Some Potential Changes to IRA Tax Rules

The total assets invested in Individual Retirement Accounts (IRAs) are growing larger. As of the end of the third quarter of 2011, IRAs (including Roth IRAs) held $4.6 trillion in assets—up from $2.6 trillion in 2000, according to the Investment Company Institute. Traditional IRAs represent almost 90% of this total. This growth in assets represents a big source of potential tax liability to many investors, and a source of potential tax revenue for the government.

In a traditional IRA, contributions are tax deductible, while withdrawals are taxed as ordinary income. This incentivizes investors to delay withdrawal as long as possible. But this incentive is currently limited by the requirement that holders of traditional IRAs withdraw a minimum amount each year starting at age 70.5. This “Required Minimum Distribution” (RMD) is equal to the value of the IRA divided by the number of years you expect to live according to the actuarial tables.

For example, if you’re 73 years old, the IRS expects you to live an additional 14.8 years. If your traditional IRA is worth $500,000, your RMD would be $500,000 / 14.8, or $33,784. The penalty for withdrawing less than the RMD is severe—you’re penalized 50% of the difference between the RMD and what you actually withdrew. So, in this example, if you only withdrew $10,000, you would be penalized by 50% x ($33,784 – $10,000), or $11,892.

However, if you die and bequeath your IRA to your children or grandchildren, their minimum withdrawal would be much smaller. Your beneficiary would be allowed to spread the withdrawals out over their entire life—over 65 years for your 18-year-old grandson could spread out withdrawals over 65 years. So, again if your IRA is worth $500,000, your grandson would only need to withdraw (and hence, be taxed on) $7,692. Meanwhile, the earnings of the IRA will continue to grow tax-deferred.

However, the Senate Finance Committee is not a huge fan of this strategy. They have considered a proposal that would require children or grand-children to empty the IRA (and thus, subject the entire principal to income tax) within five years. According to Senator Max Baucus (D-MT), this change would raise $4.6 billion over the next ten years. Although the proposal did not make it past the committee, such a reform could be part of a broader tax reform package in the near future.

For now, it appears that you could get around the proposed five-year rule by establishing a charitable remainder unitrust (CRUT) as your beneficiary. Once you die, a CRUT pays a fixed percentage of the assets every year to a recipient, who could be a grandchild. After a pre-determined period of time, whatever is left in the CRUT is donated to charity. This strategy could be advantageous because establishing a CRUT does not subject the IRA’s principal to taxation (although the annual payouts are taxable). Establishing a CRUT also enables the donor to receive a charitable tax deduction in the year of contribution, equal to the present value of the future charitable gift.

This proposed change would not affect the spouses of a deceased IRA-holder. The spouse would still be able to spread withdrawals over the remainder of his or her life, rather than the abbreviated five years in the proposal. Nor does this change extend the provision that allows holders of traditional IRAs to give up to $100,000 of the IRA directly to charity. That provision was in effect for 2011, but it is unclear whether it will be extended to 2012—and this issue probably won’t be taken up by Congress until the lame duck session.

Bob Pozen is a Senior Lecturer at Harvard Business School and a Senior Fellow at the Brookings Institution. His latest book, Extreme Productivity, is now available at your favorite local or online bookstore.

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