In a recent Private Letter Ruling (PLR 201423043), the IRS stated that a deceased person’s Roth IRA may be inherited by the Roth IRA owner’s surviving spouse through their Trust when the surviving spouse was the sole beneficiary and had sole control of the Trust upon the passing of her husband.
As many retirement account owners already know, listing your Revocable Living Trust as the beneficiary of your retirement account can be tricky as the Trust needs to meet certain requirements in order to receive rolled-over funds from the surviving spouse.
For example, Under Reg. § 1.408-8, Q&A 5, a surviving spouse of an IRA owner may elect to treat the spouse’s entire interest as a beneficiary in an individual’s IRA as the spouse’s own IRA, but only if the spouse is the sole beneficiary of the IRA and has an unlimited right to withdraw amounts from the IRA.
The IRS has stated that, “If a trust is named as beneficiary of the IRA, this requirement is not satisfied even if the spouse is the sole beneficiary of the trust.” Under the PLR though, the IRS stated that when the surviving spouse is the sole trustee of a trust and has the sole authority and discretion under the trust to pay the IRA proceeds to herself/himself, then the spouse may rollover the deceased spouses Roth IRA to the surviving spouses Roth IRA as long as the rollover occurs within 60 days of the distribution from the deceased person’s IRA.
The rules regarding spousal rollovers can be tricky and you should consult with your attorney before listing your trust as the beneficiary of your IRA. As a result, I have the following three tips to follow when listing beneficiaries on your retirement accounts.
When In Doubt, List Your Spouse Directly, Don’t List Your Trust – If you aren’t sure about whether your Trust qualifies as a beneficiary for your retirement account, then list your spouse directly as the beneficiary.
If You List Your Trust Instead of Your Spouse, Make Sure Your Trust Qualifies- Have an attorney review your Trust to make sure that it meets the requirements above (that your spouse will have sole control and authority under the trust to distribute the IRA to himself/herself) so that your spouse can rollover the retirement account in the most tax advantageous manner possible. For example, a spouse can rollover their deceased spouse’s account into their own account as was shown in the PLR above. That’s a great tax benefit as you can keep the funds in a retirement account and outside of taxation longer. However, if the Trust doesn’t meet the proper requirements then the trust receives the retirement account and it cannot be directly rolled into the retirement account of the surviving spouse and must instead be distributed.
Consider a Separate IRA Trust for IRA’s Over $1M- If you have an IRA over $1M, you may benefit by having a special IRA trust as the beneficiary of your IRA. It depends on your goals and tax planning, but is worth considering.
Bottom line, the rules here are very tricky so consult with your estate planning attorney on the best way to list your heirs as beneficiaries on your retirement accounts.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
The United States Supreme Court recently issued a 9-0 opinion holding that inherited IRAs are not exempt and protected from creditors in bankruptcy. As a general rule, IRAs receive special protections from creditors and cannot be reached by the creditors of the account owner. In Clark v. Rameker Trustee, Clark inherited her mother’s large IRA upon her mother’s death. Nine years later, Clark filed bankruptcy and sought to protect the inherited IRA from the reach of her own creditors. Under the bankruptcy code, “retirement funds” are protected from the reach of creditors and may generally be kept by the owner following bankruptcy. Justice Sotomayor, who wrote the opinion of the Court, wrote that inherited IRAs (not to include spousal inherited accounts) do not constitute “retirement funds” for three reasons. First, the owner cannot continue to contribute to the account. Inherited IRAs remain in the deceased owner’s name and cannot receive additional contributions from an heir. Second, the new owner is forced to take required minimum distributions from the account under a different set of rules than typical retirement accounts. And third, the account owner may withdraw the balance at any time without a 10% early withdrawal penalty. Because of these reasons the Court held that inherited IRAs are not “retirement funds” within the meaning of IRC 408 and as a result they are not protected from creditors. Consequently, the Clark’s entire inherited IRA is subject to the claims of creditors in bankruptcy.
In addition to the Court’s ruling in Clark, it is important to note three other facts regarding inherited retirement accounts and creditors.
IRAs Inherited From a Spouse. When a surviving spouse inherits a retirement plan from a deceased spouse, the surviving spouse may simply roll over the deceased spouses account into an IRA owned by the surviving spouse and the retirement funds become a new account or add to an existing account of the surviving spouse. This is different from a non-spousal inherited account that was involved in the Clark case. Spousal inherited IRA funds go into the surviving spouses own IRA and are subject to the typical retirement plan rules. Because of this, inherited spousal retirement plans funds are different than that of non-spousal inherited funds and are not subject to the Court’s holding in Clark.
Certain States Specifically Protect Inherited IRAs. When in bankruptcy a debtor can seek the protection of certain assets from creditors under federal exemptions and/or they can seek the protection of certain assets (such as IRAs) under the laws of their State. Under the laws of a few states, inherited IRAs are specifically protected from creditors and as a result the Court’s opinion in Clark would likely not apply. Those states include, Arizona, Texas, and Florida.
Consider an IRA Trust For Large IRAs. If you have an estate comprised of significant IRA holdings, you may be able to establish a special IRA Trust, which can be used to shelter your IRA funds from your heir’s creditors. A trust should only be listed as a beneficiary of an IRA upon careful planning and consideration as the Trust needs to contain certain provisions in order to qualify as a valid trust under retirement plan rules.
Since inherited IRAs have special rules and procedures, it is recommended that person’s with large IRAs seek the guidance and assistance of an attorney in planning their estate and retirement fund’s future. Also, if you have an inherited IRA and are considering bankruptcy, stop, consult, and plan with the proper counsel lest you lose the account to creditors.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
A Self-Directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is: “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that the large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
What Can a Self-Directed IRA Invest Into?
Under current law, a retirement account is only restricted from investing in the following:
Collectibles such as art, stamps, coins, alcoholic beverages, or antiques IRC 408(m);
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include; rental real estate, secured loans to others for real estate, small business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great assets for investors with experience in these areas.
When self-directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax advantaged accounts conducting transactions between parties who are close enough to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account as of January 1 of the year the prohibited transaction occurred. In a typical self-directed IRA investment, your IRA custodian holds your investment in their company name for your IRAs benefit (e.g. property is owned as ABC Trust Company FBO John Smith IRA) and receives the income and pays the expenses for the investment at the account owner’s direction and instruction.
What is an IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. There are many restrictions to the IRA owner being a manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, the cases, and the structuring options, please refer to my prior blog post here.
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $129,000 ($191,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.
Examples
Here’s a few examples of earners who can establish and fund a Roth IRA.
I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $191,000 for married taxpayers and $129,000 for single taxpayers.
The Process
The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction the amounts contributed but the funds are held in a Roth IRA and grow and come at tax-free upon retirement (just like a Roth IRA). Here’s how it works.
Step 1: Fund a new non-deductible traditional IRA
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. Don’t worry about having non-deductible contributions though as you’re converting to a Roth IRA so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, since 2010 all taxpayers are able to covert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.
If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.
There are two work-arounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer based plan as employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allows for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner only 401(k) plan and you can roll over your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill now so careful planning must be taken.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.
Roth IRAs can be established and owned by anyone who has earned income and that includes children. As many savvy investors have come to understand, Roth IRAs offer the best tax-free treatment for investment income and returns in the tax code. But these accounts aren’t just for adults. Minors who have earned income can also establish Roth IRAs.
I have many clients who establish Roth IRAs for their children who have earned income. Some use them to co-invest those funds with their own Roth IRAs into certain real estate deals or start-up companies. Some open up brokerage accounts and teach their kids how to buy and sell stocks. Whatever your investment strategy, don’t leave your kids out. Consider a Roth IRA as a valuable tool that can be used to teach your kids or grand-kids how to invest and how to save for their own college education. But before you open up a Roth IRA for your child, here’s what you need to know.
Earned Income – The only qualification to establishing a Roth IRA is that the account-owner has earned income. If your child works in your business, on your rental properties or real estate investments, or even if they have a part-time or summer job, give them some income so they can establish a Roth IRA. Their earned income can be contributed to the annual Roth IRA contribution limit of $6,000. My own 13 and 15 year-olds actually have their own small business and we will be establishing Roth IRAs this year for both of them. If a child has made a Roth IRA contribution, it is generally recommended that they either have a W-2 for the income for that year or that they file a 1040-EZ for their 1099 income or self-employment income even if they are under the standard deduction. While earned income to a child is taxable, if the child is under the standard deduction amount of $6,200 the child will pay no income tax (though there may be employment taxes).
Custodial IRA – If you open a Roth IRA for your child it is often times referred to as a custodial IRA because the account owner is not old enough to establish the IRA for themselves and therefore their parent or legal guardian must open and oversee the account for the child. When the child reaches age 18, the child will take over as the responsible party for the account.
Tax & Penalty Free With-Drawls – In all instances, the amounts contributed to a Roth IRA can be withdrawn penalty free and tax free. Earnings withdrawn may be subject to a penalty and tax. Earnings may be distributed penalty free for the qualified higher education expenses of the child though the earnings withdrawn can be subject to tax. Check out the IRS explanation here. http://www.irs.gov/publications/p970/ch09.html. In other words, the Roth IRA can be accessed without penalty or tax when you simply pull out the amounts comprising contributions to the Roth IRA. Keep in mind, the withdrawn earnings used for qualifying higher education expenses (e.g. the investment returns or growth in the account above the contributions) will not be subject to the 10% early withdrawal penalty but they may be subject to taxes on the child’s tax return. As a result, I wouldn’t recommend withdrawing the earnings. While using a child’s Roth IRA for education expenses is common, it is not just education expenses to consider as contributions to a Roth IRA can be withdrawal without penalty and tax for anything. That could be a new car purchase, a non-traditional education expense, church service expenses, a new business, job training, or any other worthy cause or purchase worth saving for.
If you want to teach your child how to invest or if you want to help them save for college, the first account option to consider is a Roth IRA. Why choose an account that is taxable when you can choose one that grows tax-free?
The "Self Directed IRA Handbook" by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA. Mat has performed the impossible by effectively delivering complex information in an easily understandable manner for the layperson, while providing the necessary legal basis to suit the professional. Mat's book is a "must read" for investors, attorneys, CPAs, and other professionals and other interested individuals wanting to learn about all there is to know about Self-Directed IRAs.
Mat's books is a great reference guide for self-directed IRA investing – Best I’ve seen in 30 years of being in the business.
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CEO, Polycomp Trust Company
Pamela Constantino
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President, Polycomp Trust Company
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CPA, Attorney, Author
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"Mat is an excellent attorney, well versed in the Self-Directed IRA market...His ability to distill the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none.
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Founder and Retired CEO, PENSCO Trust Company
J.P. Dahdah
Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.
