Qualified Retirement Plans: Frequently Asked QuestionsBy Louis A. Mezzullo
With millions of people each year contributing to or taking distributions from qualified retirement plans and individual retirement accounts (IRAs), estate planners are often asked about the complex rules governing these vehicles. The question and answer format of this article is designed to provide succinct, practical answers to some of the most common questions.
If you do not need the money for current living expenses, you should defer the payment of the benefits or IRAs for as long as possible.
2. What is the benefit of deferring the payment of plan benefits or IRAs for as long as possible?
You will not pay federal and state income taxes on the benefits sooner than you are required to pay them, so that the amount you would have paid in taxes remains invested for a longer period. In addition, the income on the assets held in the plan or IRA will not be subject to current tax, allowing the plan benefit or IRA to grow more rapidly than similar investments outside of a plan or IRA.
3. What are the disadvantages if I defer the payment for as long as possible?
When you receive the benefits, you may be in a higher income tax bracket than you would have been had you taken the benefits or IRA distribution sooner. Deferring the payment of the benefits or IRA balance may cause you or your estate to incur a 15% excise tax on excess (i.e., large) retirement distributions or excess retirement accumulations. Finally, although some of the earnings generated by the plan or IRAs would have been taxed as capital gains if the assets were not in a qualified retirement plan or IRA, all earnings will be taxed as ordinary income when they are distributed. Currently, there is an 11.6% differential between the federal tax rates on ordinary income and capital gains.
4. With these disadvantages, should I still attempt to defer the distribution of benefits and IRAs for as long as possible?
If you will not withdraw the plan benefit or IRA balance in the near future, then the benefit of tax-free accumulation of income will offset foreseeable higher income tax rates and the 15% excise tax. The time required to offset an increase in the tax rate or the 15% excise tax depends on the rate of return on the assets, the current size of your plan/IRA balances and your projection of the increase in your marginal income tax bracket.
5. What is the 15% excise tax on excess retirement distributions and excess retirement accumulations? The Internal Revenue Code imposes a 15% excise tax on distributions from qualified retirement plans (including tax sheltered annuities) and IRAs to the extent the total of all distributions in a calendar year exceeds a certain dollar amount, which is $155,000 in 1996. The dollar amount adjusts annually for the cost of living. This amount is increased to $775,000 if the distribution qualifies as a lump sum distribution. To take advantage of the $775,000 exemption, the recipient must currently pay tax on the entire balance of the retirement plan, thereby eliminating the benefit of any deferral. If a larger amount is distributed in a particular year, the recipient may instead offset a "grandfathered amount" from the amount of the distribution. The grandfathered amount is the value of the participant's qualified retirement plan benefits and IRAs on August 1, 1986, reduced by any dis-tributions treated as a recovery of the grandfathered amount after that date and before the date of the distribution. The grandfathered amount is only available if the balance on August 1, 1986 exceeded $562,500 and the participant made an election by the due date for the 1988 federal income tax return.
There is also a 15% additional estate tax on excess retirement accumulations, which is the value of qualified retirement plan benefits and IRAs over the greater of the present value of a hypothetical annuity of $155,000 a year (adjusted annually for inflation), based on the decedent's age at death or the grandfathered amount. If an individual with a grand-fathered amount is in a terminal condition and likely to die in the near future, the individual could withdraw the grandfathered amount and, when the individual died, his or her estate would also be entitled to reduce the value of any remaining plan benefits and IRAs by the value of the hypo-thetical annuity. This would require acceleration of the payment of income tax on the plan benefit or IRA assets, but could provide maximum offsets from the two 15% taxes. In addition, any federal or state income tax payable on the before-death distribution would reduce the individual's estate dollar for dollar. If benefits are paid after the death of the participant/owner, the recipient of the decedent's plan benefit or IRA assets would be entitled to an income tax deduction only for federal estate tax attributable to income in respect of a decedent. Consequently, it may be better to receive and pay taxes on income that will otherwise be income in respect of a decedent before death rather than have the income paid to a beneficiary after death. Again, the benefit of this tactic may be outweighed by the benefits of deferring the payment of the plan benefits or IRAs for as long as possible.
6. What are the restrictions on my ability to defer the payment of plan benefits and IRAs indefinitely?
First, your spouse has certain rights with respect to your plan benefits, and may have rights with respect to your IRAs under state law. Generally, your spouse must be named as the beneficiary of some or all of your plan benefits if you die before you begin to receive your plan benefits. In addition, your plan benefits must be paid in the form of a joint and survivor annuity once you begin to receive your plan benefits, which requires that your spouse be entitled to receive an annuity after your death equal to at least 50% of the annuity paid to you while you were alive. This requirement does not apply to most profit sharing, stock bonus or 401(k) plans. Your spouse may consent to some other form of benefit, but this consent can only be made during a period of 90 to 30 days before the benefits are paid. The spouse can also consent to having another beneficiary designated to receive your benefits if you die before the payments begin. In most cases, it will be advantageous for the spouse to be the named beneficiary, regardless of whether the participant dies before or after the payments begin.
Whether the benefits should be paid in the form of a joint and survivor annuity involves a guess about how long the participant and the spouse will actually live versus their life expectancies, as well as future investment earnings as compared to the annuity's implicit interest rate. With a joint and survivor annuity, payments will continue for the actual lifetime, whether there is a premature or later than expected death. At the death of the survivor of the participant and the spouse, nothing will be left. With other forms of distribution, the participant's beneficiaries may have a significant amount remaining after a premature death, or the benefits may run out before the participant's death.
The second restriction may be that the plan provisions do not permit the participant to elect the benefit form. Many companies do not want their plans to hold a former employee's benefit for a long time, particularly after the former employee's death. The third restriction is the 50% excise tax on required minimum distributions that are not actually made.
7. What are the required minimum distribution rules?
The required minimum distribution rules ensure that a participant in a qualified retirement plan or an IRA account holder cannot defer payment of the benefit or IRA assets indefinitely. The participant or account holder must either withdraw the entire plan benefit or IRA balance by April 1 of the year following the year in which the participant or account holder reaches age 70 1/2 (the required beginning date), or begin to receive payments on that date over one of four periods. The four periods are:
- The participant/account holder's lifetime;
- the lifetimes of the participant/ account holder and his or her designated beneficiary;
- the life expectancy of the participant/account holder; or
- the joint and last survivor expectancy of the participant/account holder and his or her designated beneficiary.
In every case, using two lives will result in a longer deferral than using one life. Whether actual lifetimes or life expectancies will result in longer deferrals depends on whether the participant and the designated beneficiary survive their life expectancies.
8. How are life expectancies determined?
Treasury regulations under Code 72 determine life expectancies. For example, a participant who was 70 on the last day of the year in which he or she reaches age 70 1/2 will have a life expectancy of 16 years. A participant who reaches age 71 by the last day of the year in which he or she reaches age 70 1/2 will have a life expectancy of 15.3 years. The joint and survivor life expectancy of a participant who is 70 and a spouse who is 65 in the year in which the participant reaches age 70 1/2 is 23.1 years. The life expectancies of a participant and a spouse may be recalculated each year, but the life expectancy of any other beneficiary may not be recalculated. If the life expectancy of an individual is not recalculated, then the life expectancy each year is determined by subtracting one from the life expectancy for the prior year. This amount is then divided into the value of the individual's plan benefits and IRAs to determine the required minimum distribution for that year. For example, if an individual is the beneficiary of a plan benefit that had a value of $1 million on the appropriate valuation date of the preceding year, and the individual's life expectancy is 20 years, the plan would have to distribute $50,000 to satisfy the minimum distribution rules.
If the life expectancy of an individual is recalculated (which can only be done for the participant and a spouse), the regulations referred to above determine the appropriate life expectancy on an annual basis. For example, a 71 year old person has a life expectancy of 15.3 years, while a 72 year old has a life expectancy of 14.6 years. An individual's life expectancy does not decrease by one full year for each year the individual survives, because the fact that the person has survived for a year means, actuarially, that he or she is expected to live slightly longer than was expected the year before. If one knew that the participant and the participant's spouse would outlive their life expectancies, as determined when the participant reaches age 70 1/2, recalculating life expectancies for both the participant and the spouse would produce the longest deferral. However, if both life expectancies are recalculated, at the death of the survivor of the participant and the spouse, any remaining plan benefit or IRA balance must be distributed to the person entitled to receive the benefit or IRA before the end of the year following the year in which the survivor died.
It is generally advisable to recalculate the life expectancy of the participant but not of the spouse. If the participant dies first, the spouse has the option, if permitted under the plan or IRA document, to transfer the plan benefit or IRA to the spouse's own IRA and begin receiving benefits over his or her life expectancy after reaching the required beginning date. The spouse may then recalculate his or her life expectancy and name a designated beneficiary both for determining the required minimum distribution during the spouse's lifetime and for deferring the payment over the designated beneficiary's lifetime after the death of the spouse. If the spouse dies first, because no recalculation occurred, the spouse's life expectancy can continue to be used to determine the required minimum distribution to the participant. For example, if the spouse is age 59 when the participant reaches age 71 1/2, the joint and last survivor expectancy is about 27 years. The spouse's life expectancy is 25 years. If the spouse dies after three years and the participant five years later and the suggested method was used, the plan or IRA can pay the remaining benefits over 17 years (25 years minus the eight years over which the payments have already been made). If the couple recalculated both life expectancies, the entire amount must be paid out before the end of the ninth year, the year after the death of the survivor of the participant and the spouse. By electing to recalculate the life expec-tancy of the participant each year, the participant can be assured that the payout period will last at least as long as the participant is alive, regardless of when the participant dies. If the spouse dies first and did not recalculate, his or her life expectancy will continue to be used to determine the payout to the participant.
9. Because the life expectancy of the designated beneficiary is used to determine the payout to the participant, wouldn't it be better to name a child or grandchild rather than the spouse as the designated beneficiary?
It is true that if the spouse is less than 10 years younger than the participant, naming a child or grandchild as the designated beneficiary will result in a smaller required minimum distribution to the participant during the participant's lifetime. Note, however, that the incidental death benefit rule treats a non-spouse beneficiary as no more than 10 years younger than the participant. Once the participant dies, the actual life expectancy of the non- spouse designated beneficiary, which is determined at the participant's required beginning date and reduced by one year for each year the participant received benefits, may be used for purposes of determining the required minimum distribution to the designated beneficiary. However, by naming a beneficiary other than the surviving spouse, the participant loses the benefit of a spousal rollover because only a spouse can roll over a decedent's qualified retirement plan benefit or IRA. If the spouse survives the participant, the spouse can name a designated beneficiary if a spousal rollover is made, thereby achieving much of the deferral that would have applied if the child had been a designated beneficiary of the participant in the first place. Moreover, because the spouse is the beneficiary, the benefit or IRA will qualify for the marital deduction, thereby deferring the payment of transfer taxes until the death of the spouse.
10. Can the payment of plan benefits or IRAs be deferred after death if the participant or account holder dies before the required beginning date?
Under the minimum distribution rules, if the participant or account holder dies before his or her required beginning date, the plan or IRA must distribute any accrued benefit in a qualified retirement plan and any account balance in an IRA by the end of the fifth year following the year in which the participant or account holder dies. If, however, the participant or account holder has named a designated beneficiary, the payment of the benefits may be further deferred. Whether or not the designated beneficiary is the spouse, the plan or IRA may make payments over the designated beneficiary's lifetime or life expectancy, provided that the payments begin before the end of the year following the year the participant or account holder dies. A spouse who is the designated beneficiary has the additional option of rolling over the qualified retirement plan benefit into his or her own IRA (if he or she can receive a current lump sum distribution under the plan), treating the deceased account holder's IRA as his or her own IRA, or deferring payment of plan benefits or IRA balance until the year in which the participant/ account holder would have reached age 70 1/2. If the spouse selects the last option, when the participant's 70 1/2 birthday is reached, the plan or IRA can make payments over the spouse's lifetime or life expectancy. If the spouse dies before the end of the year in which the participant/account holder would have reached age 70 1/2, the plan or IRA can make payments over the spouse's designated beneficiary's lifetime or life expectancy, provided that payments begin by the end of the year after the year in which the spouse died. If, however, the spouse remarries, names his or her new spouse as the designated beneficiary and then dies before payments must begin (when the deceased participant/account holder would have reached age 70 1/2), the new spouse cannot defer the payment of the benefits until the original participant's/account holder's spouse would have reached age 70 1/2.
11. Whom should I name as the beneficiary if I have children by a prior marriage or otherwise want to control the ultimate disposition of any remaining plan benefits or IRAs at the death of my spouse?
If you desire to postpone payment of transfer taxes until the death of your spouse, naming a qualified terminable interest property (QTIP) trust will allow you to control the ultimate disposition of any remaining plan benefits or IRAs and at the same time qualify for the marital deduction. The QTIP trust must provide the surviving spouse with annual distributions of all the income from the trust. In addition, no one other than the spouse can receive any distributions from the trust while the spouse is alive. At the death of the spouse, whatever remains in the QTIP trust will pass to the beneficiaries designated by the first spouse to die in the trust agreement. If the QTIP trust is the beneficiary of the plan benefit or IRA, more rapid distributions of the plan benefit or IRA may be necessary to qualify for the marital deduction. The IRS has taken the position that the plan benefit or IRA is itself a trust, and therefore the plan or IRA must pay all of its income to the QTIP trust, which must then pay the income to the spouse to satisfy the income requirement. Although the basis for this rule is questionable, the conservative approach would be to require that all income generated by the plan or IRA be paid to the QTIP trust beginning at the death of the participant. Under the minimum distribution rules, the payments could have been deferred until the date the decedent would have reached age 70 1/2 and the required minimum distribution could be less than the amount of income generated in the early years.
Most commentators on the proposed regulations dealing with the required minimum distribution rules believe that, for the spouse to be treated as the designated beneficiary of the participant when a QTIP trust is the beneficiary, the trust should be irrevocable at the earlier of the participant's death or the participant's required beginning date. It would make more sense to require the trust to be irrevocable at the later of the date of the participant's death or the date the trust is irrevocably named as the beneficiary of the trust. The minimum distribution rules clearly provide that the participant can change the designated beneficiary after the required beginning date. Note, however, that a change in the designated beneficiary after the required beginning date cannot extend the payout period, even though the new designated beneficiary is younger than the originally named designated beneficiary, but can shorten the payout period if the new designated beneficiary is older than the originally named designated beneficiary. Perhaps the IRS's concern is that the participant will change the beneficiary of the trust to an older beneficiary without informing the sponsor of the change. This concern could be handled by requiring the participant to notify the plan sponsor of any change in the beneficiaries of the trust rather than requiring the trust to be irrevocable. Nonetheless, the conservative approach is to either name an irrevocable trust as of the participant's required beginning date or to add a provision to a revocable trust that the trust will become irre-vocable for any plan benefit or IRA payable to the trust on the participant's required beginning date.
12. If the participant does not have sufficient assets to fund a credit shelter trust, should the plan benefit or IRA be paid to such a trust?
If the participant has any other assets that would not be income in respect of a decedent, it is better to use those assets to fund the credit shelter trust, because the amount passing tax free at the death of the surviving spouse (or at the death of the participant if the credit shelter amount is payable directly to children or other non-spousal beneficiaries) will not be reduced by taxes paid on the income. Nevertheless, flexibility can be obtained by naming the spouse as the primary beneficiary and a credit shelter trust as the secondary beneficiary. If it is advisable from an income and transfer tax standpoint and otherwise acceptable to the surviving spouse, he or she can disclaim the amount necessary to use any of the participant's remaining unified credit, which will then pass to the credit shelter trust. In some cases the income tax advantage of deferring the payment through the use of a spousal rollover will more than offset the benefit of using the participant's full unified credit, because the benefit of the unified credit will be reduced by the income taxes on the distributions.
13. May a qualified retirement plan benefit or IRA be used to satisfy my charitable desires?
Yes. By naming a charitable organization, such as a university, as the beneficiary of the qualified retirement plan or IRA, the participant's estate will receive an estate tax deduction and the charitable organization, because it is tax exempt, will not pay income tax on the benefit.
14. Are there any problems with naming a charity as a beneficiary?
If a charity is to be named as a beneficiary of only a portion of a plan benefit or IRA, it should be the beneficiary of a separate share or separate account. If the charity is a beneficiary of a non-separated portion of the plan benefit or IRA, the participant will be treated as not having a designated beneficiary for any plan benefit or IRA. In that case, if the participant dies before his or her required beginning date, the entire benefit must be paid out by the end of the fifth year after the year in which the participant dies. Once the participant reaches his or her required beginning date, only the participant's life expectancy may be used for determining the required minimum distribution.
15. Should I use a plan benefit or IRA to satisfy a specific cash bequest in my will?
No. If you use a qualified retirement plan benefit, an IRA or, for that matter, any income in respect of a decedent to satisfy a cash bequest, the income will be accelerated to the estate.
16. What concerns should I have about the estate and death taxes attributable to qualified retirement plan benefits or IRAs?
If your residuary beneficiaries are not the same as the beneficiaries of your qualified retirement plan or IRAs, you should consider requiring the plan or IRA beneficiaries to pay the estate tax attributable to those items to avoid having the amount passing to the residuary beneficiaries reduced by the estate tax. If your will contains a clause requiring that any estate taxes be paid by the estate and not by the beneficiaries, the residuary beneficiaries' share of the estate will be reduced by the estate taxes on the qualified retirement plan benefits and IRAs.
Qualified retirement plans and IRAs increasingly make up a significant portion of a client's estate. The unique combination of potential income tax, excise tax and estate tax requires the participant and the planner to thoughtfully designate beneficiaries, elect life expectancies and time the withdrawal of funds to accomplish the client's tax and non-tax objectives.
Louis A. Mezzullo is a member of Mezzullo & McCandlish in Richmond, Virginia. He is a member of the Section's Council (Probate and Trust Division) and is Supervisory Council Member for the Committees on Business Planning (Group E).