Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

RETIREMENT INCOME

Part VI

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PART VI

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INDIVIDUAL RETIREMENT ARRANGEMENTS (IRAS)

There are two types of individual retirement arrangements, individual retirement accounts

and individual retirement annuities. Each is often referred to as an “IRA,” or a “tradition-

al IRA.” Generally, an account is set up as a trust or custodial account with a bank, a fed-

erally insured credit union or a savings and loan association. An individual retirement an-

nuity is established by purchasing an annuity contract from a life insurer. The IRA may

not hold life insurance.

Contributions may be made up to the time when the individual’s tax return is due (ex-

cluding extensions). In order to deduct contributions an individual must: (1) have com-

pensation (earned income or alimony) and (2) not have attained age 70 1/2 during the tax-

able year for of the contribution.

In 2011, a deduction may be taken for amounts contributed up to the lesser of $5,000 or

100% of compensation includable in gross income. An additional “catch-up” contribution

of $1,000 is allowed for individuals who attain age 50 before the close of the taxable

year. Deductions may be reduced or eliminated if the individual is an “active participant”

in a qualified plan.

In the case of traditional IRAs, contributions are full deductible, regardless of the

taxpayer’s level of income, provided he or she is not an active participant in a quali-

fied retirement plan. For 2012, if the taxpayer is single and is an active participant, a

traditional IRA contribution (plus any “catch-up”) is also deductible if AGI is $58,000 or

less. Contributions are partially deductible if AGI is between $58,000 and $68,000. Ac-

tive single participants cannot deduct IRA contributions if their AGI is over

$68,000.

In the case of someone married who files a joint tax return, deductibility of a tradi-

tional IRA depends on whether or not the taxpayer or spouse is an active participant in a

qualified retirement plan. For 2012, if the married taxpayer is an active participant: [a]

100% deductibility if AGI is up to $92,000, [b] if AGI is $92,000 up to $112,000, contri-

butions are partially deductible (pro rata within this range) and [c] if AGI is over

$112,000, contributions can still be made but are not deductible.

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If the taxpayer is married, files a joint return and has a spouse who is an active partici-

pant in a qualified retirement plan then: [a] any traditional IRA contribution is 100% de-

ductible if AGI is less than $173,000, [b] partial deductibility if AGI is between $173,000

and $183,000 and [c] if AGI is over $183,000, contributions can still be made but are not

deductible (all figures are for the 2012 calendar year).

Generally, funds accumulated in a plan are not taxable until they are actually distributed.

However, amounts distributed prior to age 59 ½ are considered premature distributions

and are subject to a 10% penalty tax. Exceptions to the penalty tax include distributions:

(1) made on or after death; (2) attributable to disability; (3) as part of a series of substan-

tially equal periodic payments made (at least annually) for the life or life expectancy of

the individual or the joint lives or joint life expectancy of the individual and a designated

beneficiary (e.g., an annuity payout); (4) for medical expenses in excess of 7.5% of AGI;

(5) for health insurance premiums for those receiving unemployment compensation; (6)

used to pay for a first home or (7) to pay for qualified higher education expenses. Distri-

butions from a plan must usually begin by April 1st of the year after year in which the in-

dividual reaches age 70 ½.

ROTH IRA

In 2012, the Roth IRA permits individuals to make nondeductible contributions to an

IRA of up to the lesser of 100% of compensation or $5,000 per year. An additional

“catch-up” contribution of $1,000 is allowed for individuals who attain age 50 before

the close of the taxable year. Unlike traditional IRAs, contributions may be made after

age 70 ½ and husband and wife may contribute amounts without regard to whether either

of them is a participant in another qualified plan as long as there is sufficient compensa-

tion.

The annual contribution limit is reduced dollar-for-dollar by contributions to a traditional

IRA. Also, the maximum yearly contribution is subject to a pro rata phase-out for taxpay-

ers filing jointly with modified adjusted gross incomes between $173,000 and $183,000

(for single taxpayers with modified adjusted gross incomes between $110,000 and

$125,000). Thus, if someone files a joint return and modified AGI is more than $183,000

(if single, $125,000), no Roth IRA contribution can be made.

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As with the traditional IRA, the Roth IRA accumulates tax-deferred. Provided the ac-

count has been held for at least five years, distributions are not subject to income taxes if:

(1) the owner is at least age 59 1/2; (2) the distribution is made after the owner’s death; (3)

the distribution is attributable to the owner being disabled or (4) the distribution is for

qualified first-time home buyer expenses (limited to $10,000 for both the owner and

specified family members). A 10% penalty tax applies to the taxable portion of with-

drawals that are not qualified. Unlike traditional IRAs, there are no requirements that dis-

tributions be started or completed by any particular date, unless the owner dies.

The following factors might be considered when determining whether for a particular

taxpayer the Roth IRA is better than a traditional IRA, or whether to make a taxable roll-

over to a Roth IRA: (1) the current age of the taxpayer; (2) the taxpayer’s current and an-

ticipated future marginal income tax brackets; (3) the taxpayer’s need for a current in-

come tax deduction; (4) the availability of other funds to pay the taxes on Roth IRA con-

tributions or rollovers and (5) anticipated reduction of taxes on Social Security income

caused by receiving untaxed IRA income.

WHICH IRA – ROTH OR TRADITIONAL

A Roth IRA offers the following potential advantages: (1) if used for higher education

expenses, withdrawals can be made prior to age 59 1/2 without penalty; (2) distributions

are not required at age 70 1/2; (3) contributions may continue after reaching age 70 1/2; (4)

phase-out limits are higher than those for deductible contributions to a traditional IRA

and (5) tax-free retirement distributions will not push modified AGI above the threshold

that triggers taxation of Social Security benefits.

IRA DISTRIBUTION PLANNING

Monies cannot be kept in a traditional IRA indefinitely. For most, the calculation of re-

quired minimum distributions during life is very simple: the account balance as of De-

cember 31st of the preceding year is divided by a life expectancy factor based on the

account owner’s age in the year distribution is due using the Uniform Lifetime Ta-

ble (see next table). This method is used regardless of the beneficiary’s age, except when

the beneficiary is a spouse more than 10 years younger than the owner—a joint and

survivor table set forth in the regulations produces a lower amount.

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Lifetime Required Minimum Distributions (RMDs)

Age Distribution

Period Age

Distribution

Period Age

Distribution

Period

70 27.4 80 18.7 90 11.4

71 26.5 81 17.9 91 10.8

72 25.6 82 17.1 92 10.2

73 24.7 83 16.3 93 9.6

74 23.8 84 15.5 94 9.1

75 22.9 85 14.8 95 8.6

76 22.0 86 14.1 96 8.1

77 21.2 87 13.4 97 7.6

78 20.3 88 12.7 98 7.1

79 19.5 89 12.0 99 6.7

Application The table above is used in calculating lifetime RMDs from IRAs, qualified plans and

TSAs for someone single. For example, a client turned age 74 in 2010, and on December

31st, 2009, his account balance was $325,000. Using this table, his life expectancy is 23.8

years. He must receive a distribution of $13,655 ($325,000 ÷ 23.8 = $13,655) for the

2009 year, no later than December 31st, 2010.

If an individual owns more than one IRA, the RMD must be calculated separately for

each IRA, but the total RMD may then be taken from any one or more of the IRAs. Fail-

ure to take a minimum distribution will subject the payee to a penalty tax of 50%.

If an IRA owner dies before her required beginning date, distributions must be made un-

der one of two methods: (1) life expectancy rule–if any portion of the interest is payable

to a designated beneficiary, that portion must be distributed over the life (or life expec-

tancy) of the beneficiary, beginning within one year of the owner’s death or (2) five year

rule–the entire interest must be distributed within five years after the death of the IRA

owner (regardless of who or what entity receives the distribution). If the IRA owner dies

on or after his required beginning date, but before his entire interest in the IRA has been

distributed, remaining balance is distributed over longer of: (1) the designated beneficiar-

ies single life expectancy or (2) the remaining single life expectancy of the owner, based

on his age at death.

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Estate taxes on the IRA will be due at the death of the owner or his spouse, depending

upon the beneficiary designation. Incorrectly changing the name on an inherited IRA ac-

count can result in the IRA becoming subject to income taxes within a year. When deal-

ing with an inherited IRA the following should be determined: (1) whether distributions

have started, (2) whether the required beginning date (RBD) has been reached, (3)

whether a beneficiary has been named and (4) whom the beneficiary is. The answers will

determine which of the following options are available:

IRA inherited by spouse before RBD—A surviving spouse beneficiary may: (1) with-

draw the assets within five year; or (2) elect to treat the IRA as her own (or transfer assets

to her own IRA), name a new beneficiary and take distributions over her lifetime (begin-

ning either at end of the year following spouse's death or by end of the year she would

have turned age 70 1/2). Option (2) also allows for naming a new designated beneficiary

and deferral of distributions until surviving spouse's age 70 1/2 (i.e., a so-called "stretch

IRA").

IRA inherited by spouse after RBD—A surviving spouse beneficiary may: (1) take dis-

tributions over his lifetime, beginning no later than the end of the year following the

spouse’s death, (2) treat the IRA as his own or (3) receive distributions over the remain-

ing single life expectancy of the owner based on his age at death. In order to treat the IRA

as his own the recipient must be the sole primary beneficiary.

IRA inherited by non-spouse before RBD—A non-spouse beneficiary may: (1) with-

draw the assets within five years or (2) take distributions over lifetime, beginning no later

than the end of the year following the owner’s death (if multiple non-spouse beneficiaries

must use life expectancy of oldest beneficiary or create separate accounts before Septem-

ber 30th

of the year after death).

IRA inherited by non-spouse after RBD—A designated beneficiary may withdraw as-

sets over life (or life expectancy), beginning no later than the end of the year following

the owner’s death.

Terminology Designated beneficiary (DB)—The individual or trust designated to receive the IRA

proceeds, either by the terms of the IRA document or by an affirmative election by the

IRA owner or surviving spouse. Generally, the designated beneficiary will be determined

as of September 30th

of the year following the year of the owner’s death.

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Required beginning date (RBD)—For traditional IRAs, this is April 1st of the year fol-

lowing the owner’s attaining age 70 1/2. Roth IRA owners are not subject to the lifetime

distribution requirements.

Required minimum distribution (RMD)—Minimum required payments from an IRA

(a penalty tax of 50% is imposed on any RMD not made).

Stretch IRA—Uses a combination of beneficiary designations and life expectancy elec-

tions to delay receipt of distributions (also referred to as a “multi-generation IRA”). Typ-

ically assumes IRA owner and spouse will not need the funds for retirement or for

estate taxes. Use of disclaimers may allow post-mortem planning.

THINGS TO DO

Your Practice

Bypass the debate about the pros and cons of a traditional vs. Roth IRA by having a

strategy that includes tax diversification. Using investment vehicles that take ad-

vantage of tax deferral, tax free, and taxable means there will be the ultimate flexibil-

ity when deciding what accounts should be liquidated during retirement.

The Next Installment

Your final installment, Part VII, covers equity-indexed annuities (EIAs). Generally,

EIAs should be avoided—there are simply better alternatives. Still, there are a few

situations wherein this product can make sense. The exclusion ratio for all types of

annuities is also detailed. You will receive Part VII in a few days.

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business

& Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree.

For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.