Money Talk

Episode 19

Individual Retirement Account-Better Than Sliced Bread

Dissolving a professional corporation. The dreaded double tax. $9.8 trillion. Buy a sliced bread factory. Bad ideas never vanish. Everyone gets a 6% pay raise. There is no secret sauce. Ed’s dog picks stock winners better than an investment adviser. Greek myths and the Internal Revenue Code. Charlie Chaplin was married 5 times.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck LeFebvre:  This is Chuck.

Ed Sutkowski: I am Ed.

Chuck: Ed, before we get started today, we had a question from our listener that I thought maybe you could address and the question is, when is the best time to dissolve a professional corporation?

Ed: Well, there’s two ways that during lifetime it’s more complicated than at death. At death, you increase your cost basis for the shares of the corporation. When you receive money and liquidating that, your heirs receive money and liquidate your corporation, there’s no tax. However, during lifetime, that’s a different issue. The question is: what do you have invested in this professional corporation, for that matter any corporation and is there a difference between the fair market value and the cost basis for those assets? If you’re going to go ahead and do that, you may be the subject of a double tax. A tax inside the corporation, and then a tax when the assets are distributed to you, if the total value of the assets coming out exceeds your original cost basis for those shares.

Chuck: Now, you get to avoid one layer of that tax, if it also happens to be an S corporation.

Ed: That’s right.

Chuck: In any case, it seems like if there’s any kind of either depreciated assets inside of the corporation or appreciated assets, either way, your only real exit without incurring some kind of a tax is going to be waiting till death. Then, you really want it to be an S corp, don’t you?

Ed: Yes, you do, and having said that, I’ve not addressed the inside tax. Let’s assume that you were an actuary, or you’re an accountant, or you’re an investor and you’ve accumulated all kinds of money, value, assets, appreciated assets in the corporation, the source of income in the corporation are dividends, and maybe some interest in like. “Well, you’re on a file of two taxes and accumulated earnings tax, and then an inside tax and that passive nature of that income.” If it’s an S corporation, you may result in the termination of the S corporation status. Putting another way, there’s no simple answer, and the real issue is what’s the tax basis of your outside shares, of the inside assets? What are your objectives? How are you going to live? Can you give this away? There’s a multitude of terrifically interesting questions and the answers.

Chuck: In this example, let’s say you had someone who’s a dentist and they’re no longer practicing dentistry. This corporation is kind of sitting there as a shell and it’s earning, because there are some assets in there, they’re earning dividends and interest. Then, you may want to go ahead and dissolve it early just to avoid those types of penalties.

Ed: Yes, and the tax issues are kind of interesting. We now have a 21% tax at the corporate level. The incentive is not to be an S or a pass-through organization, but to be a regular. It’s a corporation that’s taxed in a certain way, an S corporation is taxed under the attributes expressed in Subchapter S of the Internal Revenue Code. Subchapter C dictates the taxation of a “regular” or a taxpayer that’s a separate taxpayer.

Chuck: Most people would refer to that as a C corp.

Ed: That’s right.

Chuck: But, it’s not really a C corp, it’s a regular corp.

Ed: It’s an Illinois corporation, or Delaware corporation that is taxed in a certain way, using certain rules. The tension is, “Hey, let’s take advantage of that low tax rate, that 20% but ops, we’re now trapped.” In other words, a corporation is often times referred to as a lobster pot. It’s easy to get into, very much difficult to get out of, and so, be careful on how you’re going to structure your investments. The answer to that question is, I need a little more information.

Chuck: Yes. That’s a version of the advice that what you hear on this podcast is not a substitute for individual legal advice.

Ed: Everything’s tailor-made. You cannot buy a Robert Hall suit. One time I had a big chain of Robert Hall. You can’t buy an off-the-rack suit, especially if there’s big dollars involved. Now, having said that, I’d like to– We’ve been talking about an IRA this session but more specifically I want to get back to the cash balance pension plan and make sure everyone understands the opportunities available in the cash balance pension plan. It’s a specie of a defined benefit plan versus the defined contribution plan or arrangement, SEP, SEP/IRA, Roth IRA and they are like, “we’re not talking about an IRA.” In passing, this is astronomical. The value of the assets in IRAs, guess what, Chuck?

Chuck: I’m not going to guess, tell me.

Ed: $9.8 trillion at the end of June 2019.

Chuck: That’s pretty incredible.

Ed: $9.8 trillion, a lot of zeros. That’s grown from $1.1 trillion in 1994.

Chuck: That is astronomical growth. Now a lot of that is people who’ve rolled over assets that were once in an employer-sponsored retirement plan or inherited accounts.

Ed: Yes, and we’ll get into that, but I want to get back to the cash balance pension plan and how much you can set aside. We’ve talked about this before, but as a predicate of the IRA, I want you to understand what’s going on here. Let’s assume you’re 50 years old and your IRA pre-cash balance compensation is $125,000. You would take home $125,000. With the cash balance pension plan, your employer can put away $76,000 and your W-2 is reduced to $50,000. Now, at age 62, you continue that, in theory, you’ll have almost $3 million in your IRA.

Chuck: Most people would not guess that you could start saving in your 50s and end up with that much money by retirement age.

Ed: The critical issue is that you’re saving, you’re not deferring. You’re deferring the income tax and the bulk of this, but you are outright saving. You will never pay a tax at about 25% of that.

Chuck: It seems to me that there’s a real anachronism here with, in terms of when these cash balance plans work really well. We see them and often recommend them to people who have extremely high income. If you’re making a million dollars a year, then, it can be very attractive to turn to somebody who’s making that much money and say, “Hey, guess what, you can defer $260,000 of your million dollars of income into this cash balance, retirement plan,” and that’s great. It also is, what you’re putting into the plan is income that typically would be otherwise disposable income. It seems to me like the biggest bang for the buck that you get in terms of tax savings is when you’re talking about people who are in lower-income categories. Specifically, when you’re talking about compensation levels that are below that Social Security limit which is this year, I think, what? Around $120,000 or $130,000.

Ed: There’s some movement to make it no limit.

Chuck: Well, that’s true and in that case, that’ll change the math for everybody, but if you’re in that category, if your compensation is below that level, then what you’re talking about is that tax is avoided entirely. It’s never paid.

Ed: That’s the 25% savings. Now, having said that and using some other arithmetic example, age 50, you have $350,000 in W-2 that you would otherwise take home, guess how much you can put aside? About $155,000.

Chuck: That’s pretty amazing.

Ed: Your W-2 is only $200,000. My point is, the ratios are astronomical. All designed to achieve, at your normal retirement age, typically 62, of nearly $3 million. How does this tie into the IRA? Well, in the case of a pension plan and a profit-sharing plan, with a fixed number of years, you’ve been there for a couple of years, you may, per the Internal Revenue Code, transfer from the cash balance plan and from certain profit-sharing plans with that attribute available to you to an IRA. Then you can direct your investments and do whatever you’d like to do without being constrained by the otherwise applicable rules and regulations of the subject employer. In other words, I would say that the cash balance pension plan is a little better, perhaps as good as the invention of the sliced bread. The IRA, the ultimate objective is the best possible device to accumulate and transfer wealth or a different view. Chuck, am I all wet or just a little damp?

Chuck: No, no we had on an earlier episode of this podcast we had a guest who might argue with you and suggest that real estate would be an effective alternative to that as well, but I think that in terms of vehicles that will operate without regard to what the investment inside that vehicle is, it is really no question that the IRA is by far the most flexible and the most effective. In fact, it seems like whenever I personally run into issues with clients where there’s some a problem associated with their IRA, the problem is that they’ve accumulated too much in their IRA.

Ed: Yes. We both have experienced situations where an individual could have, get this, $20 million in an IRA.

Chuck: Right.

Ed: Having said that, one client, will obviously remain nameless, because I have forgotten his name, has $18 million in a Roth IRA.

Chuck: Well, that’s fantastic.

Ed: Which means that the distributions can come out tax-free and just like a how much debt that can finance.

Chuck: That’s amazing.

Ed: They cut distribution out and you could buy a slice bread factory with that, if you inclined to buy bread, but anyway. This gets to the question of the flexibility in the event of a marital separation divorce or certain ways to handle it with very tax-efficient ways. The ability to establish multiple IRAs for each one of your descendants, and we’ll get into the issue of the new changes in the law. Then, we focus on the investment advisor fees and that’s our other hobbyhorse. I think your favorite hobbyhorse, though, is the stuff from the payroll taxes, Chuck.

Chuck: Yes, well it is returning to that question, I’m a little astonished that this is something that is not the subject of public discourse. If you want to ascribe to the theory that, “Hey, if the government needs to raise revenue and they should look for what I would call may be assets that are unproductive or income that is disposable and that’s where they should be collecting taxes from,” I look at the payroll tax and it just seems so anachronistic to me because this is a tax that’s imposed on the first dollar that anybody earns and it’s a real disincentive for employers to create new jobs or to hire new employees. It’s such a drag on what I would call the bottom end of the income stream.

Ed: It’s almost a syntax. A syntax in something that’s good.

Chuck: Right, yes. It’s like a virtue tax. Instead of imposing the tax, it’s really, really strange. It’s a regressive tax and it’s not just that it’s regressive, but that it’s imposed directly on the thing that everybody says. That everybody seems to agree is good for the economy which is the creation of jobs. I don’t understand why this is something that we all accept as if it’s just inevitable and we can’t do anything about it. This is a choice, that as a society we made and having made it we’ve never seem to have second-guessed it.

Ed: It seems we never revisit even bad ideas. They stay with us.

Chuck: Yes. I know that the issue is well wait a minute. Are you going to fund social security? My answer is well the same way you fund everything else with other taxes. There’s no magic to that. Any way, it is my pet peeve and ever since becoming self-employed, it’s an even greater pet peeve, since I paid double of what I used to but really-

Ed: You paid double the corporation reduced your wages by your share.

Chuck: Well, that’s what I understand most economists agree is really the case is that even people who are only having half of this tax withheld from their paycheck are effectively paying the whole tax because it effectively is a reduction in their wages. I would love to see the experiment run where we repeal the tax and see if everybody gets a 6.2% raise as a result.

Ed: That’d be wonderful. Hopefully, it would happen. It’s nice to address these issues, but everything defaults to the truth. Well, that’s the way I’ve done, so let’s continue to do it. It’s amazing to me how people abhor change. In the world of creativity, I think change is constant. You’re learning and moving forward, but there are certain areas that you default to not the truth about what has been done whether it’s correct or not. Given the issue of the investments in an IRA, we’ve got two broad rules that I want to focus on. First is this annotated trader business income and others if you have debt in an IRA likewise in a tax-exempt organization you attract what’s called unrelated trader business income and you get a $1,000 pass on that, but essentially anything in excess of that, you’re going to subject to a tax inside the IRA.

Chuck: That $1,000 pass. It feels, Ed, like that’s there exclusively just to add some complexity to the code. What else could possibly be the point?

Ed: Exactly, right. There was a section of Internal Revenue Code dealing with collapsible corporations. Addressing the issues in the movie industry, they would form a corporation and characterize the results when you dissolve the corporation as long term capital gain. That was addressed. Apparently, that section is a whole page of the Internal Revenue Code with one sentence. One sentence. My dog, Jack, would have a canary trying to read that. In any event, so we have this unrelated trader business income. But then, we have the question of transactions with respect to or with your IRA. Prohibited transactions.

Chuck: That trips some people up. Getting back again to this real estate discussion that we had, where I’ve seen this be an issue for people is that, in theory, you can put almost anything into an IRA. In theory, that could include real estate, but boy that is where people run into trouble.

Ed: If it is leveraged, number one.

Chuck: Well, if it’s leveraged, number one, and then, number two, is if it’s real estate that they have any personal interaction with. I know that this is going to an extreme. But, my own view on that is that, if you’re going to put real estate into an IRA, it better be some parcel of real estate that you’ve never visited, never seen, have no intention of visiting, and aren’t going to have any interaction with. Now that’s not actually what the regulations require, but the point is that, if you make personal use in any fashion.

Ed: Direct or indirect?

Chuck: Direct or indirect of that real estate, that’s inside your IRA, that’s a prohibited transaction and the consequences can be pretty severe. I’ll briefly share a story of a client several years ago that I discovered that there was this a real estate inside his IRA. And I said you know what? I want to make sure I understand what this real estate is all about. Because, this seems a little — We just got to be very careful with this stuff and I want to make sure that that’s investment real estate. He said, “Oh yes, that’s a piece of property that came up for sale several years ago and at the time the only real money I had was money inside my IRA and so I went ahead and purchased it. It was really important for me to take advantage of that when it came up for sale, because that’s the property that’s right next door to my home.” It’s property that is now essentially is his yard. I was just– it took a while to get my jaw off the floor. This was a financially sophisticated person. He was a CPA who was just astonished at how lively that this story was told to me. But, people can fall into this and it’s a dangerous thing to do.

Ed: The aside is let’s turn to and we will discuss distributions. But let’s assume you have an IRA that has a debt-free apartment building in it. A 36-unit apartment building and that’s all, that’s worth $5 million. Okay, so you start your distributions when you’re 70 ½, and we’ll talk about that age going forward, you’re going to distribute 4% of your apartment building.

Chuck: Right, I don’t know how you do that. Is it even possible to take a fractional interest without that automatically becoming a prohibited transaction?

Ed: I have some ready. You’d have to put it in a limited liability company and then issue a 0.05% of it per year.

Chuck: Make sure that you have no management or authority over the limited liability company.

Ed: What’s the value?

Chuck: Right. Oh my gosh.

Ed: Then, how do you pay the tax? You have this piece of real estate. Now you got to borrow against less than 1% interest and pleadge it  to the bank, how do you pay your tax? Putting it another way, real estate is not a really good investment inside an IRA.

Chuck: Right. Terrible situation to get yourself into unless it is again, purely, and I mean purely, investment real estate that you intend to unload before retirement.

Ed: Well, I’ve had a situation where a client came in, “I’ve got this great investment and it is real estate trust is right read.” “Wait a minute, Peter. There’s debt on that. You now have UBI in that, so how do you pay that tax?” “Well, that can’t be.” Well, okay, fine, I’m wrong. Here’s the Internal Revenue Code. Go back to sleep.” The point is, it’s a trap for the unwary.

Chuck: It is.

Ed: You do not. You got to pay attention to what’s going in an IRA, and how its invested, let alone the distribution rules. You got a great situation because not only do you save the self-employment or the payroll taxes going in, but you happen to reside in a state that doesn’t tax income when it comes out. It’s a grand slam home run. Unfortunately, there’s only about seven or eight, Illinois doesn’t tax IRA distributions today. That’s not to say they won’t tax those distributions going forward. We have Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. You want to move one to one of those states and avoid the application of the tax in any event, but other than that, you got problems.

Chuck: Seems to me, the biggest issue, when it comes to tax and IRAs other than tripping yourself up and ending up in a prohibited transaction, is the situation where you do have such a substantial amount in an IRA that you are facing the prospect of both estate tax and income tax on that money.

Ed: Killer. Why is that, Chuck?

Chuck: Well, because of the fact that you have, it really is a double tax. In some respect, you can take a deduction on one return for the tax against the other, but it really is a double tax. When you take as an example, in Illinois, where the estate tax exemption is $4 million, and who knows, we may be down on the federal level where the estate tax ends up down around that level too as an exemption amount. Let’s say you have IRA, and it’s got $5 million of assets in it, which is, that would be a pretty large IRA, but we do see those on a pretty regular basis, the income or the assets that are in that IRA then are subject to estate tax, which means you have to come up with the money somewhere to pay that estate tax. Where you’re going to get the money? Well, you can pull it out of the IRA. Guess what happens when you pull it out of the IRA? You pay income tax on it. It forces the acceleration of money coming out of that IRA, for the purposes of paying estate tax, and then once you do that, you’re paying greater income tax. It can really become a cascading problem, particularly for people where they have an accumulation of assets like that inside an IRA, and they don’t have other assets available.

Ed: Yes.

Chuck: They have to pull that out of the IRA.

Ed: I must tell you; my experience suggests that licensed professionals are typically in that class.

Chuck: Yes, it’s not too unusual, really, to see anytime someone has an IRA that is in the multi-million dollar category, that that IRA quite often does end up being for that person, a substantial part of what their total taxable estate is for estate tax purposes. This I’m sure that there are plenty of exceptions to this but of course, we’ve seen exceptions to this. But in general, people tend to accumulate their wealth either inside an IRA or employer-sponsored retirement plan, or outside their employer-sponsored retirement plan. But you don’t see a lot of people who accumulate substantial wealth in both places.

Ed: Let me address that: the 80:20 rule. Talking about license professionals on average, 80% of their assets are in a tax-qualified arrangement, typically an IRA.

Chuck: Those are the ones who have accumulated assets.

Ed: That’s right.

Chuck: There’s the ones who don’t do that really end up not having a big balance sheet.

Ed: Right. It’s this deferral. And, I can understand that you’ve gone to medical school, law school, whatever for any number of years, you’ve got huge debt, you deferred self-gratification, you get out of there, you got to pay off that. I just want to enjoy life. Guess what, that’s fine, but you burn out at age whatever and all of a sudden, you’re in this difficult lobster pot situation.

Chuck: Yes, exactly.

Ed: I am not sure the answer except that that’s a significant component of your total wealth and the other side of it, it’s got to be leveraged by stocks. You’ve got two pyramids here or two, let’s call them pyramids. You’re building on one in your IRA, your tax-qualified arrangement and the other to the extent you can use the 80:20 rule to buy other assets, for example, stocks and index fund total return. We talked about that in prior occasions, but you’re using your fallback as your IRA and hopefully, you’re accumulating some capital assets outside with some leverage.

Chuck: If you were to run across somebody who’s still in their working years, and they really been very effective at accumulating wealth in their, whether it’s an employer-sponsored retirement plan or an IRA, that sounds like you, like me, would say, “Hey, at this point in life, you may want to scale that back in order to be able to accumulate outside that to have some balance there.”

Ed: Yes. Although it’s watching the IRA go tax-deferred with the 25% savings is a little bit of magic. It is addictive. “Wow, I’ve gone up 30% and my barber went up 22%, my wife’s hairdresser went up 20%.” It is this envy; you think you’re going to have a little more money than your brother-in-law?

Chuck: I guess realistically, most people are not going to, no matter how much they defer, how aggressively they do it, most people are never going to get to the point where they’ve got a problematic balance in their IRAs. The people who really do have that opportunity, I think, are small business owners and licensed professionals who have the combination of two things, both high income and the ability to defer large amounts of that income into a retirement plan of sorts. Those people need to be cognizant of this risk.

Ed: Yes. The lesser endowed economically actually watch out for fees, costs, and expenses. That’s the– We’ve talked about that time and time again both on the podcast and with our respective clients. What occurs is the individual selling that product to the IRA or to the individual that is not that sophisticated is being taken advantage of.

Chuck: There again, you really do see the situation, kind of like my comments about the payroll tax, where that is a regressive fee in the sense that.

Ed: It’s upfront.

Chuck: Sometimes the people who are accumulating the least amount are paying the highest fees.

Ed: Percentagewise, yes, and it’s upfront. We’ve seen this with single premium deferred annuities, contracts that goes on, and on, and on. These 12B-5, 12B-1 fees going back to the provider. It’s crazy.

Chuck: Personally, I’ve talked to advisors who say, give advice, like, well forget about an IRA, just put your money in a life insurance contract. It’s also tax deferred.

Ed: The issue is who is selling it? What is the source of the recommendation? What is going on?

Chuck: What are their financial incentives?

Ed: When you’re looking at an investment advisor, the first question is, let me see your year-end balance sheets for each of the three prior years? Not your tax return, but your balance sheets. I have yet to find anyone saying, I’ll give you those. The answer always is, it’s not relevant. I’m going to a surgeon for open-heart surgery. I’m going to say, “Hey, doc, how many times have you done this? Have you done it some members of your family?” Guess what? That’s a question that’s appropriate. But, asking that individual who’s selling you something, let’s see how you’ve done, a silence that’s unbearable. I’m the bad guy.

Chuck: Yes, you get it. You do, I think universally, get that response from them.

Ed: It’s irrelevant. Now it’s a different story if you’re using an investment advisor and a large platform. I’m talking about Vanguard, Schwab or Fidelity. Where you know what’s going on there the full disclosures are being made and you have some psychological rewards by using that. We’re not denigrating the whole world of investment advisors, but its transparency that’s the issue in my world.

Chuck: Yes, I agree.

Ed: I don’t care what you do, but so you know the consequences of doing it. What are the alternatives?

Chuck: What are you doing that’s beyond what I would otherwise do on my own? I think that there is, again we’ve touched on this before, but I continue to be dismayed by the degree to which sometimes financial advisors claim to have some kind of a secret formula where they’re going to be. They’ve got some kind of magic that they can work on the markets that is simply if it’s true, it seems to only bear fruit short term. A very few can claim to have accomplished that in the long term. Again, it disenchants me with the industry that so few of them are willing to acknowledge that there really is not much of a secret sauce out there. There are some tried and true methods that you can either do on your own or they can assist you to do them, but there’s a place for them. I don’t want to– But this idea that they’re– That they’ve got some proprietary knowledge that no one else has is just simply not true. That smacks of Bernie Madoff.

Ed: Yes, it’s salad dressing. It’s all salad dressing. Do you want raspberry or whatever? My favorite story about my dog, Jack, is this, I spread out Wall Street Journal pages that have the listings of the stocks. Jack was outside, got his paws all dirty, “Come on in, Jack.” Standing at the vestibule, I had him stand on the Wall Street Journal and where his paws and I bought those stocks at very-

Chuck: How did Jack do?

Ed: Jack did very well. The point is it’s random and so if you buy the whole basket versus trying to beat the market because you are this savant, guess what? Not going to happen. The mutual funds that have done well last year are not necessarily the ones that are going to do well in the next five years. Look at the history of which subject mutual fund. How many years has it been around for 10 years, 15 years? The answer is typically No. The good readings are with Jack Bogle and his books. He addresses that the founder of Vanguard.

Chuck: It’s actually astonishing if you try to sort through and look at the– Right now, there are more mutual funds available than there are individual stocks available which seems a little topsy-turvy since the individual stocks are the components of these mutual funds. If you try to screen and you try to look for, “Look, I want to get a mutual fund that has at least a 20-year history with the current managers in place for at least 15 of those years.” Then do any kind of screening that has to do with long term financial performance on top of that. Whatever measure you’re going to use depending on what financial performance you’re looking for. It’s pretty amazing that out of this universe, of this gigantic universe of mutual funds, how few end up making through such a simple screen.

Ed: Because it gets to the random nature.

Chuck: Right. The managers move around.

Ed: Sure.

Chuck: Effectively, if you have a mutual fund that changes managers even though the fund has the same name, it is effectively a different mutual fund at that point in time. You really can’t, at least in my mind. I’d be willing to get into an argument with someone about this, but my own view is that at that point it really is not appropriate or fair to attribute a prior managers performance of that mutual fund to whoever the current manager is just because they inherited the name of the fund and whatever investments were in there at the time they took over.

Ed: The idea of a lot of planners, a lot of individuals look at performance historically and think it’s going to remain constant going forward. The world changes every day and you cannot rely and making an investment decision on historical performance. Really look at, in my world, return on investment capital. By the way, in today’s world, there are capitalists that have no invested capital. I am thinking of the IT world, for example. The point is it’s random. If you think you got a fix on it, guess what? You’re wrong.

Chuck: Yes.

Ed: Let’s talk about distributions from the IRA and more specifically the pre this year version and now the current version. Just by way of background, generally speaking, this required minimum distribution date is historically been the year in which you attain age 70 1/2.

Chuck: Now that’s changed. Now the new number is age 72. Neither 70 1/2 or 72 are necessarily rational numbers, but at least 72 is a round number. In any event, if you are not yet age 72 that means that you are not required to start taking distributions from your IRA until age 72. If you’re already at least age 70 1/2 or you were before the end of the year, then you were required to take required minimum distributions and that continues. There’s no exemption for people who’ve already reached the status where they have to start making those or taking those distributions.

Ed: Chuck, I want to– What about the 70 1/2 rule for charitable contributions? Does that still apply?

Chuck: Yes. That is an anachronism where prior to the passage of this new law, you were able to take or make what are called qualified charitable distributions from an IRA at the same age as when you were required to take distributions. So, those paired up very nicely in the sense that you could effectively divert what was otherwise your required minimum distribution into a charitable organization and thereby avoid having income tax on that required distribution. Well now, for some reason, it’s probably just an oversight but you can still, starting at age 70 ½, do those qualified charitable distributions but you’re not required to take a distribution until age 72.

Ed: It’s an example someone didn’t tie up all the ribbons.

Chuck: Right, yes. It probably is not that significant for anybody, but it is a strange anachronism that’s left in the Code. Thirty years from now someone will look at that and it’s going to be like, “Well, why do we have an appendix? Why is this 70½ in here?” It’s well because it used to be a really important number for all kinds of reasons and that’s the only place that it exists.

Ed: People forgot a line. Before we get into the other requirement, again the issue is the owner dying. We do know they’ve taken out before age 59½, you’re going to be the subject of a premature distribution tax, but there’s all kinds of exceptions to that rule. Put it another way, it really is a lobster pot, you put the money in but how do you get it out when you really need it? Well, if you need it before 59½you better fall within one of the exceptions.

Chuck: Right.

Ed: Now let’s talk about the rules when the owner, IRA owner confined to IRA, all the rules are comparable and most other tax-qualified arrangements, dies before required beginning date. Any observations there?

Chuck: We used to be able to do a thing that was referred to as the stretch IRA, where a so-called “designated beneficiary” of that IRA would be able to become the new IRA, they remained what was referred to as a beneficiary of the IRA. Notwithstanding the fact that the owner had not attained the age for required distributions and without regard to the age of the beneficiary, it became necessary to start taking distributions after the death of the owner. Those would generally be stretched over the age of the designated beneficiary.

Ed: Let’s assume it was a grandchild.

Chuck: If it’s a grandchild, you would look at the life expectancy of that grandchild which will be a very long time, it could be a 70-year life expectancy at an age of a young grandchild. You would be taking out one tiny little sliver of that each year.

Ed: You look at the 12/31 value and apply that percentage.

Chuck: Right. Exactly. That was the old rule. It’s kind of interesting they’ve passed this new law and that old rule is still embedded in the code. It’s just that it applies now to very, very few people. Now instead of that applying to any essentially human being who’s a beneficiary of the IRA, that only will apply to a small category of what I refer to now as eligible designated beneficiary. Those are generally people who are disabled, minor children, the surviving spouse of the owner of the IRA, or someone who is no more than 10 years younger than the owner of the IRA. Those are referred to as eligible designated beneficiaries. They still get the benefit of the so-called stretch. For everyone else, you’re dealing with a so-called 10-year rule which effectively says, “In year one, we don’t care how much you take out of the IRA, but by the end of year 10, it’s all got to be gone.”

Ed: Make sure I understand that. You have a $1 million in. Theoretically, you take out 10% every year. Are you saying that you can defer that until the end of the 10 or is it the end, 12/31, in which the ten-year period expires?

Chuck: Right. It’s the tenth year following the year of the owner’s death. In a way, it’s eleven years. You can from years one through nine just simply allow that money to accumulate in the account, tax deferred. Then in the final year, you can pull the entire amount out. You do have that option. For some people, this might actually be more favorable, because you get that deferral. There is really no rule with respect to what you must do in year one. For many people, at least in theory, this is going to be a detriment, or it’s been viewed by many as a detriment because of the fact that you no longer have this kind of lifetime stretch that used to be in place.

Ed: Well, let’s talk about death or honor after the required beginning date essentially the same kind of rules?

Chuck: Right. Yes.

Ed: It’s rocket scientists’ stuff in the sense that if you read the Code, you’d rather — Greek myths are easier to read than the Internal Revenue Code on that section. In any event, we know what we have to deal with, and I guess what I’m saying– What can’t you figure out in 10 years, is that the worst thing in the world?

Chuck: Well, many people are treating this as if it’s the worst thing in the world. Now, when you look at the universe of IRAs, we’ve been talking about people who have IRAs, that have multi-million dollars in assets in them, but that is not the typical IRA. The typical IRA or the typical person is much smaller than that. For such a person, a 10-year payout, you just think about one-tenth of let’s say an IRA. Most people if they inherited a $300,000 IRA, they would consider that to be a very nice windfall. To take out $30,000 a year from an IRA, that is not typically going to push someone into a higher tax bracket. For most people inheriting IRAs, they probably are already taking at least that much out if they are inheriting an IRA anyway. I’m not sure if this makes a huge difference other than in the top end of the wealth scale. For those people, it really can have a significant impact.

Ed: Except, I recall when this first was enacted, there was an editorial on the Wall Street Journal. It referred to a lot of the use of a Charitable Remainder Trust. Let’s talk about that briefly.

Chuck: Well, yes. For me and for a client who’s charitably inclined, to begin with, this is even before the enactment of the statute, this really was in my view a very favorable way to make use of an IRA when you’re talking about a wealthy individual. I’m, again, going back to this person who might have an estate tax problem in addition to the income tax issues that are embedded in having an IRA. This Charitable Remainder Trust effectively says, “Okay, you’re going to make a trust, the beneficiary of the IRA,” and the way the trust is structured is it says, “There’s X% per year,” typically maybe 5% per year.

Ed: Not more than 50.

Chuck: Not more than 50 and not less than five. You have 5% of the trust per year is going to be paid out to the beneficiary for that beneficiary’s lifetime. When the beneficiary dies, whatever is left in the IRA will go to charity.

Ed: If any.

Chuck: If any. Now you have to have at least a 10% probability that the charity will receive money in order for this to be a valid trust. By valid, I mean, a trust where you’ll get an estate tax deduction for the charitable contribution, or the charitable component of it.

Ed: Remainder. In other words, when you’re setting it up, there is a deduction anticipated for the amount of the remaining balance at your death.

Chuck: Right. Exactly. The nice thing about the way this trust works is that technically the IRA still has to be emptied within 10 years of the owner’s death, just like any other IRA. Then technically that all comes out as a taxable distribution from the IRA, but the issue here is that the trust, this Charitable Remainder Trust pays no tax.

Ed: Wait a minute, make sure I understand that. I got 1 million bucks going to, I’ll call it CRT, for our ease of explanation. It’s payable over this individual’s lifetime and the individual is fairly young. That $1 million that would otherwise be taxable if it went to the individual directly, now goes to the CRT and is not then taxed?

Chuck: Right. When the money dumps over from the IRA into the trust, there’s an accounting done where you keep track of the fact that, “Hey, a $1 million of taxable income went into this trust but there’s no tax paid.” Tax is only paid when and to the extent it gets distributed out to the beneficiary. Effectively what you do here with the CRT is you turn any inherited IRA into this so-called stretch IRA. Not only that, but because the structure is rigid, you build into this thing, 5% per year is going to go out to the beneficiary. This money will not be wasted. There’s no acceleration of what goes to the beneficiary. It has to be taken out on that 5% schedule and so it will last that beneficiary’s entire lifetime. Unless for some reason the investment goes south and the thing collapses. The beneficiary cannot overspend and thereby cause the whole thing to collapse.

Ed: Let’s use Charlie Chaplin as an example. He married at least five times. Let’s assume he has 10 children. He’s got $1 million. He could set up 10 Charitable Remainder Trusts and have 10 IRAs, for example, and each tailored to the needs of that respective child and pour that IRA in the separate Charitable Remainder Trusts.

Chuck: That’s exactly right.

Ed: My point is, a combination of multiple IRAs and multiple Charitable Remainder Trusts effectively get around two issues: the significant amounts in an IRA and the 10-year rule.

Chuck: Yes, exactly. In my mind, I view the “problem” created by this new legislation being in position of this 10-year rule is fairly easy to address. It’s not something that gets addressed automatically. People have to plan for it but for most people, for many people, they’re really probably going to have taken that IRA money out within 10 years of inheritance anyway. Really this law doesn’t affect them. For anybody who’s wealthy enough where that really is an IRA that was likely to stretch over a lifetime, you can still do that with a Charitable Remainder Trust. Now, the caveat there is that you do have to have some charitable inclinations. My experience is that most clients who are in that wealth category are at least somewhat charitably inclined. Although every once in a while, you run across someone who just has no interest.

Ed: Yes, and they want to die with their boots on I suppose. But any event, today we’ve discussed the use of the cash balance plan with 862 distributions out with significant amount to IRAs, with incidentally, no limited how much can be in an IRA. We’ve also talked about the investment management fees, for example, the UBI issues and the absence of income tax in many states, so you’re going to avoid the, not the federal but the Illinois income tax. You’re going to avoid all these payroll taxes forever and you have this investment opportunity, the planning, but stay away from prohibited transactions. The lesson, if there is one here, is defer self-gratification to the extent that you can.

Chuck: Exactly.

Ed: Thank you.

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.

More Episodes

Episode 58

With today's program, let's address who's talking. What is the source of the information that you're relying upon? Specifically, should you be listening to someone who's talking? My answer to that is no.