Two Important New IRA Rules
Summer began with announcements of a couple of surprising changes about IRAs. These important rules should figure in your IRA planning.
First, the Supreme Court weighed in.
The background is that in 2005 the federal bankruptcy law was revised. One of the revisions eliminated a patchwork of state rules and made clear that IRAs and similar retirement accounts are protected assets in a bankruptcy. Creditors cannot be awarded these assets in a bankruptcy.
But the Supreme Court said the law is not as comprehensive as many thought. In the case, a married couple declared bankruptcy after their pizza shop failed. Their main asset was $300,000 in an IRA the wife inherited from her mother. They owed $700,000 to various creditors. The bankruptcy trustee sought to distribute the IRA to the creditors.
The Supreme Court ruled that an inherited IRA is not protected in the bankruptcy code. An inherited IRA differs from a personal IRA in ways that mean it isn’t a retirement asset. When an IRA is inherited, distributions must begin and can’t be delayed until retirement. The beneficiary isn’t allowed to make additional contributions and can take distributions at any time, including a distribution of the entire account. Because of the differences, an inherited IRA is not protected as a retirement account.
You might want to consider this ruling when naming beneficiaries of your IRAs. A child or grandchild who has financial problems or is in an occupation at high-risk from creditors (such as a surgeon) might not be an appropriate beneficiary of an IRA. You could leave that loved one off the beneficiary list for your IRA and let him inherit other assets. Or you could try naming a trust as beneficiary of the IRA instead. But the rules for naming trust as IRA beneficiaries are very restrictive. You want to receive good legal advice before trying it.
Some commentators have argued that the reasoning in the Supreme Court’s decision also could apply to rollover IRAs and some other IRAs. That is speculation, since the court ruled only on inherited IRAs, but the reasoning could be expanded to other types of IRAs.
Keep in mind that states can offer IRAs greater bankruptcy protection than the federal law, and some do. If the creditor protection of an IRA concerns you, check your state’s bankruptcy law or of the states in which your beneficiaries live.
Longevity Annuities in IRAs
In other IRA news, the Treasury Department issued final rules on longevity annuities in IRAs, 401(k)s, and similar accounts.
In a longevity annuity, or deferred income annuity, you deposit a lump sum with an insurer, usually when you are between ages 50 and 65. The insurer holds and invests the money in its own account for at least five years. You select the holding period, and it can be as late as when you turn 80 or 85, depending on the annuity. When the holding period ends, the insurer begins paying you a fixed income for the rest of your life. The annual payment is fixed when you make the initial deposit in the annuity.
A downside of a longevity annuity is that there is nothing for your heirs to inherit. Also, if you don’t live to the starting age, the insurer keeps the money. If you live only a few years after the starting age, the insurer comes out ahead. (Some longevity annuities offer riders that will provide something for a beneficiary in case of a premature death, but the cost is a lower annual payment for you.) The advantage is that you receive the promised annual amount no matter how long you live after the starting date. You have a steady stream of income you can’t outlive.
The problem until the new rules was how the annuities figured into required minimum distributions you must take after age 70½. It wasn’t clear how to compute an RMD when part of an IRA was invested in an annuity that wouldn’t begin payments until the future. Many people wouldn’t buy the annuities through IRAs because of the uncertainty, and many IRA sponsors wouldn’t allow them.
The new rules state that the longevity annuity needn’t be considered in RMD calculations if the annuity is no more than the lesser of 25% of the account’s value or $125,000 at the time of purchase. The non-annuity portion of the account is used to compute RMDs before the annuity start date. In addition, an annuity counts as a longevity annuity under the rules even if it returns premiums to a beneficiary as a death benefit. These rules don’t apply to variable annuities or to other types of annuities.
The new rules make longevity annuities a more attractive purchase through an IRA because they eliminate uncertainty and allow favorable RMD calculations. The three largest longevity annuity sellers, comprising 90% of the market, are New York Life, Massachusetts Mutual Life, and Northwestern Mutual Life, according to Limra.