If you’ve inherited an IRA from a parent or another loved one, it is likely that you have a Inherited IRA (aka, Beneficiary IRA). These can be powerful accounts, but you need to understand the Required Minimum Distribution (“RMD”) rules for your Inherited IRA to properly utilize it. The inherited IRA may be a Traditional or Roth IRA, and there are three different distribution options you may elect when you inherit the IRA. These distribution options dictate how you can invest the account. Please note that if you inherit an account from a spouse, you can just do a spousal rollover and consider the account as yours. This article is for those inheriting an IRA from a non-spouse.
You will have three distribution options upon the death of your loved one to receive the funds from their IRA. In general, the best option is the “Life Expectancy Method” as it allows you to delay the withdrawal of funds from the IRA, and allows the money invested to grow tax-deferred (Traditional) or tax-free (Roth). The three options are outlined fully below:
The first option is to simply take a lump-sum and be taxed on the full distribution. There is no 10% early withdrawal penalty (regardless of your age or the deceased owner), but you are taxed on the amount distributed if it is a Traditional IRA. You’re also giving up the tax-deferred (Traditional) or tax-free (Roth) benefits of the account. Don’t take this option. It’s the worst tax and financial option you have.
Life Expectancy Method – Stretch IRA
The Life Expectancy Method is the best option. Under this option, you take distributions from the inherited IRA over your lifetime based on the value of the account. These distributions are required for Traditional IRAs and even for inherited Roth IRAs. For example, if you inherited a $100,000 IRA at age 50, you would have to take about $3,000 a year as a required minimum distribution each year and the rest can stay invested. The RMD amount changes each year as you age and as the account value grows or decreases. There is no 10% early withdrawal penalty when you pull money out of the account regardless of your age. Traditional Inherited IRA distributions are taxable to the Beneficiary while Roth IRA distributions are tax-free. And yes, Inherited Roth IRAs are subject to RMD even though there is no RMD for regular Roth IRAs.
There is pending legislation which the House has passed, but the Senate has sat on, which would limit the ability to stretch the IRA out to a maximum of 10 years. Even if that legislation passes, the Stretch IRA will be a good option to at least continue the tax benefits of the inherited IRA for 10 years.
This option is available to all inherited Roth accounts, but is only available to inherited Traditional IRAs where the deceased account owner was under age 70 1/2 at the date of their death. Under this option, the Inherited IRA is not subject to RMD. However, it must be fully distributed by December 31st of the fifth year following the year of the account owner’s death. There is no 10% early withdrawal penalty, and distributions are subject to tax. Again, this option is only available to Traditional accounts.
Investing with a Self-Directed Inherited IRA
Yes, you can self-direct your Inherited IRA (aka, beneficiary IRA). Before you do, make sure you understand the amount of funds you’ll need to take as an RMD, and that you will have available cash in the account to cover those RMDs. As I described above, assume you are 50 and inherited a Inherited IRA for $100,000. You will need to take annual distributions of around $3,000. So, if you invest all of the $100,000 into an illiquid asset, then you will be unable to take RMDs and you will force the IRA account to pay stiff penalties. Consequently, when making a self-directed investment from a Inherited IRA, you must take into account the amount of the investment, the total value of the account, and the timeline of the investment (when will it generate cash back to the IRA). If you inherited the $100,000 account above, you may decide to only invest $70,000 of the Inherited IRA into an illiquid investment (e.g. real estate or private company), while leaving the other $30,000 to be invested into liquid investments like publicly-traded stocks, CDs, cash or mutual funds. This will leave funds available for RMD until such time as the illiquid investment generates income or is sold for profit.
Stretching out the benefits of an inherited IRA can be powerful, but make sure you plan for RMDs before you make any self-directed investments from your Inherited IRA.
Self-directed Inherited IRA accounts can be set-up at Directed IRA in as little as five minutes on-line at www.directedira.com.
Kids are going back to school and it’s a great time to think about college and to make financial plans for your children or grandchildren’s education. As you consider the different plan options, you’ll want to make sure you know the two most common tax favored college savings tools.
There are two types of accounts that you can establish to save for higher education expenses in a tax favorable manner. These two types of accounts are Coverdell Education Savings Accounts and 529 Plan accounts.
The first type of account is known as a Coverdell Education Savings Account. A Coverdell account is typically set up for the higher education expenses of a child. The contributed funds grow in the account tax deferred and the money comes out for education expenses tax free. There is no tax deduction for amounts contributed to a Coverdell but you do have significant investment options including self-directed investment options (similar to IRA rules). A Coverdell has the following rules and benefits.
- $2,000 annual contribution limit per beneficiary (e.g. child or grandchild).
- Parents (or grandparents) can contribute without limitations to a Coverdell until a beneficiary reaches age 18 if the contributor has income of less than $190k (married joint) or $110,000 (single). For high-income earners, keep in mind that the child can always contribute to their own account with gifted funds (no need to have earned income) so you can always get around the income limitation by having the child contribute themselves.
- Funds can be used for tuition, fees, books, and equipment for college as well as certain K-12 expenses too.
- There are zero federal or state income tax deductions on Coverdell accounts.
- Accounts can be invested into stocks, mutual funds, and can even be self-directed. They operate similar to an IRA. Self-directed Coverdell accounts can be opened at Directed IRA, www.directedira.com.
- Contributions grow tax-free and can be withdrawn for education expenses until the account beneficiary reaches age 30. Unused amounts can be transferred to another family member beneficiary.
The second type of account is a 529 Plan account. Contributions to 529 Plan accounts can be eligible for a state income tax deduction (depending on the state). Money contributed to a 529 Plan account is invested into a state managed fund. A 529 has the following rules and benefits.
- Amounts are invested into a state run program.
- Amounts can be withdrawn for tuition, fees, books, supplies, equipment, special needs, room and board.
- Up to a few hundred thousand dollars can be invested per beneficiary by any person.
- There are no federal tax deductions or credits for contributions.
- Many states offer tax deductions for contributions to 529 Plan accounts. For example, Arizona offers a $4,000 tax deduction for married tax filers and a $2,000 deduction for single filers. Thirty-five states offer some type of state income tax deduction for 529 Plan contributions. However, there are some states, like California, who offer no tax deduction for contributions to 529 Plan accounts. Click here to see a comprehensive list that outlines the different state funds and tax deductions (or credits for some states).
- Downside, invested amounts must be invested solely into state run programs. There are no other investment options.
In summary, Coverdell accounts have the benefit of allowing account owner’s to decide how the money will be invested with zero tax deductions available on contributions while 529 Plan accounts give you zero investment options (all funds go to state run fund) but offer state income tax deductions in most states.
If you live in a state that offers a tax deduction on contributions, such as Arizona, then the 529 Plan account is a great option if you can stomach having the money go into a state run fund. On the other hand, if you live in a state with zero income tax (e.g. Texas or Florida) or if you live in state with zero 529 Plan deductions (e.g. California) then you might as well use a Coverdell account because you’re not trading any tax deductions for investment options. For those who can’t make up their mind and who have the funds, consider doing both but do the Coverdell first. There is no restriction against doing a Coverdell account (no tax deductions, but investment options) and a 529 Plan account (possible state tax deductions but no investment options).
The Government Accountability Office (“GAO”) issued their most recent report on self-directed IRAs and concluded that the IRS and DOL should do more to collaborate on prohibited transactions in IRAs. The report and the GAO’s work was an excellent analysis of some of the issues facing IRA owners.
There were two significant sections in the report for Self-Directed IRA accounts: Prohibited transaction exemption applications and IRAs with large balances likely being self-directed.
Prohibited Transaction Exemption Applications
An IRA owner may request an exemption for a prohibited transaction by making a formal written request to the DOL. While the IRS enforces the prohibited transaction rules, the DOL has interpretative authority and is the agency who can grant exemptions. An exemption must be obtained in advance of the transaction and takes on average one year to obtain.
A common prohibited transaction exemption request is one where the IRA owner owns real estate in an IRA which they would like to use personally. While the property could be distributed as an in-kind distribution there are tax consequences to such distribution. The DOL has granted this exemption request for IRA owners in the past and generally requires an appraisal to set the value and a broker/agent to effectuate the transaction.
The prohibited transaction exemption process is rarely utilized by IRA owners. The GAO noted that in the past 11 years only 48 prohibited transaction exemptions where granted for IRAs.
The biggest deterrent from my experience with clients is that it takes 6 months to 1 year to get approved and about $5,000 in legal fees to make the application and handle it to decision. Usually such long timelines are not something IRA owners are willing to wait on as circumstances change from one year to the next. The DOL does have some expedited prohibited transaction exemption procedures, known as EXPRO, that can be used when an account owner is seeking to rely on an exemption that has already been granted by the DOL to someone in a similar situation. Use of such procedures with IRA owners, which is already allowed but not readily known, could provide a better outcome as EXPRO applications are granted more quickly.
The GAO recommended that the IRS and DOL collaborate on prohibited transaction exemptions to better regulate and understand IRAs.
IRAs With Large Balances Likely Self-Directed
In their report, the GAO also noted some of their prior work on self-directed IRAs and stated the following:
“…IRA owners who have accumulated unusually large IRA balances likely have invested in unconventional assets like non-publicly traded shares of stock and partnership interests.”
While this is no news to self-directed IRA owners, it should be something of interest to policy makers and financial advisers who may view self-directed accounts with skepticism. If self-directed accounts have proven to get unusually high balances, wouldn’t we want more people to use them to do the same thing and to secure their retirement. The concept of self-directed IRAs is simple: Give more freedom and control, and let people invest in what they know. Let account owners decide and obtain the benefits (or burden) of their decisions with their money. Sure, there are risks but the best person to take risks is the person whose actual hard-earned money is on the line.
Many self-directed IRA investors use an IRA/LLC (aka “checkbook-controlled IRA”) to hold their self-directed IRA investments. For an overview, see my video here. When using the IRA/LLC structure, the name of the LLC is on title to the assets, and the LLC’s bank account receives the income. As a result of this structure, the self-directed IRA owner may be asked by a title company, property management company, or other third-party to complete an IRS Form W-9 form for the IRA/LLC. Form W-9 is the document these parties request in order to issue 1099’s for rental income or for sale proceeds for real estate, stock, or other assets sold by the LLC. Form W-9 can be tricky and needs to be handled differently when you have a single-member IRA/LLC (i.e. when the IRA owns the LLC 100%) than when the LLC has two or more owners (aka “partnership”). It is important that the W-9 is completed properly so that the IRS does not confuse whether the LLC is owned by the IRA or by the IRA owner personally.
The W-9 can be tricky to complete in the single-member IRA/LLC situation. Many IRA owners will include the LLC EIN in Part I of the form or will provide the owner’s SSN. Both of those answers are incorrect. I have provided a sample W-9 form for “ABC Investments, LLC” below:
Let’s go through each line to explain the responses. I’ll start on line 1.
- Name: In the instance of a single-member IRA/LLC, the IRS considers the LLC to be disregarded, which means that the LLC is not a separate taxable entity and instead the tax reporting goes directly to the owner. In this instance, the owner of the LLC is the IRA. Consequently, the name on line 1 should be the name of your IRA. If you have a self-directed IRA with our company, that name would be something like, “Directed Trust Company FBO John Doe IRA.”
- Business Name: Line 2 is where you will list the name of the LLC. So, for example, if your IRA/LLC is called “ABC Investments, LLC,” then you would provide that name on line 2.
- Tax Classification Box: This is the section that causes confusion and often results in incorrect selections. In this section you would check the first box, “Individual/sole proprietor, single-member LLC.” When the IRA owns the LLC 100%, the LLC is considered a single-member LLC.
- Exemptions: IRA/LLCs and IRAs are an exempt payee, and as a result, you should include Code 1 on the first blank space on line 4. See line 4 instruction on Code 1 for more details.
- Address: On line 5 and 6 you will include the mailing address for the LLC. Do not include your IRA custodian’s address as any 1099s for the IRA will be sent to the IRA custodian’s address. While most 1099s and tax reporting forms generated from a W-9 do not result in a reporting or tax obligation for the IRA, it is best that the IRA owner, who is responsible for the account and decisions, receive the 1099s at their address.
- Address (Cont’d): See line 5 response information above.
- List Account Number (Optional): You may include the IRA account number with your IRA custodian on line 7, but this is optional and is not required. If you have multiple IRAs with the same custodian, it would be helpful to also provide your account number for the specific accounts involved. Otherwise, if needed, the IRA is identifiable by the name line 1.
The next section is called Part I, and is the section where a social security number or employer identification number is used. This section is often completed incorrectly. The correct response is the EIN of party on Line 1. In this instance, Line 1 is the IRA. Most IRAs should not have their own EIN, and you should not obtain an EIN for the purpose of a W-9. You may have an EIN for your IRA because you have Unrelated Business Income Tax (UBIT) for your IRA (which is less common). However, most self-directed IRA custodians do not have an EIN for their IRA. Instead, what you should use is the reporting EIN of your IRA custodian. All IRA custodians have an EIN that is used for their customer accounts, and this EIN can be obtained by contacting your IRA custodian.
Most IRA/LLC owners have an EIN for their LLC and some will use that EIN in Part I. While that is the correct response in the multi-member IRA/LLC (“partnership”) context, it is not the correct response for the single member IRA/LLC. Another incorrect response on Part I is to use the social security number of the IRA owner. This is also incorrect as you do not personally own the LLC. An incorrect response on Part I doesn’t cause a prohibited transaction or disqualify the IRA, but it could create tax reporting confusions with the IRS.
Finally, the manager of the LLC would sign on Part II.
If your IRA/LLC has more than one owner, it is considered a multi-member IRA/LLC. Most multi-member IRA/LLCs are taxed as partnerships and as a result, the W-9 for a multi-member IRA/LLC is different from the single-member IRA/LLC.
The multi-member IRA/LLC is far more straightforward. I have provided a sample W-9 below. The important items for the W-9 in this instance are as follows:
- Line 1 is the name of the LLC: In a multi-member IRA/LLC, the entity files a tax return and is recognized at the LLC level by the IRS.
- Line 2 is blank as line 1 is the LLC name and they are the same.
- Check the box limited liability company and then indicate letter “P” for partnership.
- Skip the exemption code since the LLC itself has its own tax status (partnership usually). Even though it may be owned by IRAs the exemption doesn’t apply at the LLC level.
- Include the LLC mailing address.
- Continued mailing address.
- There is no need to list the account numbers of the IRAs here as the taxable entity itself is the LLC – not the IRAs – and there isn’t an account number for the LLC.
The LLC’s EIN should be used and provided in the box for employer identification number. Since a multi-member LLC is taxable itself as an entity (partnership return), it provides its own EIN for reporting uses on the W-9. The IRA custodian’s EIN is not used in this instance.
HSAs (“Health Savings Accounts”) are growing in popularity as Americans are discovering significant tax savings with these accounts. Why are they popular? There are many reasons why; some well known and others not so well known.
Let’s start with the primary benefits that are generally well known:
First, contributions to an HSA are fully deductible regardless of your income, and there is no high-income phase-out. The deduction also applies whether you itemize on your tax return or not, so everyone gets to use it. This isn’t the case for other major deductions like charitable contributions or mortgage interest, which only apply if you itemize on your tax return and itemizing is getting less common after tax reform that was enacted in late 2017. The other commonly known benefit of the HSA is that it can grow from the investments tax-free and comes out entirely tax-free to pay for or to reimburse the account owner for their qualifying medical expenses. For a quick summary of the basics and for qualifying rules, check out my partner Mark J. Kohler’s article here.
Now, lets discuss the additional benefits of an HSA that aren’t as well known:
You don’t need earned income to contribute to an HSA
Contrary to retirement plan rules for IRAs and 401(k)s, which require you to have earned income (i.e. wage, self-employment income) to contribute, you do not need to have earned income to contribute to an HSA. You can make the contribution from any source and that contribution will be a deduction against other income on your tax return (i.e. rental income, investment income, etc.).
Your spouse can inherit your HSA with no tax due
If you’ve built up an HSA that you don’t end up using, you can pass the HSA on to your spouse. A spouse can inherit the HSA and can transfer it over to an HSA in their name. The surviving spouse can then use the funds for their qualifying medical expenses during their lifetime. If the account is inherited by a non-spouse beneficiary, then the account is considered fully taxable to the person receiving the account. Non-spouse beneficiaries (i.e. children) are allowed to use the account to pay for the deceased account owner’s qualifying medical expenses for up to one year of the date of death as medical bills and expenses are determined, and then any remaining balance is distributed to the non-spouse beneficiaries and is subject to taxation.
You can self-direct your HSA and invest it into real estate or other alternative assets
Many HSA account owners just let their HSA funds sit in a savings account or they invest into mutual funds. Some place their HSA funds into a brokerage account,and buy and sell stock. And others are investing them into real estate, private LLCs, precious metals, private equity, venture capital or start-ups. Like a self-directed IRA, an HSA can be invested into all of these alternative assets and are subject to the same prohibited transaction rules and UBTI tax as IRAs and other accounts. We’ve been advising clients for years on how to self-direct their HSA and are now helping clients establish self-directed HSA accounts at Directed IRA & Directed Trust Company. We’ve seen account holders invest them into private placements, real estate, and into HSA-owned LLCs.