Entire Interest Rule (EIR) “Catch 22”- Loss of Death Benefit
I have an 81 year old client whose only significant asset other than her home and Social Security benefits is an IRA variable annuity with a value of $33, a 2016 RMD calculation of $80, and a death benefit of $5,730. She obviously cannot take the full RMD of $80 from the small $33 contract value and so would need to terminate the contract along with the attached $5,730 death benefit in an attempt to satisfy her RMD requirement from the IRS. Obviously, she has no intension of terminating the contract under any circumstances.
Is this assessment accurate? Would / Could the IRS legally force her to give up a death benefit she had been paying for based on a nonexistent “phantom value” for which she has no constructive receipt? Note that she has no other IRA monies and has no intension of doing a Roth-conversion of the contract whereby she would then be forced to incur taxes on the net present value of the death benefit but with no access to those values.
Thanks to all replies!
Kevin
Permalink Submitted by Alan - IRA critic on Tue, 2016-02-02 02:37
I believe the problem is real and has been recognized in some circles. Of course, client could buy time by paying the 50% excess accumulation penalty for a year or two, especially if she is in bad health and wants to preserve the death benefit. But for a healthy senior, the 50% penalty would be too steep since the unfunded RMD amount could be very large. While tremendously complex when it comes to the math and possibly with respect to contract requirements, the failure of enough notional value in the contract to meet the RMD has been recognized but there does not appear to be a good solution so far. Nothing from the IRS as far as I know, and IRS Reg 1.401(a)(9)-6 already has many shortcomings. A place to start would be to have the company double check the calculation of the actuarial present value that must be added to the notional value and provide a worksheet for review of the IRA annuity owner or more likely their representative. If confirmed to be correct and there are no other IRAs to make up the shortfall, the IRA annuity owner could try requesting an RMD waiver with Form 5329 to the extent the notional value is insufficient, instead of forking over the 50% penalty up front. A reasonable cause (RC) cited with the 5329 might include lack of understanding of how RMDs can in practice wipe out major contract benefits included in the entire interest and present value calcs. IRS might be sympathetic. A Roth conversion would eliminate future RMDs however the IRS should take the position that the conversion includes RMD amounts and therefore creates an excess regular Roth IRA contribution as a result. So that would appear to be a flawed solution from the start unless done before the year the entire interest became an RMD problem.
Permalink Submitted by Kevin Dickey on Wed, 2016-02-03 03:16
Alan – Thanks for your insight and well thought out reply! Unfortunately, I have other clients who will ultimately experience this same issue but with much higher dollars at stake ($200,000+ DB). Therefore, could the following be a realistic and workable long term solution?What about pushing this issue into the public arena by soliciting media attention and then driving it into the courts in an attempt to force a permanent change to the Entire Interest Rule. The client is on board with this and so would refuse to pay the RMD or any resulting penalties on the grounds that it would unfairly strip away the DB for which she purchased the contract. If successful, this would definitively resolve the issue once and for all for all similar cases going forward rather than hobble along with an untenable and onerous tax law. Surely the EIR was never intended to force an investor to choose between giving up a death benefit they had already paid for or incurring a penalty from the IRS for not doing so. Also, doesn’t this fall under the rules of constructive receipt? How can the IRS force taxation on monies for which there is no constructive receipt as in this case where contract termination results in loss of the death benefit? Think about it this way: It’s the death benefit that is causing the RMD to exceed contract value but by taking out the RMD the death benefit disappears. Surely this is the epitome of tax code craziness, especially since I can think of a multitude of simple solutions to resolving the problem! Do we have a case here? Thanks again! Kevin
Permalink Submitted by Alan - IRA critic on Wed, 2016-02-03 04:17
Perhaps, but predicting the outcome of such a case is sort of a crap shoot. The IRS has always been far behind the curve when it comes to the variety of annuity products continually being churned out. Take a look at p 224 and 225 of the attached IRS Reg for two examples, one which required no actuarial increase because it was under 20% of the notional value and the second which did require the increase. It’s not clear whether the IRS did not think RMDs could get this large or if they did not care, but the concept was not addressed in the Regs, which are of course highly complex. In addition, it is possible that recent structuring of the death benefit (not to mention other benefits) does not even qualify for the 20% forgiveness in the first place: https://www.gpo.gov/fdsys/pkg/CFR-2012-title26-vol5/pdf/CFR-2012-title26-vol5-sec1-401a9-6.pdf
Permalink Submitted by Bruce Steiner on Wed, 2016-02-03 15:48
Would the insurance company permit the IRA owner to take a distribution of a portion of the annuity in kind?
Permalink Submitted by Kevin Dickey on Tue, 2016-02-09 22:48
Bsteiner – Thanks for your suggested solution from 2/3. I hadn’t thought about this as a possibility but because it would involve creating a new contract out of thin air with the same features and then carrying the DB over to the new contract, I didn’t think it would be possible. I did inquire about this though and learned that in fact, it can’t be done. Also, I did some additional research into this whole issue based on the 2/2 response by Alan and cannot find anywhere where this Catch-22 dilemma has ever been resolved or even properly addressed. Therefore, it seems that the only realistic long term solution would be to push for a change to the rule, which as Alan has already stated, could be a real crap shoot.