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Dec 1993

Beyond deduction and deferral: the downside of IRAs. (individual retirement accounts)

by Deppe, E. DeVon

    Abstract- Individual retirement accounts (IRAs) are potentially troublesome investment vehicles for taxpayers right from the initial contribution stage to the final distribution phase. During the contribution phase, there is no guarantee that the level of deductibility of contributions that the taxpayer had originally hoped for will be met. A non-deductible penalty tax for excessive IRA contribution is also a drawback during this phase. On the other hand, the early withdrawal stage is beset with such difficulties as non-deductible 10% early-withdrawal penalty and inability to borrow funds from the IRA or to use it as a security for a loan. During the normal withdrawal phase, a slew of problems may also fester taxpayers. These include their non-assignment to a lower tax bracket and unfavorable tax treatment which is only given to employer-sponsored qualified plans. Even after death, estate taxation of IRAs could be a nuisance for heirs. The best solution is to simply avoid IRAs.

The individual retirement account (IRA) has been a popular investment vehicle for retirement savings since 1974 when it was created by Congress. Its use increased after 1981 when the eligibility rules were relaxed allowing all individuals with earned income to contribute to IRAs even if they were covered by an employer-sponsored retirement plan. The attractiveness of IRAs was reduced in 1986 when changes restricted the ability of taxpayers with higher incomes and employer plans to deduct IRA contributions on their tax returns.

The popularity of IRAs has primarily been due to the attraction of the front-end tax deduction for contributions combined with the deferral of taxation on earnings. This dual advantage has been widely touted over the years in articles relating to tax and retirement planning. From time to time, some of the disadvantages of IRAs have been discussed as well, but explanations of the disadvantages tend to be somewhat piecemeal. Furthermore, since the advantages of IRAs begin to take effect as soon as contributions are made while the disadvantages pertain mostly to distant events, the disadvantages may not appear as serious as they are.

Contribution Phase

Taxpayers may encounter three disadvantages during the contribution phase. The first has to do with the deductibility of contributions. All individual taxpayers with earned income can make annual contributions to an IRA, but only those who are not active participants in an employer- sponsored retirement plan can deduct the full amount of their contributions. For taxpayers covered by an employer plan, the IRA deduction is phased out as adjusted gross income increases from $25,000 to $35,000 for single filers, or from $40,000 to $50,000 for joint filers. Above the $35,000 and $50,000 adjusted gross income limits, no deduction is allowed for IRA contributions by taxpayers covered by an employer's qualified retirement plan.

What was once one of the easiest tax deductions to compute before the TRA 86, now may require a worksheet for computation. No other qualified retirement plan, with the possible exception of the HR 10 or Keogh plan for the self-employed, places this kind of initial burden on the taxpayer.

The second contribution-phase disadvantage also has to do with the question of deductibility. Since the determination of deductibility of IRA contributions is initially the responsibility of the taxpayer, the taxpayer must keep records to substantiate and distinguish between deductible and non-deductible contributions. These records must be kept throughout the entire contribution and withdrawal period. Furthermore, the taxpayer must file Form 8606 to report a non-deductible IRA contribution for each tax year a contribution is made, regardless of whether a tax return is filed. No other qualified plan has this requirement.

The third contribution-phase disadvantage is a non-deductible penalty tax for making a contribution to an IRA in excess of earned income or the $2,000 limit ($2,250 if the taxpayer has a non-employed spouse). The penalty tax is equal to 6% of the excess contribution or 6% of the IRA's value at the end of the tax year, whichever is less.

The penalty tax can be avoided by withdrawing the excess amount and any earnings on it from the IRA before the tax return due date, including extensions. Of the other qualified retirement plans available, only simplified employee pensions (SEPS), which are actually IRAs as well, and certain annuity contracts purchased by charitable organizations and public schools for their employees, are subject to this same 6% penalty tax.

Early Withdrawal Phase

The early withdrawal phase refers to the period of time after the initial IRA contribution is made and before the taxpayer reaches the age of 59 1/2. Withdrawals made during this phase from any qualified retirement plan, including IRAs, are subject to a non-deductible 10% early withdrawal penalty. This is in addition to the regular income tax that must be paid whenever there are withdrawals from qualified plans. It should be noted however, that the new 20% withholding rule effective with respect to distributions from plans made after December 31, 1992, do not apply to distributions from IRAs.

Early withdrawals from all qualified plans are exempted from the penalty in the case of death or disability of the taxpayer. There is also an exception for all qualified plans where early withdrawals are taken in substantially equal amounts over the life or life expectancy of the taxpayer or the taxpayer and his or her beneficiary. This exception, which may be referred to as annuitization of the plan, will be treated further when solutions to the problems of IRAs are discussed.

An IRA is not at a disadvantage when compared to other qualified plans with respect to the early withdrawal penalty exceptions. Nevertheless, three additional exceptions to the penalty apply to early withdrawals from qualified plans except IRAs. The first is for early separation from service. If a taxpayer's service with an terminates before he or she has reached age 59 1/2, but after reaching age 55, withdrawals from the qualified plan associated with the taxpayer's employment are not subject to the 10% penalty. The second exception relates to non-IRA early withdrawals used to pay for tax-deductible medical expenses. Finally, a court-ordered transfer of qualified retirement plan funds to a spouse or former spouse as part of a separation or divorce is not subject to the early withdrawal penalty, except in the case of a transferring of an IRA.

A second disadvantage of having an IRA during the early withdrawal phase is the inability to borrow funds from the IRA or even to pledge the IRA as security for a loan without being penalized. Borrowing from or pledging an IRA is a prohibited transaction that results in some or all of the IRA balance being treated as a withdrawal.

If any amount is borrowed from an IRA, the entire IRA balance is treated as though it were distributed to the taxpayer. If a portion of an IRA balance is pledged as security for a loan, the pledged amount is treated as a distribution to the taxpayer. The deemed withdrawal is subject to the early withdrawal penalty tax and the regular income tax. This rule applies to other qualified plans but there are some such plans for which loan and pledging transactions are not prohibited.

Normal Withdrawal Phase

The normal withdrawal phase begins after the taxpayer has reached age 59 1/2, and extends until the IRA is depleted or the taxpayer dies. Normal withdrawals do not have to begin at 59 1/2, but must begin shortly after age 70 1/2 to avoid penalties.

One assumption often made about this phase of an IRA is that the taxpayer will be in a lower tax bracket. If that happens, withdrawals will be taxed at a lower rate than the rate at which deductions for contributions were taken and the tax deferral feature will be enhanced. There is sufficient reason, however, to believe many taxpayers will not be in a lower tax bracket during this phase, or will not pay less tax on their total income even if they remain in the same bracket.

With TRA 86, the highest marginal Federal income tax rate for individual taxpayers dropped from 50% to 28%, and is now at 31%. Marginal tax rates have not been lower since before World War II. It seems very likely the top bracket rate will increase in the future.

Even if tax rates do not change, another assumption often made is that a taxpayer will receive less taxable income during retirement and will be taxed in the lower 15% bracket. For most owners of IRAs, this scenario will not be the case. IRA owners are likely to have other sources of retirement income including employer-sponsored retirement plans, investments that are not tax advantaged, and Social Security. In addition, many taxpayers do not really retire or fully retire until well past the age of 65.

Other factors may result in a taxpayer paying more taxes on the same amount of income during the normal withdrawal phase than he or she would today. Most taxpayers will no longer have dependent children or mortgages to pay off during this period. Without the personal exemptions for children and interest deductions for mortgage payments, additional taxes will be paid each year. Furthermore, many taxpayers who are presently married may find themselves single because of a spouse's death or divorce. Because the 28% tax bracket begins at a lower amount of taxable income for single taxpayers, the effective tax rate is higher for these taxpayers compared to married taxpayers.

A second problem during this phase awaits IRA owners who made both deductible and non-deductible contributions during the contribution phase. Although a taxpayer may set up more than one IRA account to suit his or her needs during the contribution phase, the IRS treats all accounts as one when withdrawals are made. For any tax year in which withdrawals are made, a ratio must be computed to determine what portion of the withdrawals will be treated as nontaxable returns of non- deductible contributions. This is required even if the taxpayer is able to trace withdrawals to either deductible or non-deductible contributions. The ratio formula is more complex than that required for withdrawals from other qualified plans in the form of annuities and in which the taxpayer has made after-tax contributions. Furthermore, the IRA ratio must be recomputed in each subsequent withdrawal year, whereas the ratio or specific non-taxable amount computed under other qualified plans remains constant until all nondeductible contributions have been returned.

A third disadvantage of IRAs in the normal withdrawal period is they are not permitted the favorable tax treatment for lump-sum distributions given employer-sponsored qualified plans. If a lump-sum distribution is made from one of the latter, the recipient may elect to calculate a separate tax on the amount received by using a five-year averaging method. In the case of a lump-sum withdrawal from an IRA, the entire withdrawal (except for nondeductible contributions) is taxed at the recipient's highest marginal tax rate.

There is another disadvantage for taxpayers who have accumulated large amounts in IRAs or who have large amounts in qualified retirement plans in the aggregate. During the normal withdrawal period, there is an annual aggregate qualified plan distribution limit per taxpayer. The limit is the greater of $150,000 or a threshold amount that is adjusted annually for inflation and is currently less than $150,000. If the aggregate amount withdrawn from all qualified plans of a taxpayer in a single taxable year exceeds this limit, a 15% excise tax is imposed on the excess amount. Because this excise tax is in addition to the regular income tax, it is possible for the tax-deferral advantage during the contribution phase to be eliminated for some taxpayers.

The final problem with normal IRA distributions is another excise tax. Again, it is one to which all qualified retirement plans are subject, but that does not apply to nonqualified plan alternatives that may be available to the taxpayer. Once the taxpayer has reached the age of 70 1/2, the tax law requires a minimum amount be distributed from a qualified retirement plan each year. The amount is determined according to a formula that may vary from plan to plan depending upon beneficiary terms. To the extent that withdrawals during a year are less than the required minimum, a 50% excise tax is levied on the difference. Unlike the 15% tax previously mentioned, the 50% tax applies on a plan basis rather than an individual taxpayer basis. For employer-sponsored plans, or those controlled by someone other than the taxpayer, distributions will likely be calculated to avoid this penalty. In the case of IRAs, however, it is up to the taxpayer to make the necessary calculations to avoid the tax.

Estate Phase

The disadvantages of IRAs as retirement funding vehicles do not end on the death of the IRA holder. There are a few problems that extend beyond death to the taxpayer's estate or heirs.

IRAs, along with other qualified retirement plan balances, are includable in the gross estate of a deceased taxpayer and are subject to the estate tax. As estates under $600,000 and transfers to surviving spouses are not subject to estate taxation, this may not be a problem for many taxpayers. However estate taxes can substantially reduce the balance left in the IRA at death for those estates subject to it.

IRAs and other qualified retirement plans are distinctly inferior to most other estate assets in that distributions from them to a taxpayer's estate or heirs are considered to be income in respect of a decedent. Thus, such distributions are taxable income to the estate or heirs, just as they would have been if they had been received by the deceased taxpayer. If an IRA is subject to estate taxes and income taxes, the balance can virtually be decimated, even after taking advantage of the income tax credit for estate taxes paid.

Finally, large IRA balances that remain unused at a taxpayer's death are subject to a 15% excise tax much like the 15% tax on excess distributions. Other qualified retirement plan balances are also subject to this penalty. There is no fixed dollar amount above which the tax applies. Rather, a threshold amount is calculated as the present value of a $150,000 annuity using the decedent taxpayer's life expectancy at the time of death and IRS tables. If the actual IRA balance exceeds the threshold amount, the 15% tax is applied against the excess.

IRA Alternatives

Perhaps the simplest solution to the many problems and disadvantages of IRAs is to consider avoiding them altogether in favor of less restrictive qualified retirement plans or even nonqualified savings and investment alternatives. In the case of a taxpayer who is accumulating a sizable retirement fund through an employer-sponsored qualified plan, an IRA may be far more trouble than it's worth. Although an IRA gives the taxpayer more investment flexibility and control than other retirement plans, it is probably the most inflexible and restrictive in every other aspect. Investment vehicles such as mutual funds and real estate may appear less attractive during the accumulation years, but they may present far fewer obstacles in the distribution years.

For taxpayers who already have IRAs, it may be wise to stop making contributions to them and invest elsewhere. This is especially true only if nondeductible contributions may be made. Even if the appeal of tax deferrals is too great for a taxpayer to resist, non-tax-deferred investments, discretionary contributions to an employer-sponsored 401(k) plan, or purchases of tax-deferred annuities may result in fewer headaches down the road.

Annuitization for Short Term Needs

If an IRA is not a taxpayer's primary source of future retirement funds, occasions may arise before age 59 1/2 or retirement, where the short- term need for funds for other purposes outweighs the desire to supplement retirement savings through an IRA. As previously discussed, there is a 10% penalty tax for easy withdrawals from an IRA, and the rules for IRAs do not include as many exceptions to this penalty as other qualified plans. Fortunately, the annuitization exception to the penalty, which does extend to IRAs, can be used to mitigate this situation.

The IRS permits three methods of calculating the annuity amount a taxpayer can withdraw from an IRA at least annually without incurring the early withdrawal penalty. The only substantial restriction on this exception is that the annuity-like withdrawals must continue for at least five years or until the taxpayer reaches age 59 1/2, whichever comes first. Of course, the withdrawal is still subject to the regular income tax. The amount that can be withdrawn each year if an IRA is annuitized can vary dramatically from less than $1,000 to more than $100,000, depending upon the size of the IRA, the life expectancy of the taxpayer, and the interest rate used to calculate the annuity amount.

IRAs with modest balances could not provide very large annuity amounts, but might nevertheless be able to provide needed funds for medical purposes, children's educations, home improvements, or to reduce the burden of debt payments until the short-term need passes or the taxpayer reaches 59 1/2. The fact that approximately the same amount has to be withdrawn from the IRA each year for up to five years can be inconvenient, since the amount withdrawn according to an annuity calculation probably would not match the amount of the short-term need. However, in the case of a taxpayer with sufficiently low adjusted gross income, any amount withdrawn but not needed in a particular year could be recontributed to the IRA or contributed to another IRA for the same tax year to avoid taxation of the unused amount.

Taxpayers with larger IRAs could also annuitize them to meet the short- term needs mentioned above, but have other short-term opportunities as well. During the recent recession, many taxpayers passed middle-age but not ready for retirement lost their jobs. Some of these may have large IRA accounts, perhaps because of rollovers from employer plans. By annuitizing their IRAs, taxpayers in such situations can provide themselves with a substantial income until another job can be found or until age 59 1/2 when the early withdrawal penalty no longer applies.

Other taxpayers with sizable IRAs may have reached age 55 and desire to retire early, taking advantage of the one-time exclusion for gain on the sale of a residence and the ability to withdraw funds from many employer-sponsored qualified plans after age 55 without an early withdrawal penalty. By using the annuitization exception, these taxpayers can use their IRAs for part of their retirement income at 55 instead of waiting the additional four and one-half years.

Annuitization for Long-Term Needs

Taxpayers without special short-term needs should project the status of their IRAs during retirement and beyond. Individuals should consider the possibility their IRAs may be subject to the 15% excise taxes on either excess withdrawals or balances included in a decedent's gross estate, as well as the estate tax and the rules concerning income in respect of a decedent. Only taxpayers with very large accumulations in their IRAs need to concern themselves with all of these possibilities. But even a modest IRA may be taxed unnecessarily under the 15% tax on excess withdrawals (if the taxpayer makes sufficiently large withdrawals from other qualified plans) or the estate-related taxes (if the rest of the estate is sufficiently large or passes to a non-spouse beneficiary).

One way to avoid these additional taxes on an IRA is to use the annuitization exception to the early withdrawal penalty to gradually reduce or eliminate the IRA balance and reinvest the withdrawals in another long-term retirement and estate planning vehicle. An increasingly attractive alternative for many taxpayers is a universal life or variable universal life insurance policy. Annual withdrawals from a large IRA can be sufficient to purchase sizable death benefits and accumulate retirement funds within such policies at the same time. After seven years of premium payments, policyholders are able to obtain zero or low net cost loans against the cash surrender value of these policies without the penalties and inflexibilities of early IRA withdrawals. When the funds accumulated in the insurance policy are needed for retirement, they can be paid out under various options that are no more restrictive than any qualified retirement plan. While a regular universal life policy may not earn a return as great as some IRA investments, variable universal life policies offer a greater variety of investment vehicles from which to choose.

At the policyholder's death, the insurance proceeds would be included in his or her estate for estate tax purposes, but would neither be subject to the 15% excise tax nor be treated as income in respect of a decedent as an IRA would. If the owner and beneficiary of the insurance policy is someone other than the decedent taxpayer, the insurance proceeds would escape estate taxation in most cases as well.

With careful planning, a married taxpayer could use the cash surrender value as needed during retirement for his or her own needs, while passing the remaining cash value and death benefit to heirs without the burden of the 15% excise tax, the regular estate tax, or the regular income tax. This could be accomplished by making the spouse the owner of the policy during the taxpayer's life. In this manner, the spouse could borrow against the policy or withdraw the cash surrender value during retirement without running the risk of the taxpayer owning the policy at death.

Kevin H. McBeth, PhD, Ronald M. Mano, PhD, and E. DeVon Deppe, JD, are all professors of Accounting at Weber State University, Ogden, Utah.

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