Take-Away: 2019 was a busy year when it comes to rule changes and reminders with regard to retirement plan distributions. A short summary of some of those changes follows, starting with the most obvious, the SECURE Act that passed last week.

Secure Act: Key changes that arise from this December Act are:

  • Age 70 years limit for contributions to traditional IRAs was eliminated, but only to be made from the IRA owner’s earned income;
  • The required beginning date (RBD) to start taking required minimum distributions (RMDs) is extended from age 70 ½ to age 72;
  • A distribution of $5,000 from an IRA or qualified plan account to pay for qualified adoption or birth expenses will be exempt from the 10% penalty for early distributions. These expenses must be incurred within one year of the distribution. The amount distributed can also be re-contributed to the IRA or qualified plan at a later date;
  • Fellowships and stipend payments received by a student will be classified as earned income which permits the recipient to contribute to an IRA;
  • Annuities become a permissible investment in a qualified plan; sponsors of the plan will have a safe harbor from liability if the plan provides this annuity option;
  • The stretch IRA option with regard to inherited IRA or qualified plan accounts disappears for most beneficiaries. It is replaced by a mandatory 10-year payout rule, which permits the inherited IRA to continue to grow tax-deferred, but the entire account balance must be distributed within 10 years of the account owner’s death. Exceptions to the 10-year rule, meaning the stretch rule continue to apply, will be for those beneficiaries who are spouses, disabled or chronically ill, or minor children of the account owner. Once the minors attain the age of majority, then they face the 10-year payout obligation. Existing inherited IRAs are ‘grandfathered’ from the 10-year payout rule.
  • Existing inherited IRAs are also exempted from the 10-year mandatory payout rule, i.e. the stretch rule continues to apply to them.

IRS Life Expectancy Changes on the Horizon: In November, the IRS adopted proposed Regulations that update its life expectancy tables to reflect increased longevity. The result is a small but discernible increase to everyone’s life expectancy. The old existing tables were effective in 2003. The new tables will become effective in 2021.

  • All three tables that are used to calculate RMDs will be updated: Single Life Table, Uniform Lifetime Table (used for those over age 72) and the Joint and Last Survivor Table (used when the spouse beneficiary is more than 10 years younger than the decedent.)
  • Example of impact: Dad died in 2015. Son inherited Dad’s IRA when Son was age 35. Son’s applicable distribution period under the ‘old’ tables used to calculate his inherited IRA was 48.5 years. Under the new tables, which will be re-set only one time beginning in 2021, Son’s re-calculated applicable distribution period, going back to 2015, would now be 50.5 years. Each of the intervening 6 years since Dad died would be subtracted, one for each year. Thus, Son’s divisor in calculating his RMD from Dad’s inherited IRA in 2021 would be 44.5 years (not 42.5 years) leading to a smaller RMD for Son for the year.
  • This favorable change could create a risk, however,  for those IRA owners who are taking substantially equal periodic payments from their account prior to age 59 ½ to avoid the 10% early distribution penalty. To avoid the penalty these substantially equal distributions must last for at least 5 years or until age 59 ½, whichever comes later. The life expectancy tables are used to calculate these required ‘equal’ distribution amounts. Thus, come 2021, the IRA owner will have to change their calculations to reflect the updated life expectancy tables. If this is overlooked, then the IRA owner will take out more than he/she was required to take as a periodic payment. If that happens, then retroactive penalties will be applied back to the date that the substantially equal periodic payments arrangement commenced.

Thrift Saving Plan Withdrawals: In September, Congress amended the federal Thrift Savings Plan (TSP), which is the 401(k) plan for over 5 million federal employees and uniformed service members, to permit more frequent distributions from their retirement account. Rather than permit only one in-service distribution prior to the employee’s retirement, now the participant will be permitted to take up to 4 distributions from their account in each calendar year. In addition, more liberal rules will apply to post-retirement distributions, which can now be taken from the TSP account every 30 days. These changes will make it easier for a federal employee who retires after age 55 years to access their retirement account prior to age 59 ½ years.

Recharacterization of Roth Contributions: An IRA Private Letter Ruling (PLR) provided some relief to a taxpayer whose tax advisor failed to take into account the modified adjusted gross income (MAGI) limitations to make Roth IRA contributions. The taxpayer earned substantial income for many years. She retained a CPA to prepare her income tax returns for many years, on each of which she reported Roth contributions. However, for each of those years, her MAGI was too high to permit a Roth IRA contribution. The problem here was that both the taxpayer and her CPA were clueless as to the MAGI limitation on Roth contributions. Moreover, the taxpayers (and presumably her clueless CPA) was also unaware of her ability to recharacterize those Roth IRA contributions as traditional IRA contributions, during those tax years. The IRS showing some heart, due primarily to the taxpayer receiving bad tax advice from her CPA, permitted the taxpayer to recharacterize those years when the Roth IRA contributions had been made, even though the deadline for recharacterizations (October 15 of the following calendar year) had long passed. The key point of this PLR is that while the 2017 Tax Act eliminated the recharacterization of Roth IRA conversions, the recharacterization of Roth IRA contributions is still permitted as a tool to fix ineligible contributions to a Roth IRA. In order to induce the IRS to demonstrate its heart and permit the recharacterizations for any prior tax years of Roth contributions, the taxpayer agreed/pledged to not claim any income tax deductions for the money that was moved by her from her Roth IRA to her traditional IRA. PLR 201930027.

60-Day Rollover Missed: We have previously covered on several occasions that implications of ‘blowing’ a 60-day rollover- immediate taxation of the entire distribution and possibly the 10% penalty for an early IRA distribution. A recent Tax Court case demonstrates the perils that arise from a ‘missed’ 60-day rollover. In June of 2014, Nancy received a $524,980 distribution from her IRA which she used to purchase a new home while awaiting the sale of her existing home. Nancy’s existing home was sold in early August, and Nancy promptly delivered the home sales proceeds check to her IRA custodian within 58 days of the initial distribution out of the IRA, with the direction to deposit the funds in Nancy’s IRA. For undisclosed reasons, the IRA custodian did not deposit the check into Nancy’s IRA until 62 days after the June IRA payout to Nancy. The IRS claimed that Nancy had to report the entire $524,980 in her taxable income for 2014. [Wonder what Nancy thought about that, or for that matter, what she thought about her IRA custodian/} Fortunately, the Tax Court (after Nancy’s considerable expense and angst) let Nancy off-the-hook. The Court found that the substance (not form) of the transaction was that the IRA custodian had accepted the deposit and that it held Nancy’s assets subject to an IRA trust instrument. Therefore, the custodian’s failure to record the transfer within 60 days was a bookkeeping error, and thus Nancy was eligible for a hardship waiver. Using a 60-day IRA rollover as a short-term financing vehicle is always playing with fire. Burack, Tax Court Memo, 2019-83.

Loss of Bankruptcy Protection of Roll-out: We have also covered in the past that qualified plan accounts are exempt in bankruptcy of an unlimited amount. IRAs are also protected in bankruptcy, but only to a dollar amount that is adjusted annually for inflation. For 2019 and 2020 the IRA exempt amount is $1,362,800. Consequently, it is possible for a bankrupt to lose the excess portion of their IRA if they later file for bankruptcy. In a recent Bankruptcy Court case the spotlight was on amounts transferred from a qualified plan to an IRA prior to the IRA owner filing for bankruptcy. Tim guaranteed a loan to his son-in-law to open a restaurant.[I will refrain from repeating old jokes about investing in restaurants.] Suffice it to say, the restaurant failed, and the bank came calling to collect on Tim’s personal guaranty. Tim filed for bankruptcy. Tim had multiple retirement accounts with an aggregate worth of over $1.8 million. Tim claimed that all $1.8 million was exempt in his bankruptcy proceeding. Claiming an exemption under Georgia law (not federal law), Tim’s traditional IRA account was exempt up to $1,477,000 along with a small 401(k) account balance. However, the Bankruptcy Court disallowed exemptions for Tim’s Roth IRAs (worth a combined $276,000) and IRA distributions that Tim had received of $55,000, or a total amount disallowed as an exempt asset of $330,000. Part of Tim’s traditional IRA contained rollovers from his qualified plan account, but Tim did not separately account for the Bankruptcy Court for those qualified plan rollovers to his IRA. The key point here is that some planning needs to go into splitting out and segregate rollovers from a qualified plan to a new IRA (which holds only the prior qualified plan account) and keep separate the traditional IRA that is funded solely with IRA contributions. If Tim had done so, he would have come out of bankruptcy with $330,000 more in assets. Hoffman, Bankruptcy Court, GA, July 26, 2019.

Exposure Due to Community Property Rights: We reported in the past that community property principles are expressly ignored in the Tax Code when it comes to the taxation of a community spouse’s IRA distribution. A federal District Court focused on this distinction in an interesting case. Gwen was found guilty of embezzling $1.8 million from a family’s bank accounts. Gwen was sent to jail and ordered to pay restitution, including 100% of Gwen’s IRA. The Court also ordered that 50% of Gwen’s husband’s (Mike’s) IRA also be paid to the victims of her embezzlement, apparently because of Gwen’s community property interest in Mike’s IRA. Gwen and Mike argued that ERISA overrides community property law. The District Judge found that the retirement benefits had been rolled into an IRA, which is not an ERISA governed plan. Again, the problem was that Mike’s qualified plan account had been rolled into an IRA, which rollout converted it from Mike’s separate property to Mike and Gwen’s community property, which then entitled the court to order a distribution of Gwen’s portion of Mike’s IRA to satisfy part of her order of restitution. This demonstrates the danger of a rollout from a qualified plan if the spouses reside in a community property (Texas) jurisdiction. Berry, S.D. Texas, 4:17-cr-00385 (2018).

Divorce Ordered Distributions: Divorce courts frequently order the transfer of retirement accounts (or portions) from one spouse to the other spouse. Normally there is no tax consequence with that court-ordered transfer of one’s IRA or qualified plan account (using a QDRO) to their former spouse’s rollover IRA.  While that tax-free transfer seems pretty simple, often one or the other spouse seems to screw things up, often ‘playing games’ post-divorce, or because their judgment is clouded by their residual anger post-divorce. The Tax Court had the occasion to address one of these situations. The divorce court ordered Bill’s former wife to pay him $10,000 from her retirement account. Rather than take a distribution and deliver the check to Bill, the ex-wife had her plan administrator transfer funds directly from her qualified plan account to Bill’s IRA. Shortly after the transfer, Bill withdrew the funds from his IRA, triggering an income tax and a 10% penalty. Bill then found himself in the Tax Court, arguing (presumably with a straight face) that the court should ignore the intermediary steps of the $10,000 transfer from his ex-wife’s retirement account to his rollover IRA and his immediate withdrawal of that $10,000 from that IRA, as entire arrangement of a payment of $10,000 cash from his ex-wife to him as ordered by the divorce court. The Tax Court spent little time addressing Bill’s ‘substance’ claim that equitable principles should be applied to the court-ordered transfer of funds, dwelling instead on the form of the transfer. The Tax Court focused on only one thing- the $10,000 was transferred to Bill’s IRA, and it was from Bill’s IRA that Bill took the distribution. Thus, the $10,000 was taxable income to Bill, along with a 10% excise tax for distribution prior to age 59 ½. Rosenberg, Tax Court Memo, 2019-124, September 19, 2019.

Conclusion: 2019 was a year for big changes in the retirement benefit world. A am confident that much of 2020 will be spent figuring out how to best deal with the required 10-year payout of inherited IRAs for beneficiaries who will begin to inherit IRAs in 2020. Most existing conduit see-through trusts will need to be re-examined if IRA distributions can now be suspended up to ten years. Many clients will spend more time looking at the pros and cons of directing their retirement accounts to a charitable remainder trust (as an alternative to the loss of the stretch distribution opportunity with a see-through trust.) More time will also be spent with clients talking about the surviving spouse’s disclaimer of a portion of the deceased spouse’s IRA so that their children can enjoy two separate 10-year payouts from inherited IRAs, each 10-year payout beginning after the death of one parent, in effect ‘doubling up’ on the mandatory 10-year taxable payouts.