Estate Planning with Individual Retirement Accounts
USING THIS REPORT
At first glance, the concept of an Individual Retirement Account (IRA) seems
simple enough: a structured way to save for your golden years while deferring
taxes on your growing nest egg. Unfortunately, that simple idea becomes one
of the most complex areas of estate planning once IRS rules are applied. That
means that not only must an estate planner consider estate tax reduction techniques,
but also the amazingly complicated income tax rules the IRS has issued in
its Proposed Regulations. Do not let the term “proposed” concern
you. The agency issued the Proposed Regulations in 1987 and has told taxpayers
they may rely on the rules until Final Regulations are issued. This report
is intended to provide general guidance on the income and estate tax considerations
involved. It is not intended as legal advice. Only an analysis of a client’s
particular financial and family considerations provides a sufficient foundation
for an estate planner to make appropriate planning recommendations.
CONSIDER THE COMPLEXITY AND UNCERTAINTY OF THE RULES
As will be discussed in the following sections of this Report, there is considerable
complexity and uncertainty in determining how the IRS and your particular
IRA administrator will manage the issue of taxation in the case of the death
of the owner. Some plan administrators require withdrawal of the IRA balance
within a period of 1 to 5 years, even though the IRS might allow 20 years.
You should consider that uncertainty when making your estate planning decisions.
As an example, if you simply name your spouse as the beneficiary of your IRA, you and your spouse can be assured of the maximum income deferral benefits for each of you. However, that form of planning may increase the estate taxes on your estate, ultimately effecting your children.
STEPS IN THE PLANNING PROCESS
Initially, a decision must be made concerning which family members are intended
to benefit from the estate plan. Each choice may have important tax consequences.
For the remainder of the report, we will assume that Mr. and Mrs. Smith and
their two children are the family for whom we will plan. Let’s look
at the unique issues involved in IRA planning.
ESTATE TAX PLANNING
All to the spouse – From a purely estate tax reduction standpoint for
the surviving spouse, each spouse may simply name the other as the beneficiary
of the owner’s IRA. When the owner dies, the surviving spouse will own
the IRA and there will be no estate taxes imposed because bequests to a spouse
are protected by the Unlimited Marital Deduction. This is a simple plan that
protects the surviving spouse from estate taxes or income tax uncertainty.
However, this method may cause Mr. and Mrs. Smith’s children to bear
the burden of paying estate taxes out of their inheritance that are otherwise
avoidable. How would that happen?
Let’s assume, for a moment, Mr. Smith has an IRA and with a balance of $675,000 and Mrs. Smith also has property with a value of $675,000. If Mr. Smith names Mrs. Smith as the beneficiary of his IRA, at this death, Mrs. Smith will own her own property and Mr. Smith’s IRA. If Mrs. Smith dies shortly thereafter, she will have a taxable estate of $1,350,000. As you may know, each person dying in 2001 can leave $675,000 without any estate taxes imposed. Thus, Mr. and Mrs. Smith could have left their children a combined value of $1,350,000. However, the “simple” plan of naming Mrs. Smith as the beneficiary has erased Mr. Smith’s $675,000 exemption because his assets were combined with hers and she subsequently died with a $1,350,000 estate. The Smith children will have to pay estate taxes at their mother’s death of $270,750. A “simple,” but expensive estate plan for the IRA.
Is there a way to avoid the $270,750 estate tax bill? Yes, Mr. and Mrs. Smith may use a specially prepared trust to receive the rights to Mr. Smith’s IRA. When Mrs. Smith dies, the balance of Mr. Smith’s IRA will be owned by the trust and not taxable in Mrs. Smith’s estate as when she was his beneficiary. The trust pays all of its income to Mrs. Smith and principal for her health, education, maintenance or support. Mrs. Smith is economically protected and the children inherit the entire $1,350,000. However, say goodbye to “simplicity.” With the trust having become the current IRA beneficiary, the $675,000 is subject not only to IRA rules but the potentially stricter IRA administrator rules. Let’s review the IRS distribution rules.
REQUIRED MINIMUM DISTRIBUTION RULES
IRAs represent savings that have grown tax-deferred. That means that when
funds are withdrawn, they are subject to ordinary income tax rates. Congress
enacted the IRA rules so that taxpayers could save for their retirement. However,
Congress’ generosity has its limits. To ensure that taxpayers ultimately
pay income taxes on their IRA balances, Congress enacted the “required
minimum distribution rules.” These minimum distribution rules require
taxpayers to begin withdrawing their IRA balances when they reach age 70 ½.
Actually, the final date to begin withdrawing is April 1 of the calendar year
following the calendar year the owner reaches 70 ½. For the sake of
simplicity (at least relative simplicity), we’ll use 70 ½ as
our benchmark. This is called your “required beginning date.”
Let’s apply the required minimum distribution rules to the Smiths.
Mr. Smith has just turned 70½ and will be considered 71 under IRS rules. Mrs. Smith is 68. Mr. Smith has to make some decisions soon about withdrawing funds from his IRA. He has several choices. He can take all the funds at one time; however, that would require the deferred income taxes to be paid all at once, so he won’t do that. His other choices are: (i) take the funds out over his life expectancy, which according to the IRS is 15.3 years; or (ii) he can withdraw the funds over his and Mrs. Smith’s joint life expectancy, because she is the beneficiary. Their joint life expectancy is 21.2 years. Because their joint life expectancy is considerably longer than his life expectancy, Mr. Smith has chosen the joint life option to defer the income taxes for as long as possible. The 21.2 years life expectancy means, if the Smiths survive, all the IRA funds must be withdrawn over the 21.2 year time frame.
HOW MUCH MUST MR. SMITH WITHDRAW?
We know how long Mr. Smith has to withdraw his IRA, but how much does he have
to withdraw in any one year? That is the second election that Mr. Smith must
make. He may choose the “elapsed years” method or the “recalculation
method.” Some IRAs force you to use the recalculation method. In the
elapsed years method, Mr. Smith simply divides the balance in his IRA, at
the end of the prior year, by the number of years remaining in the 21.2 years.
For the first year, he divides the balance by 21.2. For the final year, when
all the funds must be withdrawn, he divides the balance by one. As an example,
assume Mr. Smith’s IRA had a balance of $675,000 in the first year.
He divides $675,000 by 21.2 and finds he must withdraw $31,840. In the second
year, one year in his life expectancy has elapsed and he would divide the
balance by 20.2, and so on. The recalculation method uses the same division
method, but Mr. and Mrs. Smith’s joint life expectancy is recalculated
every year. In theory, the recalculation method allows for a longer deferral,
but if both Mr. and Mrs. Smith’s lives were being recalculated, the
funds may have to be paid out in the year following the death of the survivor.
That means that if they both died within 5 years, the funds in the IRA might
have to be withdrawn in the sixth year. This potential for early deaths is
why most clients choose the elapsed years method. Only the lives of the IRA
owner and his or her spouse may be recalculated. If Mr. Smith named his son
as the beneficiary, only Mr. Smith’s life could be recalculated. We
now know how much Mr. Smith must withdraw, but when does he have to make a
withdrawal?
WHEN MUST WITHDRAWALS BE MADE?
If Mr. Smith turns 70½ in 1998, there is a required minimum distribution
due for 1998 which he must withdraw by April 1 of 1999, his required beginning
date. It is important to understand that if the Smiths live their joint life
expectancy, there will be no funds in the IRA because the entire balance will
have been distributed. This is an important point when we discuss the income
tax aspects of using a trust as the beneficiary of Mr. Smith’s IRA.
Now that we have covered the required minimum distribution rules, let’s
revisit the estate tax planning part of the report. Remember that naming Mrs.
Smith as the beneficiary is a “simple” plan for the IRA, but increases
the estate taxes on the inheritance left to the Smith children. If Mr. and
Mrs. Smith want to protect their children’s inheritance from unnecessary
estate taxes, they must use a trust as part of their estate plan. They may
also use the “simple” plan of naming the spouse as beneficiary
and purchasing a second to die life insurance policy. Let’s look at
the rules for trusts as beneficiaries of IRAs.
USING TRUSTS AS THE IRA BENEFICIARY
A trust may be the beneficiary of an IRA without causing a loss of most of
the income deferral opportunities if the following criteria are met. However,
the IRS is interpreting these rules in a hyper-technical manner and there
is a risk that the IRS may challenge a trust for a minor infraction. The requirements
are:
1. The trust is irrevocable or, by its terms, becomes so at the death of
the IRA owner.
2. The trust is a valid trust under state law, or would be if it had corpus.
3. The beneficiaries of the trust who have a right to the IRA benefits are
identifiable by the terms of the trust.
4. A copy of the trust, or a certificate containing certain information, is
provided to the IRA administrator.
The The exact information to be contained in the certificate is not clear, so the Smiths send a copy of their living trust, and any amendments, to the administrator. If the trust meets these qualifications, the trust beneficiaries are considered to be the beneficiaries of the IRA. As an example, if Mr. Smith’s trust provided that Mrs. Smith was the beneficiary of his trust at his death, and his children received his property at her death, Mrs. Smith and her children are considered to be the beneficiaries of Mr. Smith’s IRA. Because Mrs. Smith and the children are considered beneficiaries, the IRS limits valuable income deferral benefits for inherited IRAs payable to trusts.
The trust beneficiary will receive the required minimum distributions from the IRA but not exactly the same as Mrs. Smith would have if she had been the beneficiary. In the next section, we review the IRA minimum distribution rules for inherited IRAs.
IRA DISTRIBUTIONS TO A BENEFICIARY
IRS rules for required minimum distributions to beneficiaries of inherited
IRAs are some of the most complicated in estate planning. There are two separate
time frames that affect the required minimum distributions to a beneficiary.
The first time frame involves a death occurring prior to Mr. Smith reaching
70½. The second is for a death occurring after he reaches that age.
Deaths Before the Owner’s Required Beginning Date
If the owner dies before reaching 70 ½, the beneficiary has two choices:
1. If the beneficiary is an individual, or a qualified trust, the beneficiary
may elect to withdraw the IRA balance over the beneficiary’s life expectancy
by beginning withdrawals in the calendar year following the year of the owner’s
death; or
2. If the beneficiary is not an individual, or if an individual or qualifying
trust beneficiary did not begin taking withdrawals by the end of the calendar
year following the year of death, the beneficiary must withdraw the entire
balance of the IRA by the end of the calendar year which contains the fifth
anniversary of the owner’s death.
There is a special timing rule for spousal beneficiaries. Mrs. Smith, if she is the named beneficiary, may defer taking required minimum distributions until Mr. Smith would have reached 70½. The IRS has taken the position that if a trust is named as the beneficiary, the spouse is not able to defer taking payments until the deceased owner would have attained age 70½. Therefore, trustees who are beneficiaries of an IRA must begin withdrawing the required minimum distributions by the end of the calendar year following the calendar year of the owner’s death or be subject to the 5-year rule. This is a very restrictive position by the IRS and can be a good reason to simply name Mrs. Smith if the income deferral is of sufficient value. This is the first IRS complication which arises from using a trust as the beneficiary to protect children from estate taxes. As will be discussed later, trust income tax rates also complicate the decision to use a trust as the beneficiary of an IRA. Don’t forget, the IRA administrator may ignore the IRS rules and insist on a one-year payout of the entire IRA if the trust is used as a beneficiary.
Deaths After the Owner Turns 70½
Once the IRA owner reaches 70½, the calculation of required minimum
distributions is set regardless of whether the elapsed years or recalculation
method is being used. The only exceptions to this rule are if the owner names
a new beneficiary with a shorter life expectancy or names an entity other
than a trust qualifying under the rules we discussed earlier. The owner may
name a new beneficiary at any time; however, if an individual with a shorter
life expectancy is named, a new and shorter joint life expectancy is calculated.
If an entity is named, the method of calculation is changed to use only the
owner’s life expectancy.
INCOME TAX CONSIDERATIONS WHEN NAMING A TRUST AS THE BENEFICIARY
Remember, we named a trust as the IRA beneficiary to protect the Smith children
from estate taxes. However, we now need to see the income tax consequences
of naming the trust. Trust tax rates are “compressed,” meaning
that trusts pay income taxes at the maximum rate of 39.6%, at much lower taxable
income than do individuals. In 2001 (indexed), a trust pays 39.6% of each
dollar of taxable income in excess of $8,650. A single taxpayer does not pay
income taxes at the 39.6% rate until taxable income exceeds $288,350. Prior
to reaching $288,350, the individual pays 15% up to $26,250, then 28% from
$26,251 to $63,550, then 31% from $63,551 to $132,600, and then 36% from $132,601
to $288,350. As a simple example, if a single taxpayer has a taxable income
of $50,000, the income tax bill is approximately $10,600. However, a trust
with a taxable income of $50,000 has a tax bill of approximately $18,800.
Therefore, assuming the $50,000 taxable income was from a required IRA distribution,
using the trust as the beneficiary to protect the Smith children from estate
taxes costs Mrs. Smith around $8,200 in increased income taxes. Assume the
dollar amounts and tax rates are the same and Mr. Smith’s IRA was left
to a trust with 20 years of remaining required minimum distributions and that
each distribution created a taxable income for the trust of $50,000. Mrs.
Smith would lose $164,000 due to increased income taxes. The amount is actually
considerably more because of the loss of earnings on the extra taxes. Trust
income tax rates are the biggest problem with using trusts as beneficiaries.
Balancing the Tax Rates
Very few Mrs. Smiths are going to want to have their economic security decreased
by the loss of $8,200 per year in increased trust income taxes. Is there anything
that can be done about it? Yes, if the trustee of the trust distributes the
$50,000 required minimum distribution to Mrs. Smith within 65 days of the
end of the year in which the trust received the required minimum distribution,
the trust is allowed a deduction and Mrs. Smith pays taxes at the individual
income tax rate. Of course, the after-tax income will be in her estate and
subjected to estate taxes prior to passing to her children. This is a decision
the family will need to discuss on an annual basis. Remember how we mentioned
that the entire balance in the IRA will be distributed over the joint life
expectancy? If Mrs. Smith survives the 20 years after Mr. Smith’s death,
all of the IRA will have been distributed to the trust and potentially redistributed,
so as to avoid the increased income taxes, to Mrs. Smith. If so, the distributions
will be in Mrs. Smith’s estate and subject to estate taxes unless she
spends them during her life. This generally means that the estate tax savings
of naming a trust as the IRA beneficiary will occur only if Mrs. Smith dies
before the end of the joint life expectancy period. Finally, let’s look
at the rules for rollovers.
ROLLING OVER AN INHERITED IRA
By “rollover” we mean that the beneficiary of an IRA may elect
to treat the IRA as his or her own. Only a spouse may rollover an IRA inherited
from a spouse. If a child or trust inherits an IRA, the IRA must remain in
the name of the decedent or the entire balance will be taxable when the name
is changed to the child’s or trust’s IRA. A spousal rollover is
frequently termed a “stretch out” IRA. By “stretch out”
it is meant that Mrs. Smith, now 73, is the sole beneficiary of Mr. Smith’s
IRA. Mrs. Smith may treat the IRA as her own and name, as an example, her
daughter, age 42, as her beneficiary. Mrs. Smith and her daughter, under a
rule called the Minimum Distribution Incidental Benefit rule, may use a new
joint life expectancy of 23.5 years. However, if Mrs. Smith dies the next
year, the IRA payment period “stretches out” to the daughter’s
then-life expectancy of 39.6 years. The ability of the daughter to stretch
out payments over 39.6 years is a considerable benefit. However, if any estate
taxes are owed by Mrs. Smith’s estate they may have to be made by the
daughter making income taxable withdrawals from the IRA.
PLANNING UNDER UNCERTAINTY
There is an estate planning option that adds some flexibility in dealing with
the complex IRS rules and accelerated distribution requirements of some plan
administrators. It’s called the “disclaimer” method of estate
planning. When this strategy is employed, the IRA owner names the spouse as
the beneficiary and the family trust as a contingent beneficiary in the event
the spouse refuses to accept the IRA inheritance. A “disclaimer”
is a formal refusal to take some or all of the IRA benefits so that they pass
to the family trust. In that way, the value will not be included in the survivor’s
estate. However, the survivor must take no benefit from the IRA before disclaiming,
and the formal disclaimer must occur within 9 months of the decedent’s
death.
This Academy Report reflects the opinion of the American Academy of Estate Planning Attorneys. It is based on our understanding of national trends and procedures, and is intended only as a simple overview of the basic estate planning issues. We recommend you do not base your own estate planning on the contents of this Academy Report alone. Review your estate planning goals with a qualified estate planning attorney.
The American Academy of Estate Planning Attorneys is a member organization serving the needs of attorneys committed to providing their clients with the best in estate planning. Through the Academy’s comprehensive training and educational programs, it fosters excellence in estate planning among its members and helps them deliver the highest possible service to their clients.
Legal Disclaimer
This information has been provided for informational purposes only. It does
not constitute legal advice. The receipt of this information does not establish
an attorney-client privilege. Proper legal advice can only be given upon consideration
of all the relevant facts and laws. Therefore you should not act upon any
of the information contained herein without seeking appropriate legal counsel.
Attorneys Judith Sterling and Michelle Tucker are both CPAs and licensed attorneys. They are the first two attorneys in Hawaii to be certified by the American Bar Association (ABA) accredited Estate Law Specialist Board, Inc., as Estate Planning Law Specialists, and are so certified by the Supreme Court of Hawaii. The Supreme Court of Hawaii grants Hawaii certification only to lawyers in good standing who have successfully completed a specialty program accredited by the ABA.
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