” basis (for budget reasons), and would have expired after 2010—if not extended. This year’s bill makes permanent the $1,000-per-year IRA “catch-up” contribution for persons 50 or older.  However, the $1,000 amount will not be indexed for inflation.

These provisions will be a continuing strong incentive for retirement savings, increasing total IRA deposits. 

2. Tax Refunds & Other Transfers to IRA’s.

The 2006 changes also allow a taxpayer to request that part or all of his electronic tax refund be sent directly to his IRA.   The IRS is developing a new Form 8888, for use in connection with electronic refunds for the 2006 tax year.  A taxpayer will be allowed to divide his electronic tax refund between up to three accounts, one of which can be an IRA.  

Direct deposits to an IRA are a customer-friendly concept, and something that could help banks in attracting more IRA contributions. However, the customer first must have an IRA account that allows direct deposits.

A mutual fund, by comparison, allows contributions to an IRA to be mailed by check, along with a deposit coupon.  IRA contributions to a mutual fund can also be made by authorizing an ACH transfer from the consumer’s bank account.  Furthermore, an IRA contribution to a mutual fund by mail or by an online authorization for ACH debit to a bank account can be initiated 24 hours a day–whenever it suits the customer.  Any number of separate contributions can be made during a tax year, in whatever amounts the consumer chooses, up to the individual’s maximum contribution limit.

Banks are good at serving financially strong customers who make annual IRA contributions in a lump sum, purchasing a C.D. as the IRA’s investment product.  Banks are perhaps less skilled in serving the IRA customer of more modest financial circumstances.  For example, it’s not necessarily easy for a bank’s customer to make a series of regular or random installment deposits to an IRA over the course of a year.

Most banks don’t provide deposit slips that can be used to make IRA contributions.  Most don’t provide for direct-deposits of IRA contributions–either by means of an electronic tax refund or “payroll savings” deductions.  But younger customers prefer electronic banking and dislike making unnecessary trips to the bank.  Easier ways to add to an IRA need to be created.  

Banks should probably emphasize strongly (through letters mailed to IRA owners, statement stuffers, lobby brochures, etc.) that customers can set up direct-deposits to IRA’s.  Electronic deposits could be “payroll savings” deductions, electronic tax refunds, or wire transfer “gifts” from relatives to supplement a young adult’s IRA.  (A bank also might consider setting up an arrangement for online banking transfers “into” an IRA from another account of the same customer—but online transfers “out” of an IRA before age 59 ½ must  be blocked, because the bank is required to withhold an early withdrawal penalty.)

Many banks think of an IRA as a type of C.D.  An IRA is actually an investment “arrangement” between the owner and the bank—not a specific type of deposit product.  An IRA is the “shell” that can hold different types of deposit accounts—just like a trust can hold a variety of investments.  You may wonder, “How can our bank allow a customer to direct-deposit to his IRA, if we don’t allow the balance of a C.D. to be increased between maturity dates?”  The answer is to have more than one type of deposit account in the IRA.

As an example, a bank could set up a standard IRA design that consists of two parts–(1) one or more C.D.’s, plus (2) a savings account.  A bank could give away a “premium” (gift) of some kind as an inducement for establishing this two-account IRA arrangement, which specifically makes direct deposits easier.  Through the savings account, a customer can make his IRA contributions in any pattern of direct-deposit installments that may fit his situation.  The greater convenience of this approach should cause a bank’s IRA deposits to increase.

Let’s assume that a customer has one or more C.D.’s in an IRA, and also has a savings account in that IRA.  If one of the C.D.’s in the IRA matures every six months, the savings account that is part of the IRA can be used to accumulate direct deposits made during a six-month period. Then, at the C.D.’s maturity, most of the funds in the savings account can be rolled into the C.D. balance.  Going forward, additional direct deposits can be made to the savings account during the next six months, until most of the savings account’s balance can again be rolled into the C.D., and so on.

This approach can easily work with “payroll savings”:  The typical employer authorization form for direct-deposit of payroll allows an employee to split his electronic deposit between two accounts.  An employee can direct a fixed amount (such as $200 per month) to one account (regular savings, or IRA savings), with the balance of the employee’s payroll being direct-deposited to a checking account.  

Setting up a savings account inside an IRA is also a good way to allow direct-deposit of federal tax refunds to an IRA. It should also be possible to arrange for direct deposit of an Oklahoma tax refund to an IRA, by simply designating that account number–provided that the whole amount goes into one account.  (The federal electronic tax refund soon will be eligible to be divided among as many as three accounts, one of which can be an IRA.)

There are definite advantages to direct-depositing part or all of a tax refund to an IRA.  Certainly, the psychological factor is important:  “If I never see or touch my tax refund check, I won’t be tempted to spend it on something else.”

Once a person mails his tax return with instructions to electronically deposit any refund to an IRA, his plan to save for his retirement acquires some real “backbone.”  He can no longer change his mind:  The money will be deposited as he has instructed.  If the individual who owns the IRA is not yet 59 ½, withdrawal of the money after it has been direct-deposited to the IRA is strongly discouraged by (1) an early withdrawal penalty, and (2) income tax liability.  Because of these provisions, a tax refund direct-deposited to an IRA becomes more “locked up” than any other type of savings-related deposit.

The direct-deposit IRA contribution method may help to strengthen an individual’s self-discipline, and builds up an IRA balance that cannot be very easily raided when other financial needs arise.  

There may be good reasons why a consumer cannot direct-deposit his entire tax refund to an IRA.  In some cases, a tax refund is too large—exceeding the individual’s IRA contribution limits.  In other situations, a taxpayer simply needs to split his tax refund between an IRA and other financial requirements.  The new IRS Form 8888 will make this simple, allowing the taxpayer to divide his electronic federal tax refund between an IRA and checking, or an IRA and regular savings.

3.  IRA’s of Guards & Reservists.

A new provision will help members of the National Guard or Reserves who are (or have been) called to active duty at any time after September 11, 2001, and before September 12, 2007.  (The provision is effective immediately, and also retroactive.)  A reservist can withdraw funds from an IRA (a “qualified reservist distribution”) without an early-withdrawal penalty and without being required to pay income tax on the distribution, if he or she will be serving on active duty for at least 180 days, and if the funds are re-contributed to the IRA within two years after active duty ceases.

In many cases a reservist has a regular full-time job, and takes a pay cut to go on active duty.  This can create a financial hardship if the person has substantial family living expenses, debt payments, continuing overhead for a self-employed business that must be left behind, etc.  The reservist who takes money out of an IRA will not have to make interest or principal payments (as he would on a loan), but has the use of the withdrawn funds while he remains on active duty status and for up to two years afterward.  

Within two years after active duty ends, the individual must re-contribute to his IRA the funds that he previously withdrew; but he can do so in any manner.  The reservist can repay the money to the IRA in installments from current income, or can obtain a bank loan to re-contribute the distributed amount to the IRA in a lump sum.  

All withdrawn funds must be returned to the IRA within two years after active duty ends, for the reservist to completely avoid the early-withdrawal penalty and income tax.  (If only part of the IRA withdrawals can be re-contributed, at least that portion avoids the early-withdrawal penalty and income tax.  But the rest remains subject to penalty and tax.)

Bank officers need to be aware that funds can be re-contributed to an IRA in an amount equal to what was originally distributed as the result of active duty.  Re-contributions can be made in any number of installments, and will not reduce the amount of “new” IRA contributions that the individual is also entitled to make during any year.  (For example, if $15,000 was taken out by a reservist, $15,000 can be put back in 2006, plus the $4,000 that otherwise would be allowed in 2006 as a regular IRA contribution.)

A bank officer should also understand that (1) the bank is not required to withhold a 10% early withdrawal penalty from a “qualified reservist distribution,” and (2) it’s not necessary to withhold any income tax, even on a optional basis, on a “qualified reservist distribution”—if the reservist plans to re-contribute the distributed funds to the IRA within two years after active duty ceases.

An active-duty reservist’s ability to take a tax-free temporary IRA distribution will end on December 31, 2007.  But this provision is also retroactive.  If a reservist has already completed an active duty term of at least 180 days, and that active duty began any time after September 11, 2001, and the reservist withdrew funds from an IRA, he or she already will have paid an early-withdrawal penalty and income tax on the distributed amount.  However, the statute sets up a scenario (described below) in which a reservist is entitled to obtain a refund of this penalty and income tax.  

A reservist whose active duty ended long before August 17 will still have two years after the August 17, 2006, effective date of the Act to re-contribute the amount that was distributed to him or her from the IRA.  After doing this, the penalty and income tax that was already paid will no longer be owed with respect to that re-contributed distribution.

If a person’s situation fits the pattern just described (in other words, if a reservist who was called to active duty took money out of an IRA after September 11, 2001, resulting in penalty and income tax), that person can file an amended federal income tax return for the tax year(s) during which distributions were taken. The amended return would no longer show an early withdrawal penalty, and would not include in taxable income the amount of the IRA distribution (based on retroactive changes in the law).  As a result, the amount of tax already paid for the past tax year(s) would be too much, and a federal tax refund would be due.  

(This assumes that the reservist actually re-contributes the withdrawn funds to the IRA, prior to the deadline for doing so.  It also assumes that amended returns are filed on a timely basis.)

Because Oklahoma’s income tax is calculated based on federal “adjusted gross income,” eliminating the IRA distribution from income on the amended federal tax return(s) should also allow the reservist to file amended Oklahoma tax returns for the year(s) in question.  On this basis, a reservist could also obtain a refund of Oklahoma income tax previously paid on IRA distributions taken during active duty or shortly thereafter.

By filing amended federal and state tax returns to recover the amount of early-withdrawal penalty and income taxes already paid in with respect to the early distributions, a former reservist should receive enough money to pay back one-fourth to one-third of the required re-contribution of withdrawn funds to the IRA. The remainder of the amount withdrawn from the IRA must be re-contributed by August 17, 2008—such as from current income, or loan proceeds.  

If a bank knows of reservist customers who took IRA distributions during active duty that began after September 11, 2001, it can inform those customers of the strong financial incentives for re-contributing the withdrawn amounts to their IRA’s.  (It’s greatly to a customer’s advantage to return a lump-sum distribution to the IRA, where it can grow tax-free.  And anything that increases IRA balances will also help the bank.)  

A bank might consider making a loan to a returned reservist, to help that person put distributions back into the IRA.  Certainly it’s a hardship situation, and a one-time situation. (Note:  An IRA cannot be pledged as collateral on any loan, because of unfavorable tax consequences.)

4.  IRA Distributions to Charities

If an IRA owner is at least age 70 ½, another new provision allows him to make direct transfers from his IRA to a charity, without including those distributions in taxable income.  This special provision is only available during calendar years 2006 and 2007.  It can produce significant tax benefits.

In taking advantage of this provision, the IRA owner should not receive the distribution of the money himself.  Instead, the IRA custodian (the bank) must transfer the IRA funds directly from the IRA to the designated charity.  (Think of it like a direct bank-to-bank transfer between IRA’s–except the money is sent to a charity, not another bank’s IRA.)

These non-taxable direct transfers from an IRA to a charity are permitted immediately (in 2006, and until December 31, 2007).  A bank should be ready to assist IRA owners in making such transfers, upon request.    

If an IRA customer complains about having to take a “required minimum distribution,” the bank may want to inform him that new provisions will allow him to make a “charitable” transfer that avoids tax on the required distribution.  The bank can also suggest that he contact his tax adviser for more details on how to use these provisions to save taxes in his specific situation.

Until now, an IRA owner who has reached the age of required minimum distributions from an IRA has been “stuck” with receiving those distributions and reporting them as taxable income.  

 Under this year’s new provision, a direct transfer from an IRA to a charity will count as a distribution for purposes of satisfying the owner’s “required minimum distribution” (RMD) for the particular year.  However, this distribution (transferred directly to a charity) will not count as “taxable income” to the individual.  It will not be included on his tax return.  An amount directly transferred from an IRA to a charity by means of this provision also cannot be counted as a charitable deduction on the individual’s tax return.  

As discussed later, it’s possible in the right circumstances to use a “direct transfer to charity” to reduce income taxes.  Many IRA owners can benefit from this, even if they use the provisions in a fairly small amount.  But many IRA owners (those with no tax adviser) will be unaware of these provisions, and will not learn how to structure their IRA distributions to reduce taxes.

Let me give an example of how someone can use this charitable transfer provision to avoid (or partially avoid) a required minimum distribution.

Assume that an IRA owner is required to take an RMD of $3,500 by the end of calendar year 2006.  Instead, he asks the bank to transfer $3,500 directly to one or more charities of his choice—for example, the Oklahoma Medical Research Foundation (OMRF).  He can also transfer more than the $3,500 to the OMRF, or less than $3,500—whatever he wants to do.  If he transfers $3,500, it will exactly use up his RMD, and he will have no taxable income distributed from the IRA for 2006.

Now let’s consider a similar case, where he’s required to take a $3,500 RMD, but he asks the bank to transfer only $2,000 from his IRA to the OMRF. He will have a remaining RMD of $1,500 for calendar year 2006.  This $1,500 remainder must be distributed to him, not later than December 31, 2006, and will be reported to him as taxable income.  (The $2,000 transferred directly to the OMRF does not count as a taxable distribution.)

An IRA owner (age 70 ½) can use the same provisions (in 2006 or 2007) to make a direct transfer from his IRA to a charity in an amount that exceeds the amount of his RMD.  For example, if the individual makes a one-time large gift of $10,000 or $20,000 to the local church’s building fund by means of direct-transfer from his IRA, none of the money transferred from the IRA to the charity will be counted as a taxable distribution to him.  

The maximum amount of funds that an individual (age 70 ½) can transfer directly from an IRA to a charity, not includable in the individual’s taxable income, is $100,000 per person in calendar 2006, and an additional $100,000 per person in calendar 2007.  This is a great opportunity for persons who are very wealthy; but it still benefits the average IRA owner, who can use the provisions in a much lower dollar amount.

5.  Understanding the Tax Advantages

First, I will explain how a direct transfer of funds from an IRA to a charity can help to save taxes–even for the typical person in mandatory distribution (age 70 ½ or older).  I must start with some facts and assumptions about an individual’s ability to take advantage of itemized deductions.  A single IRA owner will have a “standard deduction” of $6,250 for federal income tax purposes, but married couples filing jointly will have an $11,000 “standard deduction.”  

Unless the older IRA owner has some unusual transactions, chances are good that he will not have sufficient “itemized deductions” to reach the “standard deduction” amount.  For example, if he owns a home it’s probably “free and clear”—so it’s unlikely that he will have mortgage interest deductions.  There may be some property taxes, and Oklahoma income taxes, and various charitable deductions that could be itemized, but these items often do not total as much as the “standard deduction,” for persons age 70 ½ who are retired.

Let’s assume this same person has an annual RMD of $3,500 from his IRA, which ordinarily would have to be paid out to him and included in taxable income.  He also makes normal contributions of $2,000 per year to the church.  This level of charitable contributions, combined with other deductions, will probably not allow him to itemize deductions on his federal tax return. He probably takes a “standard deduction” on his federal tax return–and could do so just as well, even if he had no $2,000 charitable contribution to the church.

Next, let’s modify this same example somewhat, to show how the IRA owner (age 70 ½) can save taxes.  Instead of taking his RMD of $3,500 as taxable income and writing checks totaling $2,000 to the church during the year (which he would do anyway), the IRA owner instructs the bank to make distributions totaling $2,000 directly to the church, from his IRA.  If he has a $3,500 RMD to satisfy, this reduces to $1,500 the part of the RMD that actually must be paid out to him. This “remainder” of $1,500 will then be the only amount that counts as taxable income (instead of $3,500).  By doing this, the IRA owner no longer gets a $2,000 charitable deduction; but if he was already taking the “standard deduction” on his federal tax return (because he doesn’t have enough total deductions to itemize), it does not hurt him that the $2,000 charitable deduction goes away:  He can still take the “standard deduction.”
 
Now let’s compare the outcome of the first example with the modified example.  A total of $3,500 (the RMD) gets paid out of the IRA, in both cases.  The church gets $2,000 (in both cases), although the method by which it gets the money is different.  The IRA owner ends up with exactly $1,500 cash that has come out of the IRA, either way, after the church receives $2,000.  

However, in the modified example (direct transfer of $2,000 to the church, with direct distribution of only $1,500 to the individual), the IRA owner has $2,000 less in taxable income.  Depending on tax rates, he probably will save around $500 in federal and state income taxes—with no change in “who gets what.”  Anyone who is 70 ½ can do this, in both 2006 and 2007.  Customers just have to know about it, to be able to do it!

Second, I will outline several reasons why these special provisions for “direct transfer from an IRA to a charity” can be even more useful for higher-income individuals than for the “ordinary” IRA owner just described.  (Not many IRA customers will fall in the higher-income category.)

a. 50% limit on charitable contributions doesn’t apply. As a general rule, the IRS Code limits an individual’s deductible charitable contributions in one year to 50% of that persons’ net taxable income, measured before the charitable deduction is taken.  

If a person has $100,000 of net taxable income (before charitable deductions), the maximum amount of charitable contributions that could be deducted in that year would be $50,000.  If the person had $100,000 of “net taxable income” (before charitable deductions) but gave away all $100,000 to qualifying charities, he still would pay tax on $50,000.  (“Excess” charitable contributions are carried forward, and can be deducted in future years; but only 50% of net taxable income can be eliminated by charitable deductions taken in any tax year.)

What’s unusual about the “direct-transfer” provision available in 2006 and 2007 is that an IRA owner is permitted to give away 100% of the amount distributed from his IRA and directly transferred to a charity, with all of that amount excluded from income, not subject to income tax.  The amount that is directly transferred to the charity never goes into the formula for determining the taxpayer’s 50% maximum charitable contribution.  It’s completely “off the slate.”  And, in addition, the taxpayer can still give away up to 50% of his taxable net income that is “on the slate.”

b. Deductions and credits don’t phase out.  The Internal Revenue Code gradually phases out a taxpayer’s ability to take advantage of certain tax deductions and tax credits if that person’s “adjusted gross income” (AGI) rises above certain levels.   

Taking a regular distribution from an IRA increases AGI; and taking a large IRA distribution in order to be able to fund a contribution to charity would normally risk phasing out certain deductions and credits that may be very important to the taxpayer.  

One important example of a phase-out of a deduction, tied to increased income, is the “passive activity loss” deduction related to rental-income property. As AGI (before deducting passive activity loss”) increases from $100,000 to $150,000, the maximum available deduction for passive losses declines from $25,000 to $0.

 The tuition tax credit is another example of a tax benefit that phases out above a certain level of AGI.  Also, if an age 70 ½ taxpayer has an spouse who is under 65 and is not employed outside of the household, the spouse’s ability to make tax-deductible IRA contributions will phase out as the amount of AGI on the couple’s joint return increases. The IRS Code has several such examples.

Before this year’s special provisions were enacted, any large distribution from an IRA (even if used to obtain funds to donate to a charity) could result in a phasing out of some deductions and tax credits. For this reason, an IRA has been a very unlikely source of funds for major charitable giving—until now.

By contrast, wealthy individuals will find the direct-transfer-to-charity provision very useful, for several reasons:   Direct transfers of IRA funds to a charity will not be counted as income, and will not increase AGI.  The individual’s tax will not be increased based on the distribution to the charity, and the various tax credits and tax deductions that phase out as AGI increases will not be affected.  There are no unfavorable consequences.

c.  Reducing RMD’s in future years.  As suggested earlier, some IRA owners in mandatory distribution (at least age 70 ½) think they are reporting “too much” taxable income.  They would rather take no distributions at all from their IRA, if that were possible—to avoid paying income tax on distributions.  

After a lifetime of careful spending and investing, they have built up a large IRA balance.  The “downside” is that a large IRA balance results in large required minimum distributions (RMD’s).  For the person with too much taxable income already, large RMD’s are like “piling on”—and the flow of payments can’t be stopped.  (Some other IRA owners might think this is “a good misery to have.”)

The new provisions create a unique opportunity to “do something dramatic” about unwanted RMD’s.  The very wealthy IRA owner can significantly reduce future “unwanted RMD’s” by “chunking out” a whole lot of money from his IRA by direct transfer to a charity in 2006, and the same in 2007—without income tax.  As stated above, each individual (age 70 ½) is allowed to make a direct transfer of up to $100,000 from his IRA to a charity in 2006, and $100,000 more in 2007.  (For a couple, this is a combined amount of $200,000 in 2006 and $200,000 in 2007—assuming that each of them has enough separate IRA money to carry out this distribution.)

The required RMD amount for each future year is determined by dividing the then-current balance of the IRA by the IRA owner’s actuarial life expectancy as indicated on the official table used for this purpose.  If the IRA owner can afford to make a substantial direct transfer from his IRA to a charity in 2006 and in 2007, there will be a much smaller balance remaining in the IRA, and therefore a smaller amount will be subject to mandatory distribution each year.  This is an effective partial solution to the “problem” of large, taxable RMD’s in future years.

6.  Rollover to “Inherited IRA”

Existing IRA guidelines allow a surviving spouse to roll a deceased’s IRA balance into an IRA owned by the surviving spouse (a “spousal IRA”).  

Until now, a non-spouse IRA beneficiary could not roll a deceased’s IRA balance into any kind of IRA belonging to that beneficiary.  Instead, IRA regulations have required the non-spouse beneficiary’s interest to continue as part of the deceased’s IRA.  Beginning January 1, 2007, however, any beneficiary will be allowed to roll a deceased’s IRA balance into an “inherited IRA” belonging to that beneficiary.  

This “inherited IRA” approach will be available to a beneficiary who is not a surviving spouse of the deceased, including an adult child, another relative, a companion, etc.

In addition, any non-spouse beneficiary of a qualified retirement plan–such as a 401(k)–will be allowed, beginning January 1, 2007, to roll the deceased’s plan assets into an “inherited IRA” belonging to the beneficiary.  By this means, a non-spouse beneficiary of a qualified retirement plan can avoid taking a lump-sum distribution of the deceased’s plan assets.  After rolling the funds into an “inherited IRA,” the retirement plan beneficiary will be allowed to take distributions over his remaining lifetime.  (This provision gives the beneficiary of a qualified retirement plan the same pattern of distributions that a non-spouse beneficiary of a deceased’s IRA could select.)    

A surviving spouse can delay distribution of his or her own IRA funds until age 70 ½, and also can delay distribution of IRA funds inherited from a deceased spouse until age 70 ½.  For this reason, a surviving spouse is permitted to combine IRA funds from both sources in the same IRA.  (Two different payout schedules are not required.)  A non-spouse beneficiary, however, will not be allowed to mix funds in a personal IRA with inherited IRA funds.

A non-spouse IRA beneficiary who inherits an IRA–no matter how young that beneficiary may be—must start receiving IRA distributions after the IRA owner’s death.  The non-spouse IRA beneficiary can’t avoid taking distributions currently, but can avoid taking distributions in a lump sum, by spreading those distributions over the beneficiary’s actuarial life expectancy.  

Of course, an individual’s personal IRA contributions are not required to be distributed from that person’s IRA until after the individual turns 70 ½.  But a non-spouse beneficiary’s interest in a deceased’s IRA and that same individual’s personal IRA funds have two different payout schedules, so an “inherited IRA” established by a non-spouse cannot be mixed with funds that the non-spouse has contributed to his own IRA.  

The ability of a beneficiary to designate his own beneficiaries is another point that’s greatly simplified by the new roll-over provision.  Even under present law there’s a way for a beneficiary of a deceased’s IRA to designate other beneficiaries in turn, but this has not been as simple for a non-spouse who inherits the IRA.  A surviving spouse, on the other hand, has been able to roll inherited IRA funds into a spousal IRA, designating beneficiaries easily on that IRA.  

The new roll-over provision, by allowing any non-spouse IRA beneficiary to establish an “inherited IRA,” makes it easy for that non-spouse beneficiary to designate beneficiaries of the “inherited IRA.”  The issue is also important for a non-spouse beneficiary of a qualified retirement plan, who now will be able to roll inherited plan assets into an “inherited IRA,” while designating his own beneficiaries (for the first time) on that IRA.

On another important point, the new “inherited IRA” roll-over provision will allow easier handling of the interests of separate non-spouse beneficiaries in a deceased person’s IRA–for example, three adult children with equal shares.  Until now it has been required, but messy, to retain the deceased’s IRA in the deceased’s name, even when there are several non-spouse beneficiaries.  

Under the new provisions, each non-spouse beneficiary (for example, each of three adult children) can roll over his or her share of the funds into a separate “inherited IRA,” which allows for simpler accounting, simpler styling of the account, and easier designation of each adult child’s own beneficiaries.

7. Easier Conversion to Roth IRA’s

In the past, someone terminating his employment has been able to roll over his 401(k) or other qualified retirement plan balance to a regular IRA, without penalty or tax.  This will continue to be true; but until now it has not been possible for him to roll his retirement plan balance directly to a Roth IRA instead of a regular IRA.  

(It has been possible to go through a two-step conversion, first rolling from a retirement plan to a regular IRA, and then (separately) rolling from the regular IRA to a Roth IRA.  But this is cumbersome. )

Beginning January 1, 2008, a retirement plan participant will be allowed to roll his retirement plan balance directly into a Roth IRA.  Any conversion of retirement funds to a Roth will result in income tax on the amount of funds converted, but there will be no 10% early-distribution penalty.

A Roth IRA has several advantages:  (1) earnings accumulate tax-free; (2) contributions are made “after tax,” so distributions after age 59 ½ (both the original contributions and accumulated earnings) are tax-free; (3) there are no required minimum distributions during the owner’s lifetime; and (4) contributions to a Roth can continue even after age 70 ½.

It’s certainly cheaper for a person in a lower income-tax bracket to convert funds to a Roth IRA, because the “tax cost” of doing so is less.  (However, the individual also needs enough other cash to pay income tax on the amount of retirement funds converted.)

Some individuals, although fairly strong financially, have widely fluctuating levels of income from one year to the next.  Such persons may use any “down” income year as an opportunity to convert a portion of their other retirement funds to a Roth IRA, because the income tax “cost” of doing so will be less.

The timing and amount of conversion of retirement funds to a Roth IRA must be worked out carefully with a tax adviser, because so much is dependent on the individual’s specific tax circumstances.  If a retirement account beneficiary does not need inherited funds in the near future, he or she might want to talk to a tax adviser about the possible advantages of converting to a Roth IRA.