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Estate planning practitioners are encountering a growing number of clients with significant IRA balances. Often an IRA will constitute a high percentage of a client's total assets. In this environment, it is increasingly important for an effective estate planner to pay close attention to the income and estate tax issues arising out of the disposition of IRAs. This article highlights 10 general practice points for an estate planner to consider in dealing with both traditional and Roth IRAs.
1. Be aware of the required beginning date.
The interest of any owner in an IRA must be distributed in lump sum or must begin to be distributed ratably over the life expectancy of the owner (and perhaps the owner's designated beneficiary) on or before the required beginning date (RBD). Code § 401(a)(9)(A). The RBD for traditional IRAs is April 1 of the calendar year following the year in which the owner reaches age 70 1/2. Available distribution options depend on one or two applicable life expectancies (i.e., the owner and the designated beneficiary). The existence of a second relevant life expectancy depends on the nature of the beneficiary as of the RBD. Also, whether (and to whom) recalculation of life expectancy will apply is determined as of the RBD. Failure to analyze the overall objectives and make specific choices before the RBD will lock in the default election. The maximum distribution period becomes fixed as of the RBD-as does the actual or default choice for recalculation of life expectancy.
The minimum required distribution (MRD) rules that are applicable to a traditional IRA are not applicable to a Roth IRA until after the owner's death. Code § 408A(c)(5). The owner of a Roth IRA is not required to take any distributions during his or her lifetime.
There is great potential for change in this area. As a result, practitioners should calendar a client's RBD and will want the opportunity to reevaluate the planning immediately before the client reaches his or her RBD.
2. Plan for a spousal rollover.
If the IRA owner is married, planning should heavily weigh toward making the surviving spouse the outright beneficiary of the IRA, when doing so would not otherwise conflict with the owner's intent. A spouse is a favored beneficiary under the minimum distribution rules. If the IRA plan document provides all of the options permitted by law, a spouse could postpone distributions to December 31 of the calendar year in which the owner would have reached age 70 1/2. Code § 401(a)(9)(B)(iv).
The surviving spouse could also elect to treat the inherited IRA as his or her own IRA. By doing so, minimum distributions would not begin until the surviving spouse's RBD (i.e., April 1 of the year following the year in which the surviving spouse attains age 70 1/2). Even if the owner were beyond his or her RBD on his or her date of death, the surviving spouse may roll over the account and obtain a new payout period. No other beneficiary can take advantage of a rollover.
Some clients may wish to name a marital trust or applicable exclusion amount trust as the beneficiary of their IRAs. Unfortunately, there is very little guidance (other than PLRs) interpreting the proposed regulations that the IRS issued in 1987. As a result, naming a marital trust for a spouse or an applicable exclusion amount trust as an IRA beneficiary is problematic. The author prefers using the disclaimer approach for funding the applicable exclusion amount trust when necessary
It is hoped that the IRS will clarify the trust rules in the future and before the owner's death, whereupon the plan can be revised as needed. In those instances where naming the spouse as the outright beneficiary of the IRA is inconsistent with the owner's intent, the practitioner may have no alternative but to struggle with the trust rules.
Naming the spouse as the outright beneficiary is simple and fairly certain to achieve a favorable result. The potential for obtaining a longer payout with a spousal rollover is a powerful planning opportunity.
3. Recalculate one life expectancy.
When an IRA owner reaches his or her RBD, the owner must choose the manner for calculating his or her MRDs. One option is to calculate the owner's life expectancy on the RBD and distribute the IRA balance in installments over that "fixed" life expectancy. Alternatively, the owner may elect to "recalculate" the required distributions. In each year, the MRDs are adjusted to take into account the owner's new life expectancy. By using this methodology, the IRA will usually never be fully distributed as the owner will always have some actuarial life expectancy left.
When planning for a married couple with sizable accounts, recalculating only the owner's life expectancy and not recalculating the spouse's life expectancy will generally be a good solution. Recalculating the owner's life expectancy assures the continuation of payments until the owner's death, which provides a hedge against the owner's living beyond expected mortality. If the owner and spouse both die before expected mortality (with the spouse dying first), the balance remaining at the owner's death can be distributed over the predeceased spouse's remaining fixed life expectancy, as initially determined. If the spouse survives, the spousal rollover (discussed above) is available.
4. Show your client the effect of the recalculation rules.
The best way to demonstrate the pitfalls of the recalculation rules to clients is to show them the effect. It is critical to show a client what must be distributed both during his or her lifetime and at death. Simply contrasting the amounts that must be distributed under the various recalculation methods while both spouses are alive tells only half of the story. One option is to present the MRDs as percentages. By using percentages, a client (as well as most advisers) can more easily recognize the significance of a percentage like 4.385965% than by seeing an expected return multiple (sometimes called a divisor) of 22.8.
For example, assume that Bill is the owner of an IRA. He is 71 and his wife Mary is 65. They have come for advice on an appropriate payout election. Starting with the assumption that a joint payout for Bill and Mary would be appropriate, there are four options under the recalculation rules:
Bill names Mary as the outright beneficiary of the IRA, so Mary will be able to roll over the account if she is the surviving spouse. The four recalculation options are illustrated in the charts accompanying this article.
5. Plan for a client's incapacity.
Clients who come to discuss estate planning on retirement are often in their early to late 60s or even younger. It is not too early to document the distribution election plan that is to take effect on the RBD and provide the election information to the IRA custodian or trustee. If the client becomes incapacitated before his or her RBD, steps have already been taken to select and document the appropriate election. If necessary, the distribution election plan could always be changed at any time before the RBD.
Durable powers of attorney should authorize the attorney-in-fact to change the distribution election, investments and account custodians and to accelerate distributions. These powers may come in handy for purposes of making gifts to save transfer taxes or for converting to a Roth IRA. One should be careful, however, in giving the agent the power to change the IRA beneficiary.
6. Prepare custom beneficiary designations.
Planners should prepare their own IRA beneficiary designations that specify the client's primary and secondary beneficiaries. The beneficiary designation should indicate what happens in the event of a disclaimer or simultaneous death, as well as what happens on the death of a beneficiary who survives the owner but dies before the account is fully distributed. The beneficiary designation should usually provide that each beneficiary may change investments, custodians or trustees and may accelerate distributions at any time. If appropriate, the designation can require the creation of separate accounts or shares after the owner's death. Rarely does the standard IRA account agreement and beneficiary designation form provided by the financial institution cover all of these issues.
The custom beneficiary designation document should be sent return receipt requested to the IRA custodian or trustee. Many of the financial institutions are not prepared to receive such custom documents. Worried about their own liability, some IRA custodians will not accept forms that deviate from the strict or narrow interpretation of their IRA account agreements. Accordingly, the IRA custodian might refuse to allow some portion or all of a custom beneficiary designation if its account agreement does not expressly authorize each item. A practitioner should always check the terms of the underlying IRA account agreement. There is, however, a growing movement within financial institutions to allow the flexibility needed to properly plan for IRAs of significant size. See Lynn Asinof, New IRA Policies May Mean Big Savings, Wall St. J., Mar. 18, 1999, at C1; Lynn Asinof, IRS Gives Good News to IRA Beneficiary, Wall St. J., July 19, 1999, at C21.
7. Consider establishing separate accounts for children.
When children are named as beneficiaries, a practitioner should consider establishing separate accounts for each child. Unless separate accounts are established, the child who has the shortest life expectancy (i.e., the oldest child) is treated as the "designated beneficiary" for purposes of calculating the MRD. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-2(a). To enable each child to use his or her life expectancy to determine the payout period of his or her separate share (i.e., following the death of the owner), the safest approach is to establish separate IRA accounts for each of the children before the RBD (or, if earlier, the owner's death). Clients will need to evaluate the added administrative burden of having multiple accounts. If the spread in the children's ages is close, it may not be worth the effort.
8. Act quickly following an owner's death.
After an IRA owner's death, counsel should review the controlling IRA trust agreement or custodial account agreement, the beneficiary designation in effect on the owner's death (and, if the owner was beyond his or her RBD, the beneficiary designation in effect on the owner's RBD and at all times after the RBD), as well as the distribution election in effect for the account. If the owner was beyond his or her RBD, one should ensure that the MRD for the year of the owner's death is distributed before the close of the calendar year.
Many post-death options are time sensitive. For example, if the children are named beneficiaries and the owner dies before his or her RBD, distribution of the account may be made over the life or life expectancy of the designated beneficiary, but only if payments begin by December 31 of the year following the owner's death. Code § 401(a)(9)(B)(ii), (iii).
The timing of a spouse's election to treat the account as his or her own should be carefully considered. This election to treat an IRA as the surviving spouse's IRA, according to the proposed regulation, occurs when the spouse takes an action that is inconsistent with the account being the decedent spouse's account, such as making a contribution or failing to take an MRD. If the spouse does not elect to treat the account as his or her own, the spouse may have to take annual distributions as a beneficiary or continue under the deceased spouse's election. By defaulting to the rollover, the proposed regulations offer protection to the spouse who fails to take an MRD that would otherwise be required. Prop. Treas. Reg. § 1.408-8, Q&A A-4(b). Unfortunately, counsel must struggle with a number of letter rulings regarding this issue. In unusual cases, the client may need to request a private letter ruling. Finally, clients and their counsel must consider disclaimers, the importance of which cannot be overstated in planning the distribution of large accounts, and implement them within nine months after the owner's death. See, e.g., PLR 9630034.
9. Keep IRAs inherited by a nonspouse in the name of the original owner.
An IRA beneficiary must be able to identify the source of each IRA he or she holds. The IRA custodian or trustee must state the name of the beneficiary and the prior owner, such as "Brian Young, as beneficiary of the Joan Smith IRA." This is necessary because, under various sections of the Code, the rules that apply in the case of an IRA held by a nonspouse beneficiary are different from the rules that apply to the original IRA owner. For example, if the participant had made nondeductible contributions to the IRA, the beneficiary would continue to file a Form 8606, showing the nontaxable amount of each distribution. Also, different treatment may be required for IRAs received due to the deaths of different original IRA owners. An IRA received by a nonspouse beneficiary on the death of a given IRA owner must be kept separate from any IRA established by the nonspouse as an original owner, and also separate from any IRA received on the death of any other original IRA owner. The beneficiary's taxpayer identification number must be used in completing the Form 5498 reporting the portion of the IRA belonging to that beneficiary. Rev. Proc. 89-52.
10. Be wary of the lack of guidance.
The Treasury published proposed regulations under Code § 401(a)(9) on July 27, 1987. On December 30, 1997, the Treasury amended the proposed regulations regarding the requirements that must be satisfied to gain designated beneficiary status through a trust. Otherwise, there has been very little official guidance from the government on the minimum distribution rules. Concomitantly, the value of retirement accounts has dramatically increased in recent years and with it the importance of properly planning for these accounts. In many cases, an IRA may be a client's most valuable asset.
In this vacuum, significant questions have arisen in planning for the distribution of large IRAs. For example, what is the authority for a spousal rollover from an estate or trust, or a disclaimer to an applicable exclusion amount trust, with the continued payout over the spouse's life expectancy? What is the authority for the terms with which a trust may be established without jeopardizing the ability of the trust to provide a designated beneficiary? Looking for real authority on which to answer these questions and to base planning recommendations where there is no guidance will be frustrating. To its credit, the IRS has issued many private letter rulings, most of which have been favorable to the taxpayer. Many planners rely on these rulings as authority in this area. Some individuals at the IRS have been willing to share their own opinions of what the rules should be when there is no guidance. See, e.g., Estate Planning for Distributions from Qualified Plans and IRAs, ALI-ABA Satellite (May 20, 1999). Yet, when advising clients on the distribution of multimillion dollar retirement accounts, letter rulings and unofficial opinions, which amount to little more than gossip, provide only fleeting comfort.
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