5 February 2016

Five Traits of Retirement Plans (Traits 1-3)

Last week we discussed five traits of 401(k) plans, profit sharing plans, and IRAs. We need to keep these traits in mind to maximize the economic benefits of these assets. These traits come to the forefront when we are doing estate planning. This week we discuss three of the five traits and their impact:  (1) plan income grows tax free, (2) plan distributions carry an income tax liability, and (3) there are required plan distributions.

1. Plan Income Grows Tax Free.

The good news is that a retirement plan does not pay income tax on its earnings. Ultimately, the person who receives money from the plan will pay income tax on the distribution. The tax is deferred until that time.

The value of this deferral can be enormous. Assume a retirement plan beneficiary in a 35% income tax bracket receives $100,000, pays tax on it, and invests the balance so that it earns 7% per year on a pre-tax basis. After 12 years, this person will have $100,490 after tax. In contrast, assume the person left the $100,000 in a retirement account where it earned 7% per year and then took all of the money out at the end of twelve years and paid tax on it. This person would have $146,392 after tax. The beneficiary earns an extra $45,902 by leaving the money in the retirement account.

There are a few important assumptions in the above calculation. We assumed that the tax rate was 35% in all years. This may not be the case. A retirement plan beneficiary may have less income and be in a lower income tax bracket when he starts receiving distributions. This would make the deferral even more valuable. Alternatively, tax rates could go up and the beneficiary might have to pay at a higher tax rate later than when he could have first taken a distribution. This would reduce the value of the deferral.

We have that assumed all of the income is taxed at one rate. If the beneficiary took the money in year one, he could have invested it in assets that generated dividend income and capital gains. Dividends and long-term capital gains are taxed at a lower income tax rate than regular income.

On the other hand, the distributions from qualified defined contribution plans are taxed as ordinary income. This difference in tax treatment could reduce the benefit of deferring distributions compared to taking the money out and investing it in assets that generate capital gains and dividends.

If the beneficiary leaves the money in the retirement plan, there are some restrictions on how the money can be invested. These restrictions are usually not a problem for most beneficiaries. It is not necessary to take the money out of retirement plans for beneficiaries to control their funds.

A retirement plan, including an IRA, must have a trustee that cannot be the beneficiary of the plan. Many banks, brokerage houses, and other institutions will gladly serve as trustee. Most of the institutions, particularly with IRAs, will allow beneficiaries broad latitude in how they invest retirement accounts. However, most trustees will only allow beneficiaries to invest retirement accounts in publicly-traded securities, which can include stocks, bonds, mutual funds, or Exchange Traded Funds (ETFs).

Sometimes a beneficiary wants to invest in something other than publicly-traded securities. There are some IRA trustees that allow this. A beneficiary can “roll” all or a portion of her retirement benefits to an IRA managed by one of these trustees rather than take the money out and pay tax on it. The Tax Code has restrictions that apply to these out-of-the ordinary investments. Trustees that allow a beneficiary to invest in these assets typically tell the beneficiary that she is responsible for complying with the tax law. If the participant violates these rules, the penalties are severe. The beneficiary needs to get professional advice on what is allowed.

2. Plan Distributions Carry an Income Tax Liability.

When beneficiaries receive distributions from retirement plans they are subject to income tax. A recipient will pay tax on these distributions at his usual tax rate. [Note: we are not discussing Roth IRAs here; Roth IRAs are subject to a different set of rules.]

Here’s an important point that many people don’t realize: When someone inherits an asset, the income tax basis of the asset typically “steps up” (or possibly “steps down”) to its fair market value on the date of the decedent’s death. For example, assume Bill inherits an asset worth $1,000,000 from his mother. Bill’s mother had a $0 basis in this asset. The basis in the asset “steps up” to $1,000,000 on his mother’s death. Bill may now sell the asset for $1,000,000 and recognize no taxable gain.

Not so with retirement plan benefits. Retirement plan benefits do not “step up” to fair market value on the date of the decedent’s death. The person who inherits the plan must pay the income tax on distributions from the plan. In a later email, we’ll write about some of the planning opportunities available to deal with this income tax liability.

3. There Are Required Plan Distributions.

The government is unwilling to wait forever to get paid. A beneficiary must take out a minimum amount from the qualified defined contribution plan and pay tax on it. The tax regulations refer to this as the Required Minimum Distribution or RMD.

There are two sets of RMD Rules, one applicable to IRAs and one applicable to other qualified defined contribution plans. The RMD Rules are further divided into two subsets:  rules applicable to the original owner or beneficiary of the retirement plan and rules applicable to persons who inherit an interest in the plan.

Both lifetime and post-death RMDs are calculated in a similar way. Here is a very brief overview of the RMD rules. [Beware: this summary is not intended as a guide on how to calculate the RMD in a specific situation. Check the IRS rules and forms for guidance on how to calculate the RMD in a specific situation.]

The original beneficiary of a qualified defined contribution plan must take the first distribution in the calendar year after he or she reaches age 70 ½ if no longer working. The distributions can be deferred if the person is still working.

With an IRA, the original owner must begin taking distributions in the calendar year after he or she is age 70 ½. It does not matter that the person is still working.

In each distribution year, the prior year-end account balance is divided by a life expectancy factor that comes from an IRS table. This is the RMD. The owner or beneficiary of the retirement plan must withdraw the amount calculated as the RMD and pay tax on it. A steep penalty tax applies if the owner does not take the RMD out of the plan.

Nothing prevents someone from taking more than the RMD in a year. However, stretching distributions out as long as possible may give a better after-tax financial result.

The RMD is intentionally designed so that the retirement benefits are not likely to be exhausted during the participant’s lifetime. Unless the participant lives to be over 100 years old, there will still be money left in the retirement plan on the participant’s death. The RMD rules allow for lengthy deferral.

A participant may name his or her spouse as the person who will receive the retirement account on the participant’s death. In that case, the participant may use the joint life expectancy of the participant and spouse to calculate the RMD. This nearly always stretches out the RMD even longer than if based on the participant’s life alone.

Although everyone’s situation is different, a person usually benefits from deferring retirement plan distributions as long as possible.

Disclaimer: This is not legal advice for you to rely on. Consult an attorney to address your specific situation.

We’ll discuss retirement plan traits four and five next week: (4) there are restrictions on transferring these plans, and (5) the plan owner has ultimate responsibility for plan distributions and transfers.