Loading...

CPA Now Blog Archive

This is the archive of CPA Now blogs posted on the PICPA website through April 30, 2025. Want more recent blogs?

Read current blogs

IRA Contributions, Distributions, and the Effect of an Estate as Beneficiary

Individual retirement accounts (IRAs) were designed to assist taxpayers with opportunities to save for retirement in tax beneficial ways. There are, however, a number of IRS rules governing these accounts, and running afoul of these rules can result in substantial penalties.

Dec 21, 2016, 06:16 AM

Barry Williams, CPA, JDBy Barry Williams, CPA, JD | King’s College


MoneyLife100Individual retirement accounts (IRAs), both Roth and traditional, were designed to assist taxpayers with opportunities to save for retirement in tax beneficial ways. There are, however, a number of IRS rules governing contribution to and distributions from these accounts, and running afoul of these rules can result in substantial penalties up through disqualification of the IRA itself.

Contributions

For 2016 and 2017, your total contributions to all traditional and Roth IRAs cannot be more than $5,500 ($6,500 if you’re age 50 or older). It is important to remember that these are the maximum amounts that can be contributed, and there are a number of limitations that must be considered. Traditional IRA contributions may be tax-deductible, but the deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels. Any contribution to a traditional IRA that is not tax deductible creates cost basis, the amount of which can be distributed later at no tax cost. While the same general contribution limits apply to both a Roth and traditional IRA, Roth IRA contributions might be limited based on your filing status and income. These limitations must be reviewed to avoid a penalty for excess contributions

Distributions

Since the IRA was designed to produce assets for a taxpayer to use in retirement, its tax advantage is tied to keeping the money in the IRA to produce savings, not to distribute the money early. With that in mind there are a number of complex rules and regulations that you must be aware of before electing a distribution or the amount of a distribution.

The first consideration is the type of IRA you are making the distribution from – Roth or traditional. A Roth IRA must be designated as a Roth IRA when it is opened. Unlike a traditional IRA, which provides for a tax deduction at the time of the contribution, you cannot deduct contributions to a Roth IRA. Instead, qualified distributions from a Roth IRA are tax free. Contributions can be made to a Roth IRA after you reach age 70½, and you can leave amounts in your Roth IRA as long as you live. This is an important distinction from a traditional IRA, and should be considered when looking at any distribution. In the short-run you may be able to make a tax-free distribution, but in the long-run you may be giving up future tax-free accumulations.

If you elect to make a distribution from a Roth IRA, a qualified distribution is considered to be any payment or distribution that meets the following requirements: the distribution is made after the five-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and the payment or distribution is made on or after the date you reach age 59½; it is made because you are disabled; it is made to your beneficiary or your estate after your death; or it meets the requirements listed under a first home exception. If the distribution is not qualified, you may have to pay a 10 percent additional tax on early distributions.

Distributions from a traditional IRA account vary, and are dependent upon whether the contributions made were tax-deductible or nondeductible, your age, and what the distributions will be used for. If you made nondeductible contributions to any traditional IRA, you have a cost basis in the IRA equal to the amount of those contributions. This cost basis from the nondeductible contribution is not taxed when distributed to you. The distribution of the cost basis is a return of your investment in your IRA, and the appropriate ratio of the cost basis to the total distribution must be calculated to determine the nontaxable amount.

At age 70 ½ and beyond, taxpayers are required to take distributions equal to the required minimum distribution (RMD) amount. These are required, and failure to receive these distributions can result in severe penalties. Distributions above the RMD are allowed, but consideration must be given to the income tax effect of taking larger amounts. Distributions made between the ages of 59 ½ and 70 ½ are permitted without any penalty, but the amounts are subject to income tax.

When looking at a distribution from a traditional IRA made prior to age 59 ½, a penalty equal to 10 percent of the distribution may be added to the income tax liability incurred. Under certain circumstances you may be able to avoid the penalty for early distribution based upon specific exceptions. The common exceptions are as follows:

  • You have unreimbursed medical expenses that are more than 10 percent (or 7.5 percent if you or your spouse was born before Jan. 2, 1951) of your adjusted gross income.
  • The distributions are not more than the cost of your medical insurance due to a period of unemployment.
  • You are totally and permanently disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You are receiving distributions in the form of an annuity.
  • The distributions are not more than your qualified higher education expenses.
  • You use the distributions to buy, build, or rebuild a first home ($10,000 limit).
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution

Estate as Beneficiary

While most distributions are to the owner or the owner’s designated beneficiary of the IRA, what occurs when the owner dies and there is no beneficiary designation on file with the custodian of the IRA? Sometimes owners of IRAs neglect to name a beneficiary, or the person they name dies before they do and they have either have failed to name a contingent beneficiary or that beneficiary is also deceased. In these cases the custodian will look to the contract between the owner and custodian to determine the beneficiary, and in most cases it becomes the estate. That could be problematic.

As discussed previously, traditional IRAs have RMDs that are calculated based upon the life of the beneficiary and other factors. Herein lies the issue when an estate becomes the beneficiary: it has no life expectancy that can be used in the calculation. This means there is no RMD scheduled and a loss of the ability to accumulate funds tax deferred until a distribution is made. Worse still, estates and trusts have income tax rates that reach the 39.6 percent tax bracket with $12,400 of taxable income. For a single individual taxpayer, they do not reach the 39.6 percent tax bracket until taxable income reaches $415,050. This is quite a difference, and it raises the possibility of losing much more money in income tax from the distribution.

There are a few easy steps to take on a regular basis to avoid this tax trap, and there is no better time than each year-end when you are evaluating whether to make a contribution or distribution. Here are steps you can take:

  1. Review and select (or update) your primary beneficiary or beneficiaries.
  2. Name a contingent beneficiary in case the primary beneficiary (or beneficiaries) dies before you.
  3. Review and update your beneficiary (or beneficiaries) more often if there has been a change in your life circumstances, such as a birth, adoption, marriage, divorce, or death.
  4. When you make a change and send it to the financial institution that holds the account, make sure they acknowledge the change.
  5. Don’t name your estate as the beneficiary without a complete understanding and an awareness of all the tax and nontax issues.

The taxability of IRA distributions is complex. Unwary taxpayers may not only pay income tax on a distribution but also penalties if they do not plan the amounts correctly. This discussion provides an overview of the basic principles of the taxability of the IRA. The PICPA can help you locate a CPA who can assist you with planning to achieve your goals.


Barry Williams, CPA, JD, is dean of the McGowan School of Business at King’s College, Wilkes-Barre, Pa. He is a member of PICPA’s CPA Image Enhancement and Relations with Schools and Colleges committees.


Stay informed with PICPA blogs