August 2013

Administering IRAs after DOMA Ruled Unconstitutional

The IRS has released Revenue Ruling 2013-17 setting forth its positions on various tax issues as a result of the Supreme Court’s ruling in United States v. Windsor that Section 3 of the Defense of Marriage Act is unconstitutional as it violates the equal protection principles of the fifth amendment. The IRS does not expressly address the impact on IRAs.

Under DOMA the IRS had concluded that because of Section 3 of DOMA, the two individuals comprising a same-sex marriage could not be considered to be married for federal tax purposes as

Section of 3 of DOMA defined marriage to mean only a legal union between one man and one woman as husband and wife, and the word spouse refers only to person of the opposite sex who is a husband or a wife.

This article focuses on administering IRAs after Windsor.

Under the U.S. tax laws there are “tax bonuses” and “tax penalties” for individuals who are married.

The first marriage tax bonus associated with IRAs is the spousal contribution rule. The spouse with the lesser compensation is allowed to use the other spouse’s income to make a larger contribution for himself or herself than if he or she was not married. Example, John and Mark are married. John is age 48 and Mark is age 44. For 2013 John has compensation of $55,000 and Mark has compensation of $2,600 and dividend and interest income of $40,000. Since they are married under federal income tax law, Mark is able to make a $5,500 IRA for himself using John’s excess compensation.

It does not appear that Mark will be able to make a contribution in 2013 for 2010, 2011 or 2012 based on the argument he would have made a contribution had he known he could. Had Mark made contributions based on John's compensation and such contributions had been considered to be excess contributions, such contributions would now be considered to qualifying spousal contributions.

The second marriage tax bonus associated with IRAs is that a spouse beneficiary who is the sole beneficiary has the right to treat the deceased spouse’s IRA as his or her own IRA. Any spouse beneficiary has the right to a take a distribution from the deceased spouse’s IRA and then rollover such distribution to the extent that no required distribution is rolled over. The same-sex surviving spouse will now have such rights to treat as own or to make a rollover contribution.

What policies and procedures will the IRS be applying with respect to same-sex marriage?

The IRS will still be applying the general rule that whether one is married or not is determined by state law. The IRS will also be applying the following rules.

First, for federal tax purpose, the terms “spouse,” “husband and wife,” “husband,” and “wife” include an individual married to a person of the same sex if the individuals are lawfully married under state law, and the term “marriage” includes such marriage between individuals of the same sex. That is, a state must have revised its marriage laws to include same-sex marriages.

Secondly, for federal tax purpose, the IRS adopts a rule that as long as the same-sex couple has been married in a state authorizing same-sex marriages that they are not required to live or be domiciled in a state which has authorized or recognizes same-sex marriages.

Thirdly, the IRS makes the rule that the terms “spouse,” “husband and wife,” “husband,” and “wife” do not include individuals (whether the same sex or the opposite sex) who have entered into a registered domestic partnership, civil union, or other similar formal relationship recognized under state law, but which is not “marriage” under such state law.

The same-sex couple has the discretion to file original or amended returns to reflect being married for a prior tax year if such tax year is still open. The couple is not required to file or amend their tax return for a prior year claiming a married status. If they wish to change their filing status they may do so only if a prior tax year is still open under th statute of limitations. Tax years 2010, 2011 and 2012 are still open. Generally, the deadline for filing a refund claim is three years from the date the return was filed or two years from the date the tax was paid, whichever is later.

Most likely the transaction to lead a same-sex surviving spouse to file an amended tax return will be when he or she will choose to treat the inherited IRA of a deceased spouse as his or her IRA. In this situation the same-sex surviving spouse might have been required to take an RMD as he or she did not qualify as a spouse at the time. Such distributions may certainly be stopped on a prospective basis. As to past distributions, the IRS may be receptive to a request to waive the 60 day rollover rule. That is, the IRS might authorize the same sex spouse to rollover such distribution amounts.

Proposed IRA Law Changes by Senator Hatch

On July 8th, Senator Hatch introduced a tax bill which would change many IRA and pension laws. Set forth is a summary of the IRA changes. The pension plan changes are discussed in a separate article. The insurance industry and the securities industry are suggesting changes benefiting their members to the detriment of banks, credit unions and trust companies.

In general these changes would apply to 2014 (i.e. plan years commencing in 2014). Some changes would be effective as of July 8, 2013.

Considering the political situation, the fate of these proposals is uncertain. It may be possible that some will be enacted to show there can be bi-partisanship between Republicans and Democrats.

Mortality Tables for RMDs Must be Updated. Within one year of enactment the IRS shall either update the existing mortality tables or provide new tables. Any “new” table shall apply to plan years beginning after the date which is one year after publication. The IRS is to issue new tables at least every five years thereafter.

RMD will be Eligible to be Converted to Roth IRA. Under current law a person is ineligible to convert funds within a traditional IRA to a Roth IRA since the law does not permit a person to rollover a required distribution. The proposal would allow RMDs to be rolled over or converted to a Roth IRA.

Expand Law on Correcting Errors to Include IRAs. Except for the special letter program for missed rollovers the IRS has not developed any procedures to correct errors occurring with respect to traditional IRAs and Roth IRAs. Substantial filing fees apply to use the rollover letter program ($500-$3,000). The IRS has adopted procedures for SEP-IRAs and SIMPLE-IRAs. For its own reasons the IRS has not been proactive in providing additional guidance on correcting IRA mistakes. The IRS seems to forget that IRAs hold 27% of retirement assets while pension plans hold 22%

The proposed law would be, as for pension plans, any inadvertent RMD error with respect to an IRA shall be able to be self-corrected, without the imposition of the 50% tax as long as the late distribution is distributed no more than 180-days after it was required to be made.

In addition the IRS is to amend its EPCRS program to provide that inadvertent IRA errors may be corrected as long as such errors were not the fault of the IRA owner. Some of the errors which may be corrected are those discussed below, but it is intended that additional errors may also be self-corrected.

There needs to be a waiver of the 60 day deadline for a rollover where the deadline is missed for reasons beyond the reasonable control of the accountholder.

A non-spouse beneficiary will be allowed to return a distribution from an inherited IRA if the distribution was caused by the inadvertent error of the IRA custodian which gave the beneficiary the reasonable belief he or she could rollover such distribution so that the distribution would not be taxable

New Joint Authority for the IRS and the DOL Regarding Prohibited Transactions Associated with IRAs and Pension Plans. Under current law the authority to grant exemptions for prohibited transactions related to pension plan and IRAs is held by the DOL.

The proposed law would give joint authority to the IRS and the DOL. The IRS and DOL would be required to issue joint rulings. This change would be effective as July 8, 2013.

The securities industry does not like how it is being treated by the DOL. The DOL has agreed to only offer a limited prohibited transaction exemption and the securities industry finds this unacceptable. The power of the DOL will be reduced.

Authorize an Employer to Substitute a Safe Harbor 401(k) Plan for a SIMPLE-IRA Plan. Under current law an employer sponsoring a SIMPLE-IRA plan is not allowed to terminate the plan before January 1 of the following year. An employer would be authorized to terminate the SIMPLE-IRA plan during the current year as long as the employer substitutes a safe harbor 401(k) plan as of the date of termination. A combined elective deferral limit would apply.

Authorize New Rollover to an IRA. Under current law, if a qualified plan holds on behalf of a participant a qualifying insurance contract, such contract is not eligible to be directly rolled over into a traditional IRA. The insurance contract either must be liquidated for cash or distributed to the individual in-kind. This law would be changed to allow the rollover or direct rollover of an insurance contract within a qualified plan into a traditional IRA even though the general rule is that IRA funds may not invest in life insurance contracts.

New Type of Deemed IRA. Current law authorizes funds within a 403(b) custodial account then the custodial account will become a deemed IRA with the financial institution holding the 403(b) assets as of the date of the termination. The deemed IRA will be created only if the financial institution holding the assets has demonstrated to the IRS that it is qualified to serve as a IRA trustee/custodian.

Required Distribution Rules Modified for IRAs, 403(b) and Defined Contribution Plans When a Deferred Annuity is Bought Prior to Age 70½. It is ironic. The IRS cannot be persuaded to voluntarily update the RMD tables so people will be allowed to take smaller RMDs, but the IRS and the DOL are enamored with the planning features of deferred annuities. The argument being made by insurance companies and people who sell annuities is that people are living longer. Therefore, to ensure they will have money when they are in their 80’s they should be able to reduce their RMDs when in their 70’s.

The RMD proposal would be that amount invested in a deferred annuity would not be counted as part of the IRA’s fair market value for the RMD calculating. In order to receive this treatment the following rules must be met.

1. Under such an annuity, payments are deferred past age 70½ but such payments must commence no later than the date the individual attains the age of 85
2. The annuity must be a commercial annuity, a single life annuity for the life of the individual, providing substantially equal periodic payments at least annually. Or the annuity may be a qualified joint and survivor annuity which is the actuarial equivalent of the singe life annuity
3. The annuity must be purchased on or before the individual’s required beginning date
4. The individual’s investment in the annuity cannot exceed 25% of the individual’s entire interest in all plans (defined contribution, IRA and 403(b)) determined as of the close of the calendar year preceding the calendar year in which the purchase occurs. A special rule applies if the individual dies before his or her required beginning date and he or she does not purchase a qualified deferred annuity and the designated beneficiary is his or her spouse. In this case, the surviving spouse may invest any portion of the entire interest (not 25%) in the same manner as the spouse who died, but the required beginning date and the deferral period will be based on the dates the deceased spouse would have attained age 70½ or 85.

The deferred annuity has features very similar to those found in a lifetime income investment. A lifetime income investment is to have a lifetime income feature. This means a feature that guarantees a minimum level of income at least annually for the remainder of the employee’s life (or the remainder of the employee’s life along with his or her designated beneficiary) or an annuity where the payments are made in substantially equal periodic payments over the employee’s life (or the remainder of the employee’s life along with his or her designated beneficiary).