The year 2012 will be remembered as one during which the economy teetered between recovery and a second recessionary dip; there were continued reports of grossly underfunded defined benefit plans; we had to deal with the “fiscal cliff” (and what, if anything would be done about it—we don’t know the answer at the moment); and the east coast suffered from Sandy’s unthinkable devastation (hardship withdrawals from retirement accounts were authorized in Internal Revenue Service Announcement 2012-44). 

Yet, things seemed to be looking up as the year closed. For retirement account owners and plan participants, Ponzi schemes that surfaced in 2011’s IRS private letter rulings were absent from this year’s PLR crop. And, proposed regulations moved towards making lifetime benefits less precarious, by opening up a new option for so-called longevity annuities, which promises to hedge against outliving retirement account distributions. 

 

Qualified Longevity Annuity Contracts

Living an especially long life can strain the limits of retirement savings. Some might spend too much too soon, running the risk of exhausting available funds—a kind of “fiscal cliff” for individuals. Others might turn into obsessive penny-pinchers to hedge against outliving savings, only to find themselves living below their means.

 
One solution might be longevity annuity contracts (LACs), which begin paying a lifetime annuity at a specified future age, such as age 85. The payments end at death.


But, investing in LACs within an individual retirement account subject to required minimum distributions (RMDs) poses a special problem. Because each year’s RMD is based on the value of the retirement account, part of the LAC’s value must be distributed out of the account’s assets.


Proposed Treasury regulations1 would address the RMD problem by excluding a qualified longevity annuity contract (QLAC) from RMD computations. That means QLACs have relevance only for retirement accounts subject to lifetime RMDs. Since Roth IRAs don’t have lifetime RMDs, Roth IRAs would be excluded from QLAC rules.


Because the Treasury and the IRS were concerned that QLACs might be used to create an end-run around RMDs, the proposed regs would limit how much may be invested to no more than 25 percent of the sum of all of an individual’s retirement accounts, capped at $100,000. That means the percentage limitation will apply when all retirement accounts are worth less than $400,000. Then, the dollar cap will kick in at or above $400,000. The dollar limit would be adjusted for inflation in $25,000 increments.


The rules would apply to IRAs other than Roth IRAs and retirement plans qualifying under Internal Revenue Code Sections 401(a), 403(a), 403(b) and 457 governmental plans.


The proposed regs would require QLAC annuity payments to begin by age 85, but that age could be changed based on future mortality experience. Contracts would be allowed to provide an earlier date. Benefits payable to an account’s designated beneficiary would be allowed, but only in the form of an annuity that meets limitations on the amount. A surviving spouse would be permitted to receive 100 percent of the amount payable to the plan participant, while lower percentages would apply to others. Of course, relative to each premium dollar invested, buying death benefits will lower lifetime benefits.  


Those with larger retirement accounts may not feel the need to invest in LACs. But, IRC Section 1411’s 3.8 percent Medicare tax on net investment income (NII) might be a concern, starting this year. Fortunately, distributions from retirement plans are exempt. 

 

The Medicare Tax Connection

Retirement accounts can have an effect on Medicare taxes, so planning may be relevant. To understand why, it’s necessary to review some parts of the new tax’s workings.


The Medicare tax won’t apply if modified adjusted gross income (MAGI) is below certain threshold dollar amounts: 

 

$250,000 for married individuals filing joint income tax returns

$100,000 for married individuals filing separately 

$200,000 for all other individuals 

For estates and trusts, the threshold is the amount at which the top federal income tax rate applies, now just under $12,000


Once above the threshold, the amount subject to the 3.8 percent tax is equal to the lesser of NII on the one hand or, on the other hand, the difference between MAGI and the threshold amount. For example, if NII and MAGI are each equal to $260,000 and the threshold is $250,000, the taxable amount is the $10,000 difference, not the NII, so the tax will be $380. 


But, if NII is, say, $8,000, MAGI is $260,000 and the threshold is $250,000, the taxable amount is the $8,000 NII.


RMDs drive up MAGI, even though RMDs are excluded from NII. That affects whether the Medicare tax’s threshold is met, as well as the difference between MAGI and the threshold amount that potentially will become the amount subject to tax. In the example in which both NII and MAGI are $260,000, the addition of every RMD dollar to MAGI will increase the amount subject to the Medicare tax by an equal amount. But, if the RMD reaches or exceeds the $260,000 amount of NII, the Medicare tax won’t increase further.


In addition, the after-tax amount of RMDs will augment amounts invested in taxable portfolios that produce NII.


Because retirement accounts can affect the Medicare tax, and there are no lifetime RMDs for Roth IRAs, Roth IRA conversions will be more attractive than in the past. However, unlike in 2012 (when there was no Medicare tax), a Roth IRA conversion will drive up MAGI in the conversion year. A detailed cost-benefit analysis is needed to decide.


Roth IRAs escape not only MAGI-enhancing RMDs, but also income taxes when ultimately distributed. One taxpayer attempted to capitalize on that by having his Roth IRA own stock in a corporation that elected Subchapter S status. The idea met a slow and painful demise as it wound its way first through the Tax Court and, ultimately, through the U.S. Court of Appeals for the Ninth Circuit. 

 

Roth IRA-Owned Corporation

In Taproot Administrative Services Inc. v. Commissioner,2 the Ninth Circuit affirmed a 2009 Tax Court decision that a custodial Roth IRA isn’t a permitted S corporation shareholder, thus disqualifying a corporation from making an S election. The taxpayer’s reliance on Treasury Regulations Section 1.1361-1(e)(1), stating in part that “[t]he person for whom stock of a corporation is held by a nominee, guardian, custodian, or an agent is considered to be the shareholder of the corporation for purposes of [the S corporation statute],” was misplaced.

 

Ex-Spouse Recovers 401(k) Proceeds 

Taproot may not be very surprising to some, as the hoped-for result seemed too good to be true. In contrast to regulations that may be subject to different interpretations, the Employee Retirement Income Security Act’s (ERISA) anti-alienation provisions have been upheld time and again as inviolable. Yet, in Estate of William E. Kensinger Jr. v. URL Pharma, Inc., et al.,3 an ex-spouse recovered a 401(k) account’s death benefits after distribution occurred. Although the ex waived rights to the account in a marital settlement agreement, she was never removed as the account’s named death beneficiary. She received the proceeds as required under the Supreme Court’s holding in Kennedy v. Plan Administrator for DuPont Savings & Investment Plan.4 But, the Third Circuit found there was no ERISA-based bar to recovering the 401(k) proceeds after distribution to the ex. 


It’s no stretch to say 2012’s court holdings left some disappointed. In contrast, a number of PLRs showed that practitioners can help avoid other kinds of disappointments following the death of a retirement account participant.

 

Reshaping Retirement Inheritances

In PLR 201245004 (July 18, 2012), a surviving spouse, as beneficiary of her deceased husband’s IRA, accepted two IRA distributions. Her son, acting as attorney-in-fact, made a timely disclaimer on her behalf of part of the IRA, together with related income. The IRS said the surviving spouse’s disclaimer wouldn’t be a gift, because the disclaimer qualified under IRC Section 2518. The PLR relied on Revenue Ruling 2005-36, holding a partial disclaimer could be made even though RMDs had been accepted. In this PLR, the distributions exceeded the year’s RMD, but the IRS said the situation under consideration was similar. That’s because there’s authority for disclaiming a portion of property in Treas. Regs. Section 25.2518-3(c), which both the PLR and therevenue ruling cited and analyzed. 


PLR 201202042 (Oct. 18, 2011) also featured a disclaimer and held that because a trust that was named as a 401(k) account’s beneficiary was a see-through trust, RMDs could be made based on the age of the oldest trust beneficiary. The determination of which person was oldest changed for the better when a trust beneficiary’s timely disclaimer meant that the disclaimant wouldn’t be considered in that determination. 


The effectiveness of disclaimers when it comes to RMDs isn’t the only lesson to be drawn from this PLR. If one subtrust for each different trust beneficiary had been named as a beneficiary of a share of the retirement account, it would have been possible for each share to make RMDs based on the age of each beneficiary. 


A disclaimer is but one tool for reshaping RMD outcomes. Partial release of a power of appointment (POA) saved a trust from failing to qualify as a see-through trust in PLR 201203033 (Oct. 26, 2011). The partial release meant that the POA could be exercised only for the benefit of a living individual who was born on or after the date the decedent’s surviving spouse was born. The intricate facts of this ruling illustrate the difficulties of naming a trust as beneficiary of an account subject to RMDs.


All of the above rulings involved trustee-to-trustee transfers (sometimes called “direct rollovers”) to an inherited IRA. The technique is a sanctioned end-run around the rule that only a surviving spouse may make an IRA rollover from a decedent’s account.


IRA rollovers are always a concern during lifetime as well. Rulings waiving the 60-day IRA rollovers deadline of the living have become common. 


PLR 201224046 (March 26, 2012) at first may seem like just another such ruling. But, this PLR serves as a reminder that the amount of a plan loan offset qualifies for a rollover, unlike a deemed distribution. A plan loan offset occurred when the value of an employee’s account was reduced by the unpaid amount of the loan upon termination of employment. In this PLR, the terms of the loan provided that if the terminated employee didn’t commence electronic automatic monthly loan payments by a specific date, an offset would occur. A plan loan offset is treated as an actual distribution. In contrast, a deemed distribution occurs when required loan payments aren’t made. A deemed distribution isn’t considered an actual distribution and, therefore, can’t be rolled over to an IRA.5  


The IRS granted a waiver of the 60-day rollover requirement for the amount that could have been rolled over because of a plan loan offset that occurred on termination of employment. The taxpayer who sought the ruling was unaware that a loan offset had occurred, because the plan administrator misled the taxpayer, saying he could continue making loan payments after the date when his ability to do so under the terms of the plan loan had, in fact, expired. 


In the end, most of 2012’s lessons aren’t new. The most important lesson is this: The difficulty of planning for IRA death benefits is exponentially greater when trusts are involved. The size of the account should justify the cost, and it’s much better to take pains to plan correctly than to pay for a clean-up job.       

 

Endnotes

1. REG-115809-11, 77 F.R. 5443-5454 (Feb. 2, 2012). See also Natalie B. Choate, “How to Annuitize an IRA,” Trusts & Estates (June 2012) at p. 37.

2. Taproot Administrative Services Inc. v. Commissioner, No. 10-70892 (9th Cir. 2012), aff’g 133 T.C. 9 (Sept. 29, 2009).

3. Estate of William E. Kensinger, Jr., v. URL Pharma, Inc. et al., No. 10-4525 (3rd Cir. 2012).

4. Kennedy v. Plan Administrator for DuPont Savings & Investment Plan, 555 U.S. 285 (2009).

5. Internal Revenue Code Section 72(p), Treasury Regulations Section 1.72(p)-1, Q&A-13.