Roth Conversion Limit Update
Section 512(a)(1) of the Tax Increase Prevention and Reconciliation Act, Pub. L. No. 109-222, 120 Stat. 345, signed by the President on May 17, 2006, repeals the current limitations on the conversion of traditional IRAs to Roth IRAs for high-income account owners, effective for taxable years beginning after 2009. Code § 408A(c)(3)(B), which now limits IRA conversions to individuals who have modified adjusted gross income of $100,000 or less (and prevents married taxpayers filing separately from undertaking conversions), ceases to apply in 2010. Unless an account owner who converts all or a portion of a traditional IRA to a Roth IRA in 2010 elects otherwise, the amount includable in the account owner’s income because of the conversion (the balance of the traditional IRA that is converted, except to the extent that the account owner has a tax cost basis in the traditional IRA) will be included, ratably, in the account owner’s taxable income for 2011 and 2012. Subject to future legislation, the current income tax rate provisions of the Code introduced by EGTRRA for 2002 and future years sunset in 2011. Depending on the account owner’s projected income levels for 2010, 2011, and 2012, and the then income tax brackets, full inclusion of the taxable income in 2010 could be advantageous.
As discussed in the January/February Retirement Benefits Planning Update, nonqualified distributions (those made within a five-year period beginning with the first day of the year in which a conversion occurs or for which a regular contribution is made to the Roth IRA) are subject to income tax in accordance with “ordering rules.” As a result, the amount of regular Roth contributions and, then, conversion contributions, each of which ordinarily represent after-tax contributions not subject to income tax, are treated as being distributed before the investment earnings of the Roth account, which would be includable in taxable income. In the case of the deferred inclusion in the account owner’s taxable income for year 2010 conversions, nonqualified distributions in 2010 and nonqualified distributions that exceed one-half of the total includable amount in 2011 (after taking into account any 2010 distributions) are includable in income in the year received (thus accelerating the otherwise deferred income inclusion).
If an account owner who has not elected out of the deferred inclusion of taxable income for a year 2010 conversion dies in 2010 or 2011, the balance of the taxable conversion amount is generally included in the account owner’s taxable income for the year of death. If the account owner’s surviving spouse becomes the owner of the deceased participant’s entire Roth IRA, the spouse may elect to continue the deferral arrangement. The current rules imposing a 10% premature distributions tax on nonqualified distributions made to a pre-age 59 1/ 2 account owner not otherwise exempt from the tax continue to apply to post-2009 conversions.
Window Period Disclaimer by Personal Representative
As discussed in detail in the May/June 2006 Retirement Benefits Planning Update, all beneficiaries that are designated by a plan participant or IRA account owner (participant) who are living (or in existence) on the date of the participant’s death are generally taken into account in determining the required distributions under the minimum required distribution (MRD) rules of Code § 401(a)(9). If there are multiple beneficiaries, the distribution period for all beneficiaries is measured by the life expectancy of the oldest beneficiary or, if a non-individual is a beneficiary, there is deemed to be no designated beneficiary, generally causing benefit distributions to be paid out under the five-year rule or over the deceased participant’s life expectancy. Certain beneficiaries may be disregarded in determining the distribution period if, during the 9-to-21 month “window period”—the period between the participant’s date of death and September 30 of the year following the year of the participant’s death—all of the beneficiary’s benefits are distributed or the beneficiary disclaims all benefits. Treas. Reg. § 1.401(a)(9)-4, A-4.
An individual who is a beneficiary as of the date of the participant’s death and dies during the window period without disclaiming continues to be treated as a beneficiary in determining the participant’s designated beneficiary for purposes of determining the distribution period. Treas. Reg. § 1.401(a)(9)-4, A-4(c). The regulation’s phrase “dies without disclaiming” implies that a disclaimer must be made before the beneficiary’s death.
In PLR 200616041 (Apr. 21, 2006), an IRA participant was survived by his wife who died during the window period, shortly after the participant. The wife’s personal representative disclaimed the IRA benefit in accordance with Code § 2518(b) and in accordance with state law that permitted a fiduciary to disclaim an interest in property with court approval. The ruling notes that Treas. Reg. § 25.2518–2(b) provides that a disclaimer is a qualified disclaimer only if it is in writing and signed either by the disclaimant or the disclaimant’s legal representative. The IRS concluded that the disclaimer, made within nine months of the wife’s death and before any acceptance of the benefits, was a qualified disclaimer that caused the participant’s IRA to be disposed of as if the wife had predeceased the participant. To complicate matters, the beneficiary designation for the participant’s IRA named only his wife as beneficiary. But the beneficiary designation signed by the participant for an IRA (the original IRA) from which the assets of the IRA the participant owned at death had been transferred had named the wife as primary beneficiary and the participant’s two daughters as contingent beneficiaries. An affidavit from an individual who assisted the participant in establishing the transferee IRA was submitted to a state court stating that the participant had instructed that the transferee IRA was to have the same beneficiary designation as the original IRA but that the participant’s instructions were not properly implemented by the IRA provider. The state court ordered a reformation of the beneficiary designation, effective as of the participant’s date of death, under a state law that permitted an inter vivos revocable trust to be reformed after the settlor’s death for a unilateral drafting mistake upon clear and convincing evidence. As a result of the reformed beneficiary designation, each of the participant’s daughters became a 50% beneficiary of the participant’s IRA on the disclaimer. In companion rulings, PLRs 200616039 and 200616040, each of the daughters received approval to create a separate IRA in the name of the deceased participant by trustee-to-trustee transfers with the distribution period being based on the single life expectancy of the older daughter.
Window Period Trust Amendments
To what extent may a trust named as a participant’s beneficiary be amended during the window period to qualify under the see-through rules that treat the oldest trust beneficiary as the designated beneficiary? In PLR 200537044, discussed in detail in the May/June 2006 Retirement Benefits Planning Update, changes were made to certain provisions of a trust agreement governing a trust named as beneficiary by a trust protector acting within nine months of the participant’s death under specific authority granted by the trust agreement. The ruling held that the changes were effective as of the participant’s date of death for purposes of applying the MRD rules. A trust agreement amendment made under a power granted to a disinterested trustee to amend an otherwise irrevocable trust agreement or a trust agreement amendment under the order of a court of competent jurisdiction should similarly be recognized. Two recent private letter rulings, one involving a conduit trust and one a younger individual’s only trust, recognize trust amendments made after the participant’s death. But, because the trust agreement governing the trust named as beneficiary by the participant was, in each case, also amended before the participant’s death, references to the trust “as amended” or “as modified” fail to disclose which trust provisions were introduced postmortem. It may be that the postdeath amendments were made only to prohibit the use of plan or IRA benefits to pay estate taxes or estate expenses after the September 30 following the participant’s death to assure that the participant’s estate would not be treated as a beneficiary for MRD rule purposes.
In PLR 200607031 (Feb. 17, 2006), the participant’s beneficiary designation named a subtrust of his revocable trust. The trust agreement specifically authorized the trust’s independent trustee to amend the terms of any trust created under the trust agreement to qualify the trust as a designated beneficiary under the Code and Treasury Regulations. Under the terms of the subtrust, the trustee has the discretion to distribute the trust’s net income and principal to the participant’s surviving spouse and/or children as the trustee deems necessary or advisable for their health, education, and maintenance. The participant’s spouse holds a limited testamentary power of appointment exercisable in favor of the participant’s descendants.
An overriding trust agreement provision requires the trustee to withdraw MRDs from any qualified plan or IRA payable to any trust, permits the withdrawal of additional amounts, and requires the trustee to distribute all withdrawn amounts to the beneficiary of the trust (that is, to apply conduit trust rules). The IRS noted that this provision precludes the accumulation of any portion of IRA benefits distributed to the subtrust and that the participant’s spouse and children who are the current beneficiaries of the subtrust are the only beneficiaries who need to be considered in determining the designated beneficiary for MRD purposes. Accordingly, the trust is a see-through trust with the distribution period measured by the life expectancy of the participant’s spouse, the oldest current beneficiary of the conduit trust. See also PLR 200620026 (May 19, 2006), in which a court modified and reformed a trust agreement providing for a similar conduit trust following the participant’s death.
In PLR 200608032 (Feb. 24, 2006), a trust for the benefit of the participant’s six children and identified charitable organizations that was named beneficiary of the participant’s IRA was amended by court order following the participant’s death. The trust, as amended, provided that
• the shares of five of the six children were to be distributed outright from the trust;
• no portion of the trust could be used to pay decedent’s debts, taxes, or expenses after the end of the window period;
• no payments could be made to non-individuals after the end of the window period;
• the sixth child’s share of the IRA was to be held in trust with income and/or principal payable, in the trustee’s discretion, for the child’s education, health, maintenance, comfort, and general welfare during her lifetime; and
• on the child’s death, the remaining trust assets could not be paid to any non-individual beneficiary or to any individual born before the participant’s oldest child.
Each of the charitable organizations named received a distribution from the trust’s IRA before the end of the window period. The IRS ruled that the trust qualified as a see-through trust with the life expectancy period for MRD purposes to be measured by the life expectancy of the participant’s oldest child (an older sibling of the continuing trust’s beneficiary).
Transfer of IRA to a Special Needs Trust
In PLR 200620025 (May 19, 2006), an IRA account owner who died before his required beginning date designated his four sons, one of whom was eligible to receive Medicaid and other public benefits, as equal beneficiaries. Before the end of the window period, separate IRAs for three of the sons were split off from the participant’s IRA, leaving the participant’s disabled son the sole remaining designated beneficiary of the participant’s IRA. Under a petition of the remaining son’s guardian (his mother), a court issued an order creating a “special needs” trust for the son under which the son’s guardian, as trustee, may distribute to or apply for the benefit of the son as much of the income and principal of the trust as the trustee in her sole discretion deems advisable. On the son’s death, the balance of the trust assets are to be distributed to the state’s Department of Children and Families to the extent necessary to satisfy the total medical assistance paid for the son’s benefit by that department and, if assets remain, to the son’s heirs at law. The son’s mother disclaimed any interest in the trust.
In connection with the proposed transfer of the IRA benefiting the son to the special needs trust, the ruling held that the transfer will not be considered a transfer under Code § 691(a)(2) that would accelerate income tax on the IRA and that, for purposes of the MRD rules, the son’s life expectancy may be used to calculate minimum distributions from the IRA. The ruling concludes that the special needs trust is a grantor trust under Code § 677(a) because the income of the trust may be distributed or accumulated in the discretion of the grantor or a nonadverse party. The ruling cites Rev. Rul. 85-13, 1985-1 C.B. 184, providing that a transfer of the grantor’s assets to the trust is not recognized as a sale or other disposition for income tax purposes (that would require the recognition of income in respect of a decedent).
Regarding the request that MRDs be measured by the son’s life expectancy, the ruling states: “[T]he Service believes that the ‘separate account’ requirements of section 1.401(a)(9)-8 of the ‘Final’ regulations, Qs & As–2, have been met” and that it is appropriate to calculate the annual distributions required by using the son’s life expectancy. Clearly, a non-individual is expected to benefit from the special needs trust, a fact that would typically have required that the entire IRA be distributed on or before the end of the year in which the fifth anniversary of the participant’s death occurred had the participant designated the special needs trust as beneficiary. Perhaps the fact that a non-adverse trustee has the power to withdraw the IRA assets for the benefit of the son beneficiary represents a withdrawal right that permits contingent beneficiaries to be disregarded. See PLR 199903050.