Year-End Retirement Tax Changes

On Friday December 20, 2019 the President signed two spending bills, averting a government shutdown at midnight.

The reason we are talking about it is that there were several tax provisions included in the bills. Many if not most are as dry as sand, but there are a few that affect retirement accounts and are worth talking about.

Increase the Age for Minimum Required Distributions (MRDs)

We know that we are presently required to begin distributions from our IRAs when we reach age 70 ½. The same requirement applies to a 401(k), unless one continues working and is not an owner. Interestingly, Roths have no MRDs until they are inherited.

In a favorable change, the minimum age for MRDs has been increased to 72.

Repeal the Age Limitation for IRA Contributions

Presently you can contribute to your 401(k) or Roth past the age of 70 ½. You cannot, however, contribute to your IRA past age 70 ½.

In another favorable change, you will now be allowed to contribute to your IRA past age 70 ½.

COMMENT: Remember that you generally need income on which you paid social security taxes (either employee FICA or self-employment tax) in order to contribute to a retirement account, including an IRA. In short, this change applies if you are working past 70 ½.

New Exception to 10% Early Distribution Penalty

Beginning in 2020 you will be allowed to withdraw up to $5,000 from your 401(k) or IRA within one year after the birth or adoption of a child without incurring the early distribution penalty.

BTW, the exception applies to each spouse, so a married couple could withdraw up to $10,000 without penalty.

And the “within one year” language means you can withdraw in 2020 for a child born in 2019.

Remember however that the distribution will still be subject to regular income tax. The exception applies only to the penalty.

Limit the Ability to Stretch an IRA

Stretching begins with someone dying. That someone had a retirement account, and the account was transferred to a younger beneficiary.

Take someone in their 80s who passes away with $2 million in an IRA. They have 4 grandkids, none older than age 24. The IRA is divided into four parts, each going to one of the grandkids. The required distribution on the IRAs used to be based on the life expectancy of someone in their 80s; it is now based on someone in their 20s. That is the concept of “stretching” an IRA.

Die after December 31, 2019 and the maximum stretch (with some exceptions, such as for a surviving spouse) is now 10 years.

Folks, Congress had to “pay” for the other breaks somehow. Here is the somehow.

Annuity Information and Options Expanded

When you get your 401(k) statement presently, it shows your account balance. If the statement is snazzy, you might also get performance information over a period of years.

In the future, your 401(k) statements will provide “lifetime income disclosure requirements.”

Great. What does that mean?

It means that the statement will show how much money you could get if you used all the money in the 401(k) account to buy an annuity.

The IRS is being given some time to figure out what the above means, and then employers will have an extra year before having to provide the infinitely-better 401(k) statements to employees and participants.

By the way …

You will never guess this, but the law change also makes it easier for employers to offer annuities inside their 401(k) plans.

Here is the shocked face:

 Expand the Small Employer Retirement Plan Tax Credit

In case you work for a small employer who does not offer a retirement plan, you might want to mention the enhanced tax credit for establishing a retirement plan.

The old credit was a flat $500. It got almost no attention, as $500 just doesn’t move the needle.

The new credit is $250 per nonhighly-compensated employee, up to $5,000.

At $5 grand, maybe it is now worth looking at.

New Life Expectancy Tables For Your Retirement Account

On November 7, 2019 the IRS issued Proposed Regulations revising life expectancy tables used to calculate minimum required distributions from retirement plans, such as IRAs.

That strikes me as a good thing. The tables have not been revised since 2002.

There are three tables that one might use, depending upon one’s situation. Let’s go over them:

The Uniform Lifetime Table

This is the old reliable and the one most of us are likely to use.

 Joint Life and Last Survivor Expectancy Table

This is more specialized. This table is for a married couple where the age difference between the spouses is greater than 10 years.

The Single Life Expectancy Table

Do not be confused: this table has nothing to do with someone being single. This is the table for inherited retirement accounts.

Let’s take a look at a five-year period for the Uniform Lifetime Table:

Age	Old	New	Difference
71	26.5	28.2	1.7
72	25.6	27.3	1.7
73	24.7	26.4	1.7
74	23.8	25.5	1.7
75	22.9	24.6	1.7

If you had a million dollars in the account, the difference in your required minimum distribution at age 71 would be $2,275.

It is not overwhelming, but let’s remember that the difference is for every remaining year of one’s life.

As an aside, I recently came across an interesting statistic. Did you know that 4 out of 5 Americans receiving retirement distributions are taking more than the minimum amount? For those – the vast majority of recipients – this revision to the life expectancy tables will have no impact.

Let’s spend a moment talking about the third table - the Single Life Expectancy Table. You may know this topic as a “stretch” IRA.

A stretch IRA is not a unique or different kind of IRA. All it means is that the owner died, and the account has passed to a beneficiary. Since minimum distributions are based on life expectancy, this raises an interesting question: whose life expectancy?

COMMENT: There is a difference on whether a spouse or a non-spouse inherits. It also matters whether the decedent reached age 70 ½ or not. It is a thicket of rules and exceptions. For the following discussion, let us presume a non-spouse inherits and the decedent was over age 70 ½.

An easy way to solve this issue would be to continue the same life expectancy table as the original owner of the account. The problem here is that – if the beneficiary is young enough – one would run out of table.

So let’s reset the table. We will use the beneficiary’s life expectancy.

And there you have the Single Life Expectancy Table.

As well as the opportunity for a stretch. How? By using someone much younger than the deceased. Grandkids, for example.

Say that a 35-year old inherits an account. What is the difference between the old and new life expectancy tables?

                                Old             48.5

                                New            50.5

Hey, it’s better than nothing and – again – it repeats every year.

There is an odd thing about using this table, if you have ever worked with a stretch IRA. For a regular IRA – e.g., you taking distributions from your own IRA – you look at the table to get a factor for your age in the distribution year. You then divide that factor into the December 31 IRA balance for the year preceding the distribution year to arrive at the required minimum amount.

Point is: you look at the table every year.

The stretch does not do that.

You look at the table one time. Say you inherit at age 34.  Your required minimum distribution begins the following year (I am making an assumption here, but let’s roll with it), when you are age 35. The factor is 48.5. When you are age 36, you subtract one from the factor (48.5 – 1.0 = 47.5) and use that new number for purposes of the calculation. The following year you again subtract one (47.5 – 1.0 = 46.5), and so on.

Under the Proposed Regulation you are to refer to the (new) Single Life Expectancy Table for that first year, take the new factor and then subtract as many “ones” as necessary to get to the beneficiary’s current age. It is confusing, methinks.

There are public comment procedures for Proposed Regulations, so there is a possibility the IRS will change something before the Regulations go final. Final will be year 2021.

So for 2020 we will use the existing tables, and for 2021 we will be using the new tables.

IRS Notices And Waiting To The Last Minute

We have been fighting a penalty with the IRS for a while.

What set it up was quite bland.

We have a client. The business had cash flow issues, so both the owner and his wife took withdrawals from their 401(k) to put into the business.

They each took the same amount – say $100,000 for discussion purposes.

OK.

They did this twice.

Folks, if you want to confuse your tax preparer, this is a good way to do it.

At least they clued us that the second trip was the same as the first.

They told us nothing.

The preparer thought the forms had been issued in duplicate. It happens; I’ve seen it. Unfortunately, the partner thought the same.

Oh oh.

Eventually came the IRS notices.

I got it. The client owes tax. And interest.

And a big old penalty.

Here at CTG galactic command, yours truly seems to be the dropbox for almost all penalty notices we receive as a firm. In a way it is vote of confidence. In another way it is a pain.

I talked to the client, as I wanted to hear the story.

It is a common story: I do not know what all those forms mean. You guys know; that is why I use you.

Got it. However, we are not talking about forms; we are talking about events – like tapping into retirement accounts four times for the exact amount each time. Perhaps a heads up would have been in order.

But yeah, we should have asked why we had so many 1099s.

So now I am battling the penalty.

Far as I am concerned there is reasonable cause to abate. Perhaps that reasonable cause reflects poorly on us, but so be it. I have been at this for over three decades. Guess what? CPA firms make mistakes. Really. This profession can be an odd stew of technicality, endurance and mindreading.

However, the IRS likes to use the Boyle decision as a magic wand to refuse penalty abatement for taxpayer reliance on a tax professional.

Boyle is a Supreme Court case that differentiated reliance on a tax professional into two categories: crazy stuff, like whether a forward contract with an offshore disregarded entity holding Huffenpuffian cryptocurrency will trigger Subpart F income recognition; and more prosaic stuff, like extending the return on April 15th.

Boyle said the crazy stuff is eligible for abatement but the routine stuff is not. The Court reasoned that even a dummy could “check up” on the routine stuff if he/she wanted to.

Talk about a Rodney Dangerfield moment. No respect from that direction.

So I distinguish the client from Boyle. My argument? The client relied on us for … crazy stuff. Withdrawals can be rolled within 60 days. Loans are available from 401(k)s. Brokerages sometimes issue enough copies of Form 1099 to wallpaper a home office.

I was taking the issue through IRS penalty appeal.

The IRS interrupted the party by sending a statutory notice of deficiency, also known as the 90-day letter.

Class act, IRS.

And we have to act within 90 days, as the otherwise the presently proposed penalty becomes very much assessed. That means the IRS can shift the file over to Collections. Trust me, Collections is not going to abate anything. I would have to pull the case back to Appeals or Examination, and my options for pulling off that bright shiny dwindle mightily.

You have to file with the Tax Court within 90 days. Make it 91 and you are out of luck.

I am looking at a case where someone used a private postage label from Endicia.com when filing with the Tax Court. She responded on the last day, which is to say on the 90^th day. Then she dropped the envelope off at the post office, which date stamped it the following day.

I get it.

That envelope has an Endicia.com postmark. Then it has a U.S. Postal Service postmark dated the following day.

Then there is another USPS postmark 13 days later.

And the envelope does not get delivered until 20 days after the date on the Endicia.com label.

Who knows what happened here.

But there are rules with the Tax Court. One is allowed to use a delivery service or a postmark other than the U.S. Post Office. If the mail has both, however, the USPS postmark trumps.

In this case, the USPS postmark was dated on the 91^st day. 

You are allowed 90.

She never got to Tax Court. Her petition was not timely mailed.

Sheeeessshhh.

BTW always use certified mail when dealing with time-sensitive issues like this. In fact, it is not a bad idea to use certified mail for any communication with the IRS.

And - please - never wait to the last day.

Rolling Over An Inherited IRA

I am not a fan of the 60-day IRA rollover.

I admit that my response is colored by being the tax guy cleaning-up when something goes awry. Unless the administrator just refuses a trustee-to-trustee rollover, I am hard pressed to come up with a persuasive reason why someone should receive a check during a rollover.

Let’s go over a case. I want you to guess whether the rollover did or did not work.

Taxpayer’s mom died in 2008.

Mom had two IRAs. She left them to her daughter, who received two checks: one for $2,828 and a second for $35,358.

The daughter rolled over $35,358 and kept the smaller check.

On her tax return, she reported gross IRA distributions of $38,194 (there is a small difference; I do not know why) and taxable distributions of $2,828.

She did not have an early distribution penalty, as that penalty does not apply to inherited accounts.

The IRS flagged her, saying that the full $38,194 was taxable.

What do you think?

Let’s go over it.

There is no question she was well within the 60-day period.

The money went into an IRA account. This is not a case where monies erroneously went into something other than an IRA.

This was the daughter’s only rollover, so we are not triggering the rule where one can only roll IRA monies in this manner once every twelve months.

The Court decided that the daughter was taxable on the full amount.

Why?

She ran face-first into a sub-rule: one cannot rollover an inherited account, with the exception of a surviving spouse.

The daughter argued that she intended to roll and also substantially complied with the rollover rules.

Here is the Tax Court:

The Code’s lines are arbitrary. Congress has concluded that some lines of this kind are appropriate. The judiciary is not authorized to redraw the boundaries.”

This is a polite way of saying that tax rules sometimes make no sense. They just are. The Tax Court, not being a court of equity, cannot decide a case just because a result might be viewed as unfair.

The Court did not address the point, but there is one more issue at play here.

There are penalties for overfunding an IRA.

Say that you can put away $6,500. You instead put away $10,000. You have overfunded by $3,500.

So what?

You have to get the excess money out of there, that’s what.

Normally I recommend that the $3,500 be moved as a contribution to the following year, nixing the penalty issue.

Let’s say that you do not do that. In fact, you do not even know to do that.

For whatever reason, the IRS examines your return five years later. Say they catch the issue. You now owe a 6% penalty on the overfunding.

That’s not bad, you think. You will pay $210 and move on.

Nope.

It is 6% a year.

And you still have to get the $3,500 out.

Except it is now not $3,500. It is $3,500 plus any earnings thereon for five years.

Say that amount is $5,500, including earnings.

You take out $5,500.

You have five years of 6% penalties. You also have tax on $2,000 (that is, $5,500 minus $3,500).

If you are under 59 ½ you probably have an early-distribution penalty on the $2,000.

Plus penalties and interest on top of that.

I like to think that the Tax Court cut the taxpayer a break by not spotlighting the overfunding penalty issue.

Our case this time was Beech v Commissioner.

Deducting a Divorce

I am looking at two points on a case:

(1)  The IRS wanted $1,760,709; and

(2)  The only issue before the Court was a deduction for legal and professional fees.

That is one serious legal bill.

The taxpayer was a hedge fund manager. The firm had three partners who provided investment advisory services to several funds. For this they received 1.5% of assets under management as well as 20% of the profits (that is, the “carry”). The firm decided to defer payment of the investment and performance fees from a particular fund for 2006, 2007 and 2008.

2008 brought us the Great Recession and taxpayer’s spouse filing for divorce.

By 2009 the firm was liquidating.

The divorce was granted in 2011.

Between the date of filing and the date the divorce was granted, taxpayer received over $47 million in partnership distributions from the firm.

You know that point came up during divorce negotiations.

To be fair, not all of the $47 million can be at play. Seems to me the only reachable part would be the amount “accrued” as of the date of divorce filing.

He hired lawyers. He hired a valuation expert.

Turns out that approximately $4.7 million of the $47 million represented deferred compensation and was therefore a marital asset. That put the marital estate at slightly over $15 million.

Upon division, the former spouse received a Florida house and over $6.6 million in cash.

He in turn paid approximately $3 million in professional fees. Seems expensive, but they helped keep over $42 million out of the marital estate.

He deducted the $3 million.

Which the IRS bounced.

What do you think is going on here?

The issue is whether the professional fees are business related (in which case they are deductible) or personal (in which case they are not). Taxpayer argued that the fees were deductible because he was defending a claim against his distributions and deferred compensation from the hedge fund. He was a virtual poster boy for a business purpose.

He has a point.

The IRS fired back: except for her marriage to taxpayer, the spouse would have no claim to the deferred compensation. Her claim stemmed entirely because of her marriage to him. The cause of those professional fees was the marriage, which is about as personal as an event can be. The tax Code does not allow for the deduction of personal expenses.

The IRS has a point.

The tax doctrine the IRS argued is called origin-of-the-claim. It has many permutations, but the point is to identify what caused the mess in the first place. If the cause was business or income-producing, you may have a deduction. If the cause was personal, well, thanks for playing.

But a divorce can have a business component. For example, there is a tax case involving control over a dividend-paying corporation; there is another where the soon-to-be-ex kept interfering in the business. In those cases, the fees were deductible, as there was enough linkage to the business activity.

The Court looked, but it could not find similar linkage in this case.

In the divorce action at issue, petitioner was neither pursuing alimony from Ms [ ] nor resisting an attempt to interfere with his ongoing business activities.

Petitioner has not established that Ms [ ] claim related to the winding down of [the hedge fund]. Nor has petitioner established that the fees he incurred were “ordinary and necessary” to his trade or business.

While the hedge fund fueled the cash flow, the divorce action did not otherwise involve the fund. There was no challenge to his interest in the fund; he was not defending against improper interference in fund operations; there was no showing that her action led to his winding down of the fund.

Finding no business link, the Court determined that the origin of the claim was personal.

Meaning no deduction for the professional fees.

NOTE: While this case did not involve alimony, let us point out that the taxation of alimony is changing in 2019. For many years, alimony – as long as the magic tax words were in the agreement – was deductible by the payor and taxable to the recipient. It has been that way for my entire professional career, but that is changing. Beginning in 2019, only grandfathered alimony agreements will be deductible/taxable, with “grandfathered” meaning the alimony agreement was in place by December 31, 2018.

Mind you, this does not mean that there will be no alimony for new divorces. What it does mean is that one will not get a deduction for paying alimony if one divorces in 2019 or later. Conversely, one will not be taxed upon receiving alimony if one divorces in 2019 or later.

The Congressional committee reports accompanying the tax change noted that alimony is frequently paid from a higher-income to a lower -income taxpayer, resulting in a net loss to the Treasury. Changing the tax treatment would allow the Treasury to claw back to the payor’s higher tax rate. Possible, but I suspect it more likely that alimony payments will eventually decrease by approximately 35% - the maximum federal tax rate – as folks adjust to the new law.

Our case this time was Sky M Lucas v Commissioner.

Blowing Up An IRA

I am not a fan of using retirement funds to address day-to-day financial stresses.

That is not to downplay financial stresses; it is instead to point out that using retirement funds too easily can open yet another set of problems.

Those who have followed me for a while know that I disapprove of using retirement funds to start a business: the so-called Rollovers as Business Startups, whose humorous acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate the tax risks that ROBS pose. I do not however practice in a seminar setting. Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting ready to do.

Let me give you a couple of ROBS pitfalls:

(1) You have your IRA buy a fourplex. You spend time cleaning, doing maintenance and repairs and routinely running to Home Depot.

Question: Is there a tax risk here?

(2) You have your IRA buy a business. You have your son and daughter run the business. You work there part-time and draw a paycheck.

Question: Is there a tax risk here?

The answer to both is yes. Consider:

(1) You are buying stuff at Home Depot, stuff that the IRA should have been buying - as the IRA owns the fourplex, not you. If you are over age 50, you can contribute $6,500 to the IRA annually. Say that you have already written that check for the year. You are now overfunding the IRA every time you go to Home Depot. Granted, one trip is not a big deal, but make routine trips – or incur a major repair – and the facts change. That triggers a 6% penalty – every year - until you take the money back out.

(2) There are restrictions on direct and indirect benefits from an IRA. You are receiving a paycheck from an asset the IRA owns. While arguable, I am confident that your paycheck is a prohibited benefit.

I am looking a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005. A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps the custodian could not transfer the promissory notes. Perhaps there were no notes. Perhaps the custodian realized that a loan to one’s dad is not allowed. This part of the case is not clear.

COMMENT: It is possible to have an IRA lend money. I have a client who does so on a regular basis. Think however of acting like a bank, with due diligence, promissory notes, periodic interest and lending to nonrelated independent third-parties.

The IRS saw easy money:

(1)  There was a taxable distribution in 2013;

(2)  … and a 10% penalty for early distribution;

(3)  … and the “substantial understatement” penalty because the tax numbers changed enough to rise to the level of “substantial.”

How do you think it turned out for our tax protagonist?

Go back to the dates.

She loaned money to her dad in 2005.

Let’s glance over IRC Section 408(e)(2)

 (2)  Loss of exemption of account where employee engages in prohibited transaction.

(A)  In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.

The loan was a prohibited transaction. She blew up her IRA as of January 1, 2005. This means that she should have reported ALL of her IRA as taxable income in 2005, of which we can be quite sure she did not.

Can the IRS assess taxes for 2005?

Nope. Too many years have gone by. The standard statute of limitations for assessments is three years.

So, the IRS will tag her in 2013, right?

Nope, they cannot. For one thing, the prohibited transaction did not occur in 2013, and the IRS is not allowed to time-travel just because it serves their purpose.

But there is a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that” would require the existence of an IRA.

And there was no IRA.

The name of the case for the home gamers is Marks v Commissioner.

When Your Employer Bungles Your Retirement Plan Loan

I admit that I am not a fan of borrowing from an employer retirement plan, except perhaps as a next-to-last step before being evicted.

Things go wrong.

Lose your job, for example, and not only are you looking for work but you also have a tax bill on a loan you cannot pay back.

You do not even have to lose your job.

Ms. Frias participated in her company’s retirement plan. She was getting ready to go on maternity leave when she borrowed $40,000 from her 401(k). Her employer was to withhold from her paycheck (to be paid biweekly), and there was a make-up provision allowing her to correct any shortfall by the end of the following month.

COMMENT: Retirement plan proceeds are normally tax-free if repaid over a period of five years or less.

She went on leave on or around August 1^st.  She was drawing on her accumulated vacation and sick time.  Sounds pretty routine.

She returned to work October 12th.

In November, she learned that her employer had failed to withhold any monies for her 401(k) loan.

She immediately wrote a $1,000 check and increased her withholding to get caught-up.

Nonetheless, at the end of the year the plan administrator (Mutual of America Life) sent her a $40,000 Form 1099R on the loan.

They however sent it to her electronically. Having no reason to expect one, she did not realize that she had even received a 1099. Goes without saying it was not on her tax return.

You know the IRS matched this up and sent her a notice.

What do you think: does she have a tax issue?

No question her employer messed up.

And that she tried to correct it.

However, the law is strict:

Although a loan may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements … of this section are not satisfied, in form or operation.”

Her first payment was due in August, the month following the loan. If she had a deemed distribution, it would have occurred then. A distribution – even a “deemed” one – would be taxable.

There remained hope, though:

The plan administrator may provide the plan participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period.”

This is a nice safety valve. If the employer gives you a “cure” period, you can still avoid having the fail and its associated tax.

What was her cure period?

The end of the following month: September.

When did she write a check?

November, when she realized that there was a problem.

Too late.

She had one last long shot: a “leave of absence” exception.

Which is Code section 72(p)(2)(C), and it provides for interruption in a loan repayment schedule if one is not drawing a paycheck or not drawing enough to meet the minimum loan payment.

Her argument? She was not receiving her “regular” paycheck. She instead was drawing on her vacation and sick time bank.

Problem: she nonetheless received a check, and the Court was unwilling to part-and-parcel its source. She was collecting enough to make the loan payments.

She was hosed.

She did nothing wrong, but her employer’s negligence cost her somewhere near $15 grand in unnecessary taxes.