INDIVIDUAL RETIREMENT ARRANGEMENTS

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1 Insights on... WEALTH PLANNING INDIVIDUAL RETIREMENT ARRANGEMENTS Maximizing the Benefits and Avoiding the Pitfalls of IRAs Mairav Rothstein Senior Tax Counsel Wealth Advisory Services April 2017 Saving for retirement is a high priority for successful financial wealth planning, a consideration that grows more important as our longevity increases. The Employee Retirement Income Security Act of 1974 (commonly known as ERISA) created individual retirement arrangements or IRAs as a mechanism for employees to control their retirement savings independent of employer managed pensions and defined contribution plans, by funding and maintaining personal retirement accounts. When ERISA was enacted in 1974, the maximum annual contribution was $1,500 (just under $7,400 in today s dollars) and limited to 15% of the employee s earned income. The law has since changed and expanded to include Roth IRAs, SEP and SIMPLE IRAs, as well as catch-up contributions and qualified charitable distributions, but the guiding principle remains the same. As an inducement to save for retirement, IRAs offer tax free growth to the employee who complies with the associated restrictions on investments and distributions. The employee who contributes to a traditional IRA also exchanges preferred rates of taxation for tax deferral, as distributions are taxed at ordinary rates, regardless of the nature of the underlying income. Finally, upon reaching retirement age, the employee must begin taking annual required minimum distributions or RMDs from a traditional IRA (but not from a Roth IRA). RMDs are structured to stretch the account s savings over the employee s lifetime, while preventing perpetual accumulation of tax deferred investments. 1 To encourage strict compliance with these restrictions, the Internal Revenue Code (Code) imposes significant penalties on the IRA owner who does not follow all of the rules. This Insights highlights key requirements to help you get the most out of your IRAs. As a reminder, financial and tax planning should take into account both tax and non-tax considerations and involve financial, legal and tax advisors familiar with your particular circumstances, able to add perspective and guidance throughout the planning process. THE LIFE CYCLE OF AN IRA An IRA has a lifecycle comprised of three distinct phases. In the first, or accumulation phase, the employee makes contributions to the IRA and invests the assets to maximize earnings, free from income taxation. During the second, or distribution phase, the employee withdraws funds from the IRA, taking special care to timely receive RMDs from traditional IRAs. During life, the beneficial interest in an IRA can be transferred to another person only pursuant to a court ordered marital settlement agreement relating to the parties separation or divorce. Thus, the transfer phase typically occurs when the IRA owner dies and leaves the IRA to designated beneficiaries. ACCUMULATION Contributions Until the year in which s/he reaches age 70 ½, a taxpayer may contribute to an IRA the lesser of (i) the maximum IRA contribution amount, or (ii) earned income for the year, on or before the April due date for the personal income tax return for that year. Thus, a 1 At least for lower income employees, Roth IRAs provide even greater tax benefits than traditional IRAs because qualified distributions are tax-free, and RMDs do not begin until after the IRA owner s death. northerntrust.com Insights on...wealth Planning 1 of 8

2 taxpayer whose 2016 wages exceeded the maximum IRA contribution of $5,500 could contribute that amount on or before April 18, The deadline for contributions based on 2017 wages is April 17, Under the catch-up contribution rules, an employee who reached age 50 during the year may begin making an additional annual contribution of $1,000. (Although the $1,000 IRA catch-up contribution amount is not subject to inflation adjustment, the base funding amount is adjusted at $500 increments; the 2017 maximum base amount remains $5,500.) Although taxpayers whose modified adjusted gross income, or AGI, falls below inflation adjusted thresholds are eligible to contribute to both a traditional IRA and a Roth IRA, total annual employee contributions to IRAs cannot exceed these maximum amounts. As noted above, an employee is permitted to make a Roth IRA contribution only if his/her modified AGI does not exceed inflation adjusted limits, as described in the following chart. Roth IRA Modified AGI Limits Filing Status Year Modified AGI Contribution Amount Married filing jointly or 2016 less than $184,000 $5,500 (plus $1,000) Qualifying widow(er) between $184,000 and reduced amount $194,000 more than $194,000 $ less than $186,000 $5,500 (plus $1,000) between $186,000 and reduced amount $196,000 more than $196,000 $0 Married filing separately 2016 & less than $10,000 reduced amount Single, Head of household, or Married filing separately (if not living together during the year) 2017 $10,000 or more $ less than $117,000 $5,500 (plus $1,000) between $117,000 and reduced amount $132,000 more than $132,000 $ less than $118,000 $5,500 (plus $1,000) between $118,000 and reduced amount $133,000 more than $133,000 $0 Because qualified Roth IRA distributions are completely tax free, contributions to a Roth IRA must be made with after-tax dollars. By contrast, because traditional IRA distributions are subject to tax, certain taxpayers may take an unlimited tax deduction for contributions to a traditional IRA. Under these rules, taxpayers who cannot benefit from participation in an employer retirement plan (either personally or through his/her spouse) may make pre-tax contributions to a traditional IRA, regardless of their modified AGI. The deduction for contributions by taxpayers who are eligible to participate in an employer funded retirement plan may be reduced or disallowed, depending on his/her modified AGI, as described in the following chart. northerntrust.com Insights on...wealth Planning 2 of 8

3 Tax Deductible IRA Contribution Modified AGI Limits Filing Status Eligible to Year Modified AGI Deduction Participate in Employer Plan Married filing Self 2016 $98,000 or less full jointly between $98,000 and partial $118,000 $118,000 or more none 2017 $99,000 or less full between $99,000 and partial $119,000 $119,000 or more none Married filing Spouse 2016 $184,000 or less full jointly between $184,000 and partial $194,000 $194,000 or more none 2017 $186,000 or less full between $186,000 and partial $196,000 $196,000 or more none Single or Head of Self 2016 $61,000 or less full household between $61,000 and partial $71,000 $71,000 or more none 2017 $62,000 or less full between $62,000 and partial $72,000 $72,000 or more none Married filing Self or spouse 2016 less than $10,000 partial separately and 2017 $10,000 or more none If the taxpayer s modified AGI reduces or negates his/her deduction, the after-tax portion of the contribution to the traditional IRA will create non-taxable basis in the account. However, because all of the net earnings in a traditional IRA will be taxable upon distribution, after tax contributions to a traditional IRA are substantially less beneficial than either pre-tax contributions to a traditional IRA (where all tax is deferred) or after-tax contributions to a Roth IRA (for which current taxation achieves tax exempt growth). Fortunately, ever since the 2010 statutory removal of AGI limitations on Roth IRA conversions, taxpayers whose modified AGI makes them ineligible to make either a Roth IRA contribution or a tax deductible contribution to a traditional IRA can fund a Roth IRA in two steps using what is known as the back door Roth IRA funding technique. First, the taxpayer makes a non-deductible contribution to a traditional IRA, creating an IRA which has an account value equal to its basis. Immediately thereafter, the taxpayer converts the traditional IRA to a Roth IRA by transfer to a Roth account. Because the traditional IRA has no earnings in excess of its basis, the Roth conversion does not trigger additional tax. Importantly, if the taxpayer has any pre-existing traditional IRAs, the pre- northerntrust.com Insights on...wealth Planning 3 of 8

4 tax value of all of those accounts will be aggregated with the basis of the newly funded traditional IRA, so that the immediate Roth conversion will generate an additional income tax. Thus, this technique offers special advantage only for taxpayers who have no existing traditional IRAs. Investments Because all IRAs are exempt from income tax, they are optimal vehicles for investments in ordinary income assets (bearing in mind the desirability of diversification within the taxpayer s retirement accounts). That said, like all tax-exempt entities, IRAs are subject to tax at regular rates on unrelated business taxable income or UBTI. Thus, an investment in a business enterprise (other than via shares of stock in a C corporation) will require the IRA to file an income tax return and pay tax on that UBTI as if it were a taxable trust. Likewise, income from an investment purchased with borrowed funds will be subject to regular tax. Even worse than the tax liability of an investment that generates UBTI are the effects of what are characterized under the Code as prohibited transactions, which include any investment in the class of prohibited assets, as well as transactions between the IRA and disqualified persons. Disqualified persons include the IRA custodian or trustee, the owner or beneficiary, certain family members, and various entities related to those parties through ownership or beneficial interests. If the IRA owner or beneficiary engages in the prohibited transaction, the IRA will be disqualified. Note that when the prohibited transaction involves the purchase of a prohibited asset, disqualification is effective only with respect to the asset, which is deemed to have been distributed (subject to ordinary income tax) at the time of the purchase. Prohibited transactions involving anyone other than the IRA owner or beneficiary trigger a 15% excise tax on the participating disqualified persons, but do not disqualify the entire IRA or create a deemed taxable distribution. Prohibited assets include life insurance policies, a personal residence of the IRA owner or beneficiary, and collectibles (e.g., artwork, rugs or antiques, metal or gems, stamps or coins (with limited exceptions), wine and other alcoholic beverages, and any other tangible personal property specified by the IRS). Prohibited transactions between the IRA and disqualified persons extend to sales, leases, and loans (including pledging the IRA), as well as breaches of the duty of prudent investment. Because most IRA trustees/custodians limit investments to marketable securities, prohibited transactions typically occur only when the IRA owner or beneficiary is making investment decisions for a self-directed IRA. Although many prohibited transactions are easy to identify, the law is so broad and murky at the edges, that it is crucial for the IRA owner/beneficiary of a self-directed IRA to seek legal advice before engaging on behalf of the IRA in transactions that may be risky or involve parties with whom the owner/beneficiary has a personal connection. DISTRIBUTION Because the legislature bestowed the benefit of tax advantaged savings to IRAs to insure that retirees retain an income stream after they stop working, the rules regarding distributions are designed both to discourage early withdrawals (which could leave the spendthrift IRA owner without a nest egg during retirement) and require distributions during retirement (lest the IRA owner use the tax deferred account to perpetually avoid income taxation). Thus, unless an exception applies, withdrawals from an IRA prior to reaching age 59 ½ are subject to an additional excise tax of 10%. On the flip side, once the IRA owner reaches age 70 ½, minimum distributions must be withdrawn from a traditional IRA annually. northerntrust.com Insights on...wealth Planning 4 of 8

5 Taxation of distributions Withdrawals from a traditional IRA are subject to federal tax at ordinary income rates (although they are exempt from the 3.8% Medicare tax on net investment income), except to the extent they represent a distribution of basis. As previously explained, a taxpayer s after-tax contribution to a traditional IRA is added to his/her basis in the account. All distributions from a traditional IRA are deemed to be made proportionately from basis and earnings. Thus, if a taxpayer takes out $50,000 from a traditional IRA, when the total value of all her traditional IRA assets is $1 million, and her total basis is $100,000, 90% of the distribution will be taxable and the remaining 10% will be a non-taxable receipt of basis. On the other hand, qualified distributions from a Roth IRA are wholly exempt from tax. As long as the IRA owner has reached age 59 ½ and has waited for 5 years after funding any Roth IRA, all distributions will be qualified and tax-free. Exceptions to penalties for early withdrawals Certain distributions prior to reaching age 59 ½ are not subject to the 10% additional tax. Exceptions are made for the cost of health insurance for an unemployed IRA owner; higher education expenses of the IRA owner, spouse, children and grandchildren; up to $10,000 to help pay for a home for first-time buyers (if the buyer is the IRA owner, spouse, child, grandchild, or parent of the owner or his/her spouse); and for distributions made to a person called from the military reserves into active duty for a period of at least 179 days. An IRA owner can also avoid the 10% excise tax by establishing what is known as a series of substantially equal periodic payments or a SOSEPP, under which the IRA owner must commit to taking a minimum distribution at least annually for the greater of 5 years or the period before reaching age 59 ½. Finally, distributions made after the death of the original IRA owner are never subject to the early withdrawal penalty. RMDs Upon reaching age 70 ½, a traditional IRA owner must withdraw an annual minimum, which is calculated by dividing the account balance on the last day of the prior year by the owner s life expectancy, as found on the Internal Revenue Service (IRS) Uniform Life Table. 2 The IRA owner s first annual minimum distribution may be deferred until April 1 of the following year (not the April 15 th tax filing due date). Roth IRA owners do not have RMDs. The distribution rules for the beneficiary of an inherited IRA (whether a traditional IRA or a Roth IRA) differ from the rules for the owner. The individual designated as the beneficiary of an inherited IRA must begin taking RMDs shortly after the death of the IRA owner. Assuming that the beneficiary is an individual who was named directly by the IRA owner, the beneficiary s first RMD will be for the year after the IRA owner died. The calculation is the same as for the IRA owner, but the life expectancy will be based on the age the beneficiary reached in that first RMD year, as found on the IRS Single Life Table. 3 A surviving spouse who does not roll over the inherited IRA to his/her own IRA 2 This table provides the actuarially determined joint life expectancy for a person of a stated age and another person 10 years younger. An IRA owner who has designated his/her spouse as the sole beneficiary of the IRA may use the IRS Joint and Survivor Table to calculate RMDs if the spouse is more than 10 years his/her junior. 3 This table provides the actuarially determined survival period for a person of the stated age. Thus, while a 70 year old s life expectancy on the Uniform Life Table is 27.4 years, his/her expectancy is only 17 years on the Single Life Table. northerntrust.com Insights on...wealth Planning 5 of 8

6 may recalculate his/her life expectancy annually, whereas non-spouse beneficiaries must subtract one from the prior year s expectancy when calculating subsequent RMDs. Note that non-qualified beneficiaries, such as the estate of the deceased owner, must use the deceased IRA owner s remaining life expectancy to calculate RMDs if the owner died after having started to take RMDs. Those non-qualified beneficiaries inheriting an IRA from an owner who was under 70 ½ at death must withdraw the entire inherited IRA before the start of the 6 th year following the year in which the IRA died (the so-called 5 year rule ). Finally, qualified beneficiaries inheriting from a pre-rmd status IRA owner may elect to receive the IRA under the 5 year rule. The beneficiary of an inherited Roth IRA must withdraw annual RMDs, calculated just as for an inherited traditional IRA, except that the life expectancy is determined as if the Roth IRA owner had died before reaching age 70 ½. 60-day rollovers An IRA owner is entitled to withdraw funds from the IRA and avoid taxation by returning the funds or rolling them over within 60 days of the withdrawal. Note, however, that an IRA owner may do only one such 60-day rollover in a 12 month period (which starts on the date of the last returned distribution), and only if the amount withdrawn was not part of an RMD. The first distribution in the year is considered the account owner s RMD and RMDs may not be rolled back into an IRA. The beneficiary of an inherited IRA is never entitled to roll over a distribution. Importantly, there is no limitation on the number of permitted direct rollovers from qualified plan accounts (such as 401(k)s) to IRAs (and vice versa), Roth IRA conversions and re-characterizations, and transfers directly between IRAs (from trustee-to-trustee). Qualified charitable distributions ( QCDs ) An IRA owner or beneficiary who has reached age 70 ½ is permitted to exclude from gross income up to $100,000 distributed directly from the IRA to a qualified charity (which excludes private foundations and supporting organizations). This direct distribution, commonly referred to as a QCD, fulfills up to $100,000 of the RMD for the year (despite being excluded from the IRA owner s gross income), but is not limited to the RMD. Thus a charitably inclined, 71 year old IRA owner who has a $30,000 RMD may nevertheless transfer $100,000 to her favorite public charity and omit the entire distribution from gross income on her income tax return. QCDs are not permitted from qualified plan accounts, such as 401(k)s. Penalties Failure to withdraw the RMD before the end of the year creates an excess accumulation which must be corrected by promptly distributing the late RMD and reporting the failure to the IRS. A 50% excise tax applies to the excess accumulation, but the IRS has discretion to waive this penalty if the taxpayer demonstrates reasonable cause for the failure to timely withdraw the RMD. A recurring annual excise tax of 6% applies to excess contributions to an IRA. Although the excess contribution may be corrected by distribution, there is no mechanism for the IRS to waive the penalty. TRANSFER In general, an IRA owner s transfer of the IRA will be treated as a taxable distribution to the IRA owner, followed by a gift (or sale) of non-ira assets to the recipient. There are three northerntrust.com Insights on...wealth Planning 6 of 8

7 exceptions to this rule: QCDs (described above), transfers made pursuant to a divorce or separation agreement, and transfers at death. Divorce An IRA owner may transfer assets directly from his/her IRA to a spouse s IRA in fulfillment of an existing divorce or separate maintenance decree (including any court decree dictating support of one spouse by the other). Importantly, transfers made prior to the issuance of the decree will not qualify for exclusion from the IRA owner s income. Death When the IRA owner dies, beneficial ownership of the account may be transferred to one or more designated beneficiaries without triggering recognition of income. How these inherited IRA assets can be held depends on the identity of the recipient. When deciding whom to designate as beneficiary of an IRA, the owner must weigh the benefits of maximizing income tax deferral against the desirability of passing wealth to particular individuals or the need to create spendthrift and creditor protection by embedding the IRA assets in a trust. Surviving spouse If the surviving spouse is the sole designated beneficiary of IRA assets, s/he may either transfer the funds to an inherited IRA or roll them over to his/her own IRA. A surviving spouse s inherited IRA may be rolled over to his/her own account at any time, but once rolled over the assets can never go back to an inherited IRA benefitting the surviving spouse. Retaining the account as an inherited IRA has the following advantages: Deferral of RMDs until the deceased spouse would have reached age 70 ½ if s/he had survived (most useful for a surviving spouse who is older than the IRA owner and would have RMDs from his/her own IRA) Penalty-free withdrawals from the IRA (if the surviving spouse has not reached age 59 ½) On the other hand, a spousal rollover offers these advantages: Smaller RMDs (because they are based on the spouse s Uniform Life Table expectancy) Eligibility for 60-day rollovers RMD reset at death, i.e., the spouse s beneficiaries may use their own life expectancies to calculate RMDs Creditor protection under federal bankruptcy law Individual or qualified look-through trust A qualified non-spouse beneficiary must begin taking RMDs in the year following the IRA owner s death, and such RMDs are calculated using the individual s life expectancy. For a qualified lookthrough trust, RMDs are based on the life expectancy of the oldest beneficiary of the trust (whether or not they receive the distributions). Depending on the terms of the agreement governing the IRA, a beneficiary may designate successor beneficiaries, who may establish a new inherited IRA for their sole benefit, but must continue to withdraw RMDs based on the primary beneficiary s life expectancy. IRAs established for the benefit of a trust continue to be held in trust, until the trust s termination (regardless of the death of one or more trust beneficiaries), at which time the IRAs may be transferred to remainder northerntrust.com Insights on...wealth Planning 7 of 8

8 beneficiaries. Note that all qualified beneficiaries of a decedent who has died prior to reaching age 70 ½ may elect to take RMDs under the 5 year rule. Under this rule, no distributions are required until the last day of the 5 year period. Special care is required when designating a trust as an IRA beneficiary in order to obtain maximum tax benefits. Decedent s estate, non-qualified look-through trusts, and other entities - Although an IRA owner may execute a valid beneficiary designation naming his estate or favorite charity, such beneficiaries are not qualified to maximize distribution deferral under the rules governing inherited IRAs. Instead, the nonqualified designated beneficiary must withdraw the account under the 5 year rule if the IRA owner died before reaching age 70 ½ or using the deceased IRA owner s remaining life expectancy, if the owner died after age 70 ½. CONCLUSION Because IRAs allow taxpayers to invest their retirement savings on a tax deferred or taxexempt basis, they are a powerful wealth accumulation tool. However, in an effort to reign in taxpayers use of these vehicles, applicable law is complicated and the penalties for noncompliance can be severe. Thus, the foregoing discussion has focused on the major requirements for funding and maintaining traditional and Roth IRAs, since strict and consistent compliance is the primary way to optimize the financial benefit of these retirement plans. As always, planning for retirement is complex and technical, and should involve financial, tax and legal advisors who are familiar with you, your goals and retirement planning concepts. FOR MORE INFORMATION Northern Trust Wealth Management specializes in Goals Driven Wealth Management backed by innovative technology and a strong fiduciary heritage. Northern Trust Wealth Management is ranked among the top 10 U.S. wealth managers, with $248 billion in assets under management as of December 31, 2016, and a wide network of wealth management offices across the United States. Our Wealth Planning Advisory Services team leverages our collective experience to provide financial planning, family education and governance, philanthropic advisory services, business owner services, tax strategy and wealth transfer services to our clients. It is our privilege to put our expertise and resources to work for you. 2017, Northern Trust Corporation. All rights reserved. LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. OTHER IMPORTANT INFORMATION: Opinions expressed and information contained herein are current only as of the date appearing in this material and are subject to change without notice. northerntrust.com Insights on...wealth Planning 8 of 8