Denise Appleby- Author, Speaker on IRAs & Employer Retirement Plans; Consultant, and Trainer of Choice for Financial and Tax Professionals
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Taxpayers often “borrow” funds from their retirement accounts to fill short-term financial needs, and roll over the amounts within 60 days of receipt. But, as a taxpayer found out in PLR 202033008, IRAs are not designed for loans, and taking one can result in unintended distributions that cannot be repaid to the IRA.
Taking a distribution from an IRA with the intent of returning (rolling over) the amount so that it is non-taxable is a risky business. Risky because missing the 60-day rollover deadline could result in the amount being included in income, which is the contrary effect of a rollover. The IRS will waive the 60-day deadline under certain qualifying circumstances, such as if the deadline is missed because of an error made by a financial institution. But, as one taxpayer found out in Private Letter Ruling (PLR) 202033008- the IRA custodian not informing him about the 60-day deadline is not a qualifying circumstance.
Amounts held in IRAs and other retirement accounts grow on a tax-deferred basis. This tax-deferred benefit is lost for amounts that are distributed (withdrawn), and such amounts are instead included in the account owner’s income for the year in which the distribution is made. But an exception applies to distribution amounts that are properly rolled over (recontributed to an eligible retirement account). One of the requirements that must be met for an amount to be ‘properly rolled over’, is that the rollover must be completed within 60 days of the account owner receiving the distribution.
The IRS May Waive The 60-Day Deadline
As provided under I.R.C. § 408(d)(3)(I ), the IRS has the authority to waive the 60-day deadline, where “…failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement”. When determining whether to grant a waiver of the 60-day deadline, the IRS will consider factors such as whether the deadline was missed due to errors committed by a financial institution and the use of the amount distributed. For example, in the case of payment by check, whether the check was cashed and the funds were in use at the time the rollover was required to be completed.
Requirement For Written Explanation To Recipients Of Distributions Eligible For Rollover Treatment: Notice Of Rollover Rules (IRC § 402(f) Notice)
If a plan administrator receives a request for a distribution from an employer-sponsored retirement plan and the amount is eligible to be rolled over, the plan administrator must provide the distributee with a written explanation of the rollover rights and the tax and other potential consequences of the distribution or rollover. This includes an explanation that the distribution will not be subject to income tax, if the amount is rolled over to an eligible retirement plan within 60 days after the date on which the distributee receives the distribution.
The Facts Of The PLR
The following are the highlights of the PLR.
IRA Owner Took IRA Advice From Real Estate Agent
According to PLR 22033008, the IRA owner (let’s call him Sorano for the purpose of this article) and his spouse wanted to sell their existing home and purchase a new home. The couple worked with a real estate agent, who advised Sorano to take the money that was needed to purchase the new house from his IRA. The real estate agent assured Sorano that he could “repay the amount back into his IRA at a later time, after the sale of his current residence”, but made no mention of the 60-day rollover deadline.
Sorano had no other funds available to make the cash purchase, and followed the advice of his real estate agent, to take a distribution of the amount from his IRA.
While the distribution request form included language explaining that the amount may be taxable, it did not make any reference to whether the amount could be rolled over within 60 days. However, it included language to the effect that the IRA owner agreed to obtain legal and tax advice to make the determination of whether the amount would be taxable.
First Home Sold Too Late
When the first home was eventually sold, the 60-day deadline had already passed. And, for that reason, the IRA custodian refused to accept the amount for rollover.
Stated Reason for Waiver Request
Based on these facts and circumstances, Sorano asked the IRS to waive the 60-day deadline, asserting that his failure to meet the deadline was caused by the failure of the real estate agent and IRA custodian to inform him of the 60-day rollover period.
IRS’s Reason For Denying The Request
As mentioned earlier, the IRS will generally waive the 60-day deadline for reasons that include the deadline being missed due to errors committed by a financial institution. However, the IRS determined that this was not a case of ‘financial institution error’, and denied the waiver request. In their response, the IRS explained that:
IRA Lessons From PLR 202033008
PLR 202033008 provides valuable lessons and insight into the operational and compliance requirements of IRAs, which include the following:
Another important point of consideration not mentioned in the PLR, is that the IRS charges a fee of $10,000 for a PLR request. This means that in addition to the unfavourable ruling which requires the amount to be included in income, the IRA owner is out of pocket for $10,000 plus any fees paid to the professional whose service was engaged to assist with requesting the PLR. Further, income tax would be owed on any pre-tax amount, plus a 10% early distribution penalty if the IRA owner was under age 59 ½ at the time the distribution was made from the IRA and does not qualify for an exception.
While PLRs are not authoritative, they give a good idea of how the IRS might respond to a case with similar facts and circumstances. And, PLR 202033008 presents an opportunity for others to learn from the mistakes that were made. For advisors, it creates an opportunity to educate clients about the rules that govern their IRAs.
IRA Custodians Can Help
Finally, the PLR demonstrates that there is room for improvement for IRA custodians who do not include more information about the tax consequences of distributions on their distribution request forms. While it is true that they have met their disclosure requirements by providing IRA owners with IRA disclosure statements, we all know that almost no one reads the fine print of these contracts, and even for those that do, it is not realistic to expect someone to check their IRA Disclosure Statement every time they want to engage in an IRA transaction. Adding an extra line or two, in a strategic–cannot be missed–place on an IRA distribution form, can help to avoid the negative consequences of an IRA owner being unaware of the tax implications of an IRA distribution.
Can you do a Roth conversion of a coronavirus-related distribution? It would be nice if you could, as that would allow you to spread the income from the Roth conversion over three years. Follow me as I guide you to my answer.
The coronavirus disease 2019 (COVID-19) pandemic has wreaked havoc on the finances of many Americans. In response, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, to provide relief for individuals and businesses. One of the relief provisions relaxes the rules for distributions from retirement accounts through a coronavirus-related distribution provision, which allows taxpayers to (A) repay these distributions within three years, or (B) spread the income from the distribution over three years. One hot topic around this provision is whether a coronavirus-related distribution could be converted to a Roth IRA, thus allowing a taxpayer to benefit on both ends, in effect eating his cake and having it too.
Let’s Start With The Basics
A. What Is A Coronavirus-Related Distribution?
A distribution is a coronavirus-related distribution if it meets three requirements:
Coronavirus-related distributions boast three attractive features that are not usually available to regular distributions:
B. What is a Roth Conversion?
Technically, a Roth conversion is also a rollover and occurs when a distribution is made from a traditional account under an eligible retirement plan and rolled over to a Roth account. For example- from a traditional IRA to a Roth IRA.
The difference between a Roth conversion and other rollovers is that, with other rollovers, the amounts are rolled back to the same type of account from which the amount was distributed (traditional to traditional or Roth to Roth), resulting in a nontaxable transaction; whereas with a Roth conversion, the amount is distributed from a traditional account to a Roth account, and any pre-tax amount is taxable.
A Conversion Of A Coronavirus-Related Distribution Would Be A Bonus Deal- If Permitted
Roth accounts are more attractive than traditional retirement accounts because qualified distributions of earnings are tax-free; whereas, with a traditional account, distributions of earnings are taxable.
One of the ways to fund a Roth IRA without income & amount limitations is by converting amounts from a traditional retirement account. However, this is often seen as a deterrent for some, because any pre-tax amounts included in a Roth conversion is generally required to be included in the owner’s income for the year in which the Roth conversion is done. One way to mitigate the taxes that would be due is to spread the conversion over multiple years.
If a coronavirus-related distribution could be converted to a Roth, the owner could get up to $100,000 into a Roth IRA for 2020 and spread the income ratably over three years- 2020, 2021, and 2022. This could make the tax burden more manageable, and potentially reduce any income tax that would be owed should the lower income per year result in the individual being in a lower tax bracket than he would have been, had the $100,000 been included in income for only one year.
The Reason Some Believe It Is Permitted
Under the CARES Act, a coronavirus-related distribution may be taken from an eligible retirement plan and may be repaid by the end of the 3-year period to an eligible retirement plan:
For this purpose, the CARES Act’s definition of an eligible retirement plan is consistent with the Tax Code, specifically IRC §402(c)(8)(B), which means:
The only restriction on portability between these accounts is that any distribution made from a designated Roth account – such as a Roth 401(k) – must be rolled over to another designated Roth account or Roth IRA.
As such, those who believe a coronavirus-related distribution can be converted to a Roth IRA argue that:
The question then becomes: If a coronavirus-related distribution may be repaid to an eligible retirement plan, and a Roth IRA is an eligible retirement plan, why can’t a coronavirus-related distribution from a traditional retirement plan/account be rolled over to a Roth IRA?
Here is Why it Is Not Permitted
Recall from my explanation above, that a Roth conversion results in any pre-tax amount being included in income. This means that a Roth conversion of any pre-tax amount would be taxable; as opposed to a rollover between accounts of the same type (traditional to traditional or Roth to Roth) which would be nontaxable (tax-free).
The IRS has confirmed on more than one occasion that a repayment of a coronavirus-related distribution would be treated as a tax-free rollover – which means that it must occur between accounts of the same type – for example, traditional 401(k) to Traditional IRA or Roth 401(k) to Roth IRA.
They made a point of reminding us six times in Notice 2020-50, by using language that indicates that the option for spreading the income over three years applies only to amounts that would have been tax-free if rolled over. For example, in the Purpose section, they state the following:
“…and, to the extent the distribution is eligible for tax-free rollover treatment and is contributed to an eligible retirement plan within a 3-year period, will not be includible in income.”
The full list of occurrences is:
Remember, one of the requirements of a coronavirus-related distribution is that a repayment of the amount must result in tax-free rollover treatment, causing the repaid amount to be excluded from income. Therefore, a coronavirus-related distribution cannot be converted to a Roth, because a Roth conversion is not tax-free, and is includible in income.
There Is More- The Tax Reporting Forms
According to the IRS, aqualified individual receiving a coronavirus-related distribution claims the favorable tax treatments by reporting the distribution on the individual’s federal income tax return for 2020 and Form 8915-E, Qualified 2020 Disaster Retirement Plan Distributions and Repayments (or if there is no federal income tax return for 2020, by filing just Form 8915-E).
At the time of writing this article, Form 8915-E was not yet available. However, we can refer to previous versions of Form 8915, that were used to report Disaster Retirement Plan Distributions and Repayments.
According to the instructions, there are two options for these distributions:
Amounts that are repaid are excluded from the equation used to figure out how much to include on the tax return. According to the instructions, the equation is:
(Taxable portion of coronavirus-related distribution amount / 3)
any amount repaid before filing the 2020 tax return
amount to be included on return as taxable income
This excludes a Roth conversion from the repayment formula. If it is included, it would incorrectly show that the conversion amount is nontaxable. The IRS would find this problematic.
Consider this demonstration:
Assume a coronavirus-related distribution of a pre-tax amount of $100,000 and an election to spread the amount over three years.
Assume also, that $10,000 is rolled over in 2020
(Taxable coronavirus-related distribution amount / 3)
This shows that the rollover of the $10,000 should result in a tax-free rollover, and therefore cannot be a Roth conversion, as a Roth conversion is not tax-free.
Could This Change?
Maybe, but I doubt it!
Generally, the IRS provides exceptions to certain general rules, to help taxpayers who face adverse tax consequences for reasons beyond their control. For instance, the IRS will waive the 60-day deadline for rollovers, where the deadline is missed due to hardship or certain reasons beyond the control of the taxpayer- like a pandemic.
Most, if not everyone, would agree that a Roth conversion does not fall into a category of hardship- and is more of a tax strategy for taxpayers who are on the opposite spectrum of financial hardship.
Could the IRS somehow provide an exception that permits the conversion of a coronavirus-related distribution? It is not impossible, but I think it is unlikely.
So, for now, if anyone takes a distribution from a traditional retirement account and decides to roll over any portion of that amount to a Roth IRA or designated Roth account, the amount must be included in income for the year in which the conversion occurs- and 2020 is no exception.
The IRS provides answers to some key questions about coronavirus-related distributions from IRAs, 401(k)s and other eligible retirement plans; and expands qualification for it, by association.
On March 27, 2020 the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, in response to the coronavirus disease 2019 (COVID-19) outbreak and its impact on the economy, public health, state and local governments, individuals, and businesses. Section 2202 of the CARES Act permits qualified individuals to take coronavirus-related distributions, from eligible retirement plans, which are penalty free and qualify for other special tax benefits. But there were- and still are- many unanswered questions about coronavirus-related distributions. The Internal Revenue Service (IRS)- in their quest to answer these questions, have provided guidance, including the recently issued Notice 2020-50 which provides some unexpected answers and opportunities. This article covers five of these.
What’s The Big Deal About Coronavirus-Related Distributions?
Coronavirus-related distributions are a hot commodity right now, as they allow qualified individuals to access funds from their tax deferred retirement savings accounts without the usual immediate tax consequences and penalties. These are:
These tax friendly features make a coronavirus-related distribution- which is capped at $100,000 per person- an attractive solution for those who are facing financial difficulties. But, one requirement for eligibility is that they are available only to qualified individuals. The following are some of the surprising revelations provided by the IRS in Notice 2020-50, including the expanded definition of a ‘qualified individual’ for coronavirus-related distribution purposes.
A coronavirus-related distribution must meet three key requirements. It must be made:
For this purpose, an eligible retirement plan means:
The definition of a qualified individual has been expanded under Notice 2020-50 to include your spouse or a member of your household, who faces adverse financial consequences as a result of COVID-19. The following is the definition under the CARES Act and the addition provided under Notice 2020-50:
This expanded definition now confirms that if you are not adversely affected by COVID-19- financially speaking- you would still be eligible for a coronavirus-related distribution if your spouse or a member of your household experiences adverse financial consequences as a result of COVID-19.
Jimmy Cliff’s very popular song “You Can Get It If You Really Want” is appropriate here. Because, if you are a qualified individual, you may take a coronavirus-related distribution if you want to, even if you do not have a financial need arising from COVID-19.
As to whether you should, is a different question of course, and one that should be seriously discussed with a financial and/or tax advisor.
One of the outstanding questions about who is a qualified individual, for purposes of taking a coronavirus-related distribution, is whether the holder of a beneficiary account under an employer sponsored retirement plan or IRA could qualify. IRS Notice 2020-50 confirms any distribution received by a qualified individual can be treated as a coronavirus-related distribution, even if the distribution is made from a beneficiary IRA or beneficiary account under an employer sponsored retirement plan. As a result, the income from such amounts are eligible to be spread ratably over 3-years.
4. A Distribution That Is Ineligible For Rollover Cannot Qualify As A Coronavirus-Related Distribution
Amounts distributed from eligible retirement plans can be restored to the same or another eligible retirement plan through rollovers- where permitted, only if the amount is eligible to be rolled over. If an amount is not ordinarily eligible to be rolled over, such an amount is not eligible for the benefits available to coronavirus-related distributions. These amounts include certain substantially equal periodic payments, and a distribution that is made on account of hardship of an employee.
An exception applies to a hardship distribution, if it meets the requirements to be considered a coronavirus-related distribution. Under that exception, the usual hardship withdrawal rules are disregarded, and the coronavirus-related distribution rules would apply- making the amount eligible for rollover.
Notice 2020-50 confirmed that because there is no required minimum distribution (RMD) for 2020, any distribution that would have otherwise been an RMD except for the CARES Act, is an eligible rollover distribution- and eligible for the coronavirus-related distribution benefits, if taken by a qualified individual. This RMD exception does not apply to RMDs from defined benefit plans- as those are not waived, and distributions taken by beneficiaries from retirement accounts- unless the beneficiary is the surviving spouse of the decedent.
Because You Can, Does Not Mean That You Should
A large number of Americans face adverse financial consequences as a result of the COVID-19 pandemic- including loss of job-related income. And for many, a coronavirus-related distribution is the only solution to staying above choppy financial waters. But, if you are a qualified individual who does not need to take a coronavirus-related distribution, it might be in your best financial interest to leave the amount in your retirement savings account.
There are factors that must be considered- most of which are not broached in this article. Regardless of your choice, be sure to consult with your financial and tax advisor before taking action.
By law, Plan trustees and custodians are required to provide account statements and notices to participants- many of which are critical to the successful operation of the account. But, these- while important, are not helpful to the account owner, if they are sent to an invalid address.
Account statements, showing account balances and performance of investments, are only one of the notices that individual retirement account (IRA) custodians and plan administrators must provide to account owners. Others include statements of tax reporting activity, such as Internal Revenue Service (IRS) Form 1099-R that reports distributions, and notification of any change in custodianship or administrators. Whether electronically or by physical mail, the information is sent to the account owner’s address of record. For account owners who change addresses, failing to notify IRA custodians and plan administrators could be costly, as evidenced by private letter ruling (PLR) 202023007.
In PLR 202023007, the IRA owner failed to notify his IRA custodian that he had moved. That failure resulted in the custodian distributing his IRA without his permission or knowledge, and costing him an IRS PLR fee of $10,000.
There are several background rules that are addressed in this PLR.
An IRA Custodian’s Right to Resign as Custodian
Just as an IRA owner can choose to move his IRA to another financial institution, an IRA custodian can decide that it no longer wants to serve as custodian of an IRA. This right to resign as custodian is included is the governing contract for most IRAs.
An IRA disclosure statement should include information about the circumstances under which an IRA may be closed without any further action by the IRA owner, and the timing requirements that apply. One such example – commonly referred to as a 30-day resignation notice, gives an IRA custodian the authority to close an IRA within 30 days of sending the IRA owner a notice of resignation. Such a notice generally includes an explanation of why the custodian is resigning, and instructions on how the IRA owner may move the IRA to another financial institution without incurring any tax consequences.
If the custodian does not get a response by the deadline, the IRA holdings are usually distributed and any relevant notification sent to the address of record. In such cases, the distribution would be reported to the IRA owner- and the IRS, on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. (Form 1099-R).
1099-Rs and Income Requirement
A distribution reported on IRS Form 1099-R must be included on the recipient’s tax return as income. If the amount is rolled over within 60 days, the amount must be reported as nontaxable income- provided the amount is eligible to be rolled over.
The 60-day period can be waived under certain circumstances, such as under the IRS PLR Program. Under this program, the IRS may waive the 60-day deadline, "where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement." IRC § 402(c)(3).
The IRS charges a fee of $10,000 to review PLR requests, regardless of whether their ruling is favorable.
The IRS’ Document Matching Program
The IRS has a Document Matching Program, which is used- in part- to identify taxpayers who underreport their income. Under the program, an amount might be flagged as underreported income, if it is reported on a Form 1099-R as income and is not included on the IRA owner’s tax return. In such cases, the IRS generally amends the tax return to include the amount and issues a CP2000 notice to the IRA owner.
The Facts of PLR 202023007
The IRA owner, let’s call him Tyrone, established an IRA with Custodian-D. The IRA held shares of a real estate investment trust (REIT).
Tyrone subsequently moved to another state, but failed to notify Custodian-D about his change of address.
Custodian-D sent a letter to Tyrone’s address that they had on record- which is his old address- informing him that they were resigning as custodian of his IRA. The resignation resulted in the assets held in the IRA being distributed to him.
Neither the resignation letter nor the 1099-R issued for the distribution was forwarded to Tyrone’s new address. As a result, Tyrone was not aware of the distribution until he received a CP2000 notice from the IRS.
Upon receiving the CP2000 notice, Tyrone consulted with his CPA, the issuer of the REIT and a new IRA Custodian-E; and subsequently rolled over the shares of the REIT to a new IRA with Custodian-E.
Based on the facts and representations, Tyrone requested that the IRS waive the 60-day deadline, which would result in the rollover being valid and eligible to be excluded from his income.
The IRS issued a favorable ruling in response to Tyrone’s request, contingent upon the fact that all other rollover rules were satisfied. These other rollover rules include the one-per-year rule for IRA-to-IRA rollovers, under which an individual may perform only one IRA-to-IRA rollover during a 12-month period.
Tax-Deferral Status Saved- but at a Cost
Had the IRS not issued a favorable ruling, Tyrone would have been required to include the amount in income and pay income tax on any pre-tax amount, pay an additional 10% early distribution penalty if he was under age 59 ½ at the time the distribution was made by Custodian-D, and remove the amount from the IRA with Custodian-E as a return of excess contribution- to avoid the amount being subject to a 6% excise tax that would apply for every year it remained in his IRA.
But Tyrone was able to avoid these consequences – albeit at a cost of an IRS fee of $10,000, plus any professional fees incurred for assistance with filing the PLR.
The IRS’s fee and other expenses incurred for requesting the PLR might be worth it, as it provides an assurance that the IRS would not later disqualify the rollover, as long as all other rollover requirements are satisfied. But this could have been avoided, if Tyrone had notified Custodian-D that he had moved and instructed them to update his address of record.
How Advisors Can Help Clients
This is one of those areas in which the requirements must be made clear during the account opening process. The potential consequences of failing to notify the financial institution about a change of address should be emphasized. These consequences include unintentional distributions, accounts being escheated to states, and beneficiaries being effectively disinherited because of owners losing track of accounts.
A good practice for an account owner is to maintain a list of financial accounts and notify the issuers/trustees/custodians of any change of mailing address, email address and telephone numbers.
The SECURE Act changed the options that are available to designated beneficiaries. But, for those who inherited IRAs and other retirement accounts in 2019, the year 2020 might be a last chance to hang on to the older and more beneficial beneficiary distribution options.
One of the most impactful changes made under the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) is the elimination of the life expectancy distribution option for designated beneficiaries. These changes are effective for designated beneficiaries who inherit retirement accounts after 2019. Those who inherit retirement accounts in 2019 are the last set of designated beneficiaries to benefit from the generally more beneficial pre-SECURE Act life expectancy options; but for some, certain steps must be taken during 2020 to preserve that benefit.
Please note: Because a spouse beneficiary has the option of moving an inherited retirement account to the spouse beneficiary’s own retirement account, this article focuses on nonspouse beneficiaries.
Starting with the Basics: Who is a Designated Beneficiary?
When it comes to retirement accounts, terminology matters. And, identifying who is a designated beneficiary is a prime example.
A nonperson- such as an estate or charity- can be designated as a beneficiary of a retirement account; so can an individual. However, only an individual may be a designated beneficiary.
A designated beneficiary generally has the option of taking distributions from an inherited retirement account over the designated beneficiary’s life expectancy. A nonperson beneficiary cannot, as a nonperson beneficiary has no life expectancy.
Exception for Trust Beneficiaries: A trust is a designated beneficiary, if certain requirements are met. These are defined under Treas. Reg. §1.401(a)(9)-4, Q&A-5. If these requirements are met, the life expectancy of the oldest beneficiary of the trust may be used for required minimum distribution (RMD) purposes. Retirement account owners and beneficiaries should consult with an estate planning attorney, for assistance with determining whether a trust is qualified to be a designated beneficiary.
Continuing with the Basics: What is the Required Beginning Date (RBD)?
When determining the distribution options available to a beneficiary who inherited a retirement account before 2020, one must first determine if the retirement account owner died before the RBD. The RBD is the deadline by which a retirement account owner must start taking RMDs.
For beneficiaries who inherit retirement accounts before 2020, the RBD is April 1 of the year that follows the year in which the retirement account owner reached age 70 ½.
For employer sponsored retirement plans that permit deferral of RMDs past age 70 ½, the RBD is the later of:
This means that April 1, 2020 would have been the RBD for retirement account owners who reached age 70 ½ in 2019. For retirement accounts under employer sponsored plans that permit the aforementioned RMD deferral, April 1, 2020 would be the RBD for those who separated from service with the employer in 2019 and were at least age 70 ½ in 2019.
Distribution Options for Designated Beneficiaries Who Inherit Retirement Accounts before 2020
A designated beneficiary who inherits a retirement account before 2020, is eligible to take distributions as follows:
(a) over the designated beneficiary’s life expectancy; which is the default option under the RMD regulations, or
(b) under the 5-year rule.
5-year rule: Under the 5-year rule, distributions are optional until December 31 of the 5th year that follows the year in which the retirement account owner died, at which time the entire remaining balance is the RMD and must be distributed.
(a) the decedent’s remaining life expectancy, or
(b) the life expectancy of the designated beneficiary.
Life expectancy rule: When distributions are made under the life expectancy option, they must begin by December 31 of the year that follows the year in which the retirement account owner died.
The life expectancy option could be limited by the provisions of the governing plan document or IRA agreement and when there are multiple beneficiaries of a retirement account. In those cases, a designated beneficiary might need to take action, to preserve the life expectancy option.
Reminder: For 2020, the Coronavirus Aid, Relief, and Economic Security Act waives RMDs for IRAs and defined contribution plans- for account owners and beneficiaries.
Action Might Be Needed in 2020 to Preserve Designated Beneficiary Options for 2019 Beneficiaries
If a designated beneficiary is the sole primary beneficiary of a retirement account, and the IRA agreement or plan document defaults to the life expectancy option, then the life expectancy option is automatically preserved. But, if that is not the case, there are factors that could limit the designated beneficiary’s options. The good news is, for 2019 beneficiaries, these limitations can be overridden if the appropriate action is taken in 2020. The following is a high-level explanation of these limitations and how they can be overridden.
If there are multiple designated beneficiaries of a retirement account, the life expectancy of the oldest beneficiary is used for beneficiary RMD purposes. This puts younger beneficiaries at a disadvantage, as it forces them to take larger RMD amounts which depletes the account faster than if they were eligible to use their own life expectancies; thus, reducing the period over which eligible amounts may continue to grow tax-deferred.
Solution for 2019 beneficiaries: Perform separate accounting by December 31, 2020
If separate accounting occurs by December 31 of the year following the year of the account owner’s death, each designated beneficiary may use his own life expectancy.
Please note: Beneficiaries must contact the plan administrator or IRA custodian in advance of the deadline, for assistance with meeting the trustee or custodian’s operational and documentation requirements for performing separate accounting.
Example: Janet died in 2019. Her 65-year-old cousin Carl and her 25-year-old nephew Jonathan are the beneficiaries of her Roth IRA; to be shared equally.
Assuming a balance of $200,000, of which no more than RMD amounts are taken each year, and a rate of return of 5%, the total distribution amounts would be:
Scenario A: If separate accounting does not occur by December 31, 2020- then distributions would be made over Carl’s life expectancy.
Scenario B: If separate accounting occurs by December 31, 2020, Carl’s share would be distributed over Carl’s life expectancy and Jonathan’s share would be distributed over Jonathan’s life expectancy.
If there are multiple beneficiaries of a retirement account, and a nonperson is one of the beneficiaries, the account is treated as not having a designated beneficiary (except for certain trusts- See Exception for Trust Beneficiaries earlier).
This would require the inherited amounts to be distributed under the 5-year rule if the owner died before the RBD and over the remaining life expectancy of the decedent, if death occurred on/after the RBD. For Roth IRAs, the 5-year rule would apply regardless of the age of the owner at death.
Solution for 2019 beneficiaries: Have nonperson beneficiaries take full distributions of their share by September 30, 2020
The determination of whether a retirement account has a designated beneficiary is made by September 30 of the year that follows the year in which the retirement account owner dies. Any beneficiary that takes a full distribution or makes a full disclaimer of that beneficiary’s share by this September 30th date, is disregarded for purposes of determining the period over which beneficiaries may take distributions. Reminder: Disclaimers must meet the requirements of IRC § 2518
Example: 45-year-old Tom died in 2019. His 50-year-old brother Harry and his estate are the beneficiaries of his Traditional IRA; to be shared equally.
Assuming a balance of $1,000,000, of which no more than RMD amounts are taken, and a rate of return of 5%, the total distribution amounts would be:
Scenario A: If the estate’s share remains in the account, both beneficiaries would be subject to the 5-year rule.
Scenario B: If the estate distributes its share by September 30, 2020- Harry would be able to take distributions over his life expectancy.
The terms of a plan document or IRA agreement may permit a designated beneficiary to override the 5-year rule by making an election to do so. Such an election must be made by December 31 of the year that follows the year in which the retirement account owner died- which would be December 31, 2020 for accounts inherited in 2019.
Much ado is made about the changes to beneficiary options made by the SECURE Act- and rightfully so, as they limit the distribution period to the new 10-year rule for many designated beneficiaries. But, for those who inherited retirement accounts in 2019, there are still opportunities to take distributions under the life expectancy method. When consulting with beneficiaries, advisors must determine whether the account was inherited before 2020, as that drives the distribution options.
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