Have you taken a loan from your employer 401(k) plan and plan on leaving? Unfortunately, most company plans will require you to repay the loan within 60 days, or they will distribute the amount outstanding on the loan from your 401(k) account. Its one of the ways they try to keep their employees from leaving. “Don’t leave or we’ll distribute your 401(k) loan that you took from your money in your 401(k) account.”
How to Buy Yourself More Time & Avoid the Distribution
The good news is that following the Tax Cuts and Jobs Act (TCJA) you now have the option to re-pay the loan to an IRA to avoid the distribution and you have until your personal tax return deadline of the following year (including extensions) to contribute that re-payment amount to an IRA. By re-paying the amount outstanding on the loan to an IRA, you will avoid taxes and penalties that would otherwise arise from distribution of a participant 401(k) loan.
How It Works In Practice
Let’s say you left employment from your employer in February 2019 and that you had a 401(k) loan that was distributed by your employer’s plan following your termination of employment. You will have until October 15th of 2020 (if you extend your personal return, 6 month extension from April 15th) to make re-payment of the amount that was outstanding on the loan to an IRA. These funds are then treated as a rollover to your IRA from the 401(k) plan and your distribution and 1099-R will be reported on your federal tax return as a rollover and will not be subject to tax and penalty. While it’s not perfect it’s far great time than was previously allowed. Traditionally, you had 30 or 60 days at most to try to make re-payment.
The ability to rollover an outstanding 401(k) loan amount to an IRA is only available when you have left an employer (for any reason). It does not apply in instances where you are still employed and have simply failed to re-pay the loan or to make timely payments.
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.
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.
When you establish an IRA, 401(k), or other retirement account you are required to designate the beneficiary of that account so that the institution/custodian holding the account knows who will receive the account upon your death. You will die one day (sorry for the bad news), and without a properly completed beneficiary designation, your account will be stuck and won’t be able to be moved until a probate court orders otherwise. The form can be completed easily, so make sure you take care of this important step when establishing your retirement accounts and bank accounts.
What’s a beneficiary designation?
A beneficiary designation is simply a written and signed statement placed on record with your account custodian that specifies who receives your account upon your death. Beneficiary designations are used on IRA accounts, 401(k) accounts, HSA accounts, and life insurance policies. Beneficiary designations are used by IRA custodians, 401(k) account custodian/administrators, banks/credit unions, and life insurance companies to pass the deceased persons account on to the person(s) designated on the form without reference to the deceased person’s will, trust, and without the involvement of the probate courts. As a result, your beneficiary designation form is a powerful instrument.
You can list a primary beneficiary and secondary beneficiaries. A primary beneficiary is the first person whom you list, and this person or persons receive the account upon your passing. A secondary (aka “contingent”) beneficiary is someone you list who receives the account if the primary beneficiary is not living. For example, a common way to list your beneficiary designations is to list your spouse as your primary beneficiary and your children as your secondary beneficiary. If your spouse is not living when you die, then your account passes to your secondary beneficiary.
To have a valid beneficiary designation you must ensure the following:
- Designation: Use your institution’s/custodian’s form and designate the person(s) you desire as your beneficiary by listing their name, city/state, date of birth, and relationship to you. You can list one beneficiary or multiple beneficiaries in percentages. So, for example, if you had two children you wanted to receive the account, you would list them as 50% each on the designation form.
- Sign the designation: This may be eSigned using an eSign method accepted by your institution/custodian.
- Spousal waiver where applicable: If you have a spouse and you HAVE NOT listed your spouse as your primary beneficiary, then your spouse must sign a spousal waiver agreeing to someone else being listed as the primary beneficiary and your spouse’s signature on the waiver must be notarized. This is required as a matter of law. Failure to provide the waiver will result (at best) to your surviving spouse receiving at least half of your account upon your passing with the rest passing to your secondary beneficiaries.
- Coordinate with your estate plan: If you list your trust for estate planning as the beneficiary of your IRA, 401(k), or other retirement account, you must provide a copy of the trust to your institution/custodian. The trust must have readily identifiable beneficiaries who receive your account upon your passing and must be considered a see-through trust (most revocable living trusts are).
The beneficiary designation is the “trump card”
Your beneficiary designation is the “trump card” when it comes to estate planning documents. For example, your beneficiary designation on your retirement account or bank account will control over a will which states someone different is to receive all your assets. As a result, it is critical that you provide a beneficiary designation for every account you have, and that these designations are updated when certain major life events arise.
Action required in three common situations
If you already provided beneficiary designations on your retirement accounts, bank accounts or life insurance, it is critical that you review them and update them upon the following events:
- Divorce: There are plenty of cases when someone who failed to update their beneficiary designation passes away and their ex-spouse ends up receiving the account. This is usually contrary to the account owner’s wishes, but if you fail to update your beneficiary designations, your heirs could be in this predicament. (Talk about not leaving gracefully!) This situation is now going to be ugly for your ex, your new spouse (if you had one), and your children.
- New child: If you have a new child who was not previously identified as a beneficiary, you should update your designations to add this new child.
- New estate plan: If you establish an estate plan (will, or ideally, revocable living trust), you should ensure that your wishes in your beneficiary designations for your retirement accounts and bank accounts match-up with the terms of your trust.
When to list your trust versus your spouse/children directly
Even if you have a revocable living trust, you may want to list your spouse as your primary beneficiary. As a rule of thumb, most estate planning attorneys recommend that, for IRA or 401(k) accounts, you list your spouse as your primary beneficiary and your trust as your secondary beneficiary. The reason is that your spouse can receive your retirement account upon your passing and can do what is called a spousal rollover. This rule only applies to spouses. For example, under a spousal rollover, the retirement account of the deceased person can be transferred/rolled over into an IRA surviving spouse. This is an advantageous way for a spouse to receive a retirement account as the account is treated simply as an account of the surviving spouse, and is not subject to RMD or other quirky rules associated with inherited retirement accounts (aka “inherited IRAs” or “beneficiary IRAs”). Rather, the funds are just treated as a Traditional IRA or Roth IRA of the surviving spouse.
Your Trust can be listed second, and, in the case where your primary beneficiary is not living, certain provisions in your trust designated to protect the funds from creditors or misappropriation from inheriting children or other heirs would apply. Your children, or other heirs under your trust who are listed as secondary beneficiaries on your form would receive the funds from your retirement account in an inherited IRA (aka “beneficiary IRA”) and would have RMD requirements to remove funds from their account over their life expectancy. This is sometimes called a “stretch IRA” and is a great tax strategy as it allows them to extend the tax-free (Roth) or tax-deferred (Traditional) benefits of the account over their own lifetime.
Remember, the beneficiary designation is critical and must be completed properly. Take the extra time to get it done right, and check up on the designations on any of your existing accounts that you may be unsure of. It’s better to get these things squared away and in order now than to presume that you completed them right when you set-up the account long ago.