Questions on Trusts as Beneficiaries, Roth IRA 5-Year Rules and NUA Highlight Mailbag

By Joe Cicchinelli, IRA Technical Expert

Follow Me on Twitter: @JoeCiccEdSlott

Retirement planning is all about proper decision-making. In this week’s Slott Report Mailbag, we answer your questions about important decisions, including who to name as a beneficiary, how to handle Roth IRA distributions and if a certain key tax break applies to a certain situation. We hope you enjoy these Thursday mailbags, and make sure to send your question to [email protected].  As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Ed,

I am 65 and have a number of IRAs ($500,000) which all go to my wife if I die first. What should I do for my contingent beneficiary, name her son or leave it to my estate? I have a will, which creates a family trust, which I would expect to take care of all my accounts. My wife can also choose to put these inherited assets in a trust. Does that complicate matters?

Thanks for your help!

Steve

Answer:
Generally, it is not advisable to name your estate as a primary or contingent beneficiary because death distribution options will be limited when an estate inherits an IRA. This is because an estate does not have a life expectancy and thus cannot stretch death distributions over a long period of time. You could, however, name the family trust under the will as a beneficiary, which is essentially naming the family trust as beneficiary. In general, trusts do complicate matters. If the trust does not qualify as a see-through trust, then death distribution options will also be limited. If you want your wife’s son to inherit your IRAs, the simplest thing to do is to name him as the contingent beneficiary.

2.

Hi Ed,

I work for the federal government and we have a program that I’m eligible for called the voluntary contribution program. It’s an after-tax, tax-deferred account that I can make large contributions to at any time. So, I made a deposit and immediately converted the contribution to a Roth. My understanding is that since the conversion was tax free (no earnings and moving from an after-tax non-IRA account to an after-tax Roth) I would be exempt from the 5-year rule? What taxes and penalties would I be subject to before age 59 1/2 if any?

Also, my wife has done the same thing, but she was past age 59 1/2 at the time of the conversion. Is it different for her?

Thanks in advance for your help.

Canon

Answer:
There are two 5-year rules for Roth IRAs. There are also ordering rules for distributions. All Roth IRAs are considered one account for the purposes of these rules.

Annual contributions are considered to be distributed first. Distributions of these funds are always tax and penalty free.

Converted amounts are the next funds to be distributed. These funds are subject to the 10% early distribution penalty if they are distributed before the conversion has been held for five years or if you are under the age of 59 ½ at the time of the distribution. However, the penalty only applies to amounts that were taxable at the time of the conversion, so in your case, it appears that you are not subject to this penalty. This is one of the 5-year rules.

Earnings are the last funds distributed. Earnings could be taxable and subject to the 10% early distribution penalty if the distribution is not a “qualified” distribution. For a distribution to be qualified you must have established any Roth IRA at least 5 years ago and you must be over the age of 59 ½ at the time of the distribution. If either you or your wife takes a Roth distribution that contains earnings before you meet these qualifications, you will be subject to income tax and you would be subject to the 10% penalty, if applicable, on the amount of the earnings distributed to you. This is the other 5-year rule.

3.

I have a substantial amount of company stock in my IRA that was rolled over from a 401(k). At the time it was worth substantially more (by a factor of three) and I didn’t want to pay the taxes at that time so early in my retirement. I have the documentation relative to that stock just before my rollover. I have the tax cost per share info (average) on the shares in the account at that time. The stock is essentially untouched with the exception that I have always re-invested the dividends in the IRA account. What are my options if any to minimize the tax consequences? I realize that I may be too late, but I want to be sure that I take advantage of anything that might be available. I have the cash to cover the tax on the capital gain for a good portion of these shares. Do you have any good words of advice for my situation? Thank you for any and all help. I have attended an event where Mr. Slott gave a very informative and interesting presentation. I am in the middle of reading his book, but there is a lot of information to digest.

Scott Tripp
 

Answer:
Because you rolled over the company stock to an IRA, the fair market value of the stock will be taxed when you receive a distribution from the IRA. You cannot use the special tax break known as net unrealized appreciation (NUA) because the funds were rolled over. Because distributions for IRAs are taxed as ordinary income when received and there is no capital gains tax on distributions from IRAs, you no longer need the tax cost per share info when the stock was in the 401(k) plan.