Tax planning for a large IRA can pose a number of complex problems, resulting in part from the complex interplay of several distinct sets of tax rules. On the death of the IRA owner, the IRA faces a potential tax double-hit. First, as a general rule, the value of the account is includable in the person=s taxable estate for estate tax purposes. Second, payments from the IRA to other beneficiaries are subject to income taxes, based on the theory that no income taxes were paid during the life of the original owner. The periodic payments are taxed under the rules of ' 72 for annuity payments, as modified by I.R.C. ' 408(d)(2). Distributions to other beneficiaries are taxed in the same manner as distributions to the original IRA owner.
Even though IRAs are commonly thought of as income tax-related devices, the estate tax implications of IRAs can be even more significant because estate tax rates are often substantially higher than income tax rates. Estate tax rates, for example, can often approach or exceed 50%. For this reason, part of the process of planning for a large IRA is balancing income tax and estate tax consequences against each other.
Moreover, improper planning or a lack of planning can make this tax problem even worse. For example, IRA accounts are generally treated as items of “income in respect of a decedent.” See Rev. Rul. 92-47 , 1992-1 CB 198. If the IRA assets are used to fund a formula bequest, such as from a decedent to a spouse for a marital deduction trust, this could trigger recognition of income on the value of the IRA under I.R.C. ' 691(a)(2). If that occurs, payment of the income tax, otherwise due when the IRA assets are paid out, can be accelerated. In that event, unless the IRA otherwise qualifies for the marital deduction, both the estate tax and the income tax would fall due almost simultaneously soon after the death of the IRA owner.
Proper planning for handling a large IRA is made more difficult by the sometimes complex rules on mandatory and minimum distributions that are applicable to IRAs. One of the most important components in determining what planning options are available and how best to use them in a given situation are the rules relating to Required Minimum Distributions ("RMDs").
Prior to 2001, these rules were particularly inflexible and unforgiving of mistakes. Under the pre-2001 rules, for example, the planning opportunities and problems differed considerably depending upon whether distributions from the IRA had already begun and on whether the IRA owner had reached age 702.
In January 2001, the IRS released a new set of proposed regulations, Prop. Regs. § 1.401(a)(9)-1 et seq., that greatly altered the landscape for IRAs. While there are still Required Minimum Distributions, the rules for determining how much must be distributed have been greatly simplified. Perhaps even more significantly, the rules governing distributions after the death of the IRA have been liberalized in a number of important ways. These changes will be considered in detail.
Although there are myriad different ways to plan for a large IRA, there are several fundamental strategies that are employed in most of these plans. One common element in many plans is to preserve maximum flexibility after the death of the original IRA owner. Because of the IRA distribution rules, flexibility can easily be lost without proper planning.
With respect to reducing taxes, there are two basically different approaches. One approach, which might be called the Aspend now approach,@ seeks to reduce the estate tax burden by beginning distributions as early as possible, in the hope of drawing down a significant portion of the IRA and thereby removing it from the IRA owner=s taxable estate. This strategy can backfire, for example, if the IRA owner dies unexpectedly within a few years after beginning to receive distributions. Moreover, this strategy, which obviously incurs income tax in the hope of saving estate taxes, tends not to work so well on large IRAs where it is difficult to take large distributions in a short period of time without disproportionately increasing the income tax burden by increasing the marginal tax rates and through the loss of deductions and exemptions as income levels increase.
It is also important to observe that taking distributions from the IRA does not automatically remove the assets from the estate for estate tax purposes. If the distribution proceeds are saved, reinvested, or used to purchase any non-wasting assets, the value of the savings or reinvestments will still be included in the taxable estate. The only practical way to avoid inclusion in the estate of those amounts would be to make tax-exempt gifts (i.e., gifts using the annual exclusion) or charitable gifts of the after-tax IRA proceeds.
An alternative strategy is to seek to reduce the economic cost of the inevitable tax burden by deferring the payment of the tax for as long as possible. This might be called the Apay later approach.@ With proper planning and document preparation, it is possible to delay the income tax burden until the original IRA owner reaches 702 and then to spread it over a number of years. It is also possible, by using the marital deduction, to defer the payment of any estate taxes until the death of the IRA owner=s spouse. In many instances, particularly where the IRA owner and the surviving spouse are not likely to need to access the IRA assets for basic living expenses, this deferral strategy can significantly reduce the economic cost (or present value) of the taxes.
A drastically different approach is to use all or a part of an IRA to fund a charitable gift, which can have both income and estate tax benefits. Making a gift from an IRA to a charity creates some planning issues that must be considered.
This memorandum will consider each of these points in greater detail and outline some of the considerations that are applicable to choosing among the various alternatives. The memorandum will also outline some of the requirements that must be satisfied in order to implement these strategies successfully.
Planning for a large IRA requires careful consideration of a number of different sets of tax rules. Income tax will be due when the IRA is distributed. For a detailed discussion of most of the significant income tax aspects of the IRA rules, see IRS Publication 590, AIndividual Retirement Arrangements IRAs,@ pages 21-31 (2000 edition).
So long as the IRA owner is older than age 592, the amount and timing of the distributions is largely optional, until the IRA owner reaches the age of 702, when the rules for Required Minimum Distributions (RMDs) come into play. The RMD rules also control the options and requirements for distributions after the death of the IRA owner.
As noted above, these rules were dramatically changed in January, 2001. Under the prior rules, the application of the RMD rules after the death of the IRA owner varied depending upon whether distributions from the IRA had begun and whether the IRA owner had reached age 702. Under the 2001 version of the rules, these factors are no longer controlling.
A central concept involved in the IRA rules is the term Arequired beginning date@ (sometimes abbreviated as ARBD@), which is the date at which IRA distributions must commence. This is defined as April 1 of the calendar year following the year in which the owner reaches or would have reached age 702. See Prop. Regs. ' 1.401(a)(9)-1 (as amended). Beginning in 1997, an employee (other than a 5% owner of the business) who continues to work is not subject to this required beginning date. I.R.C. ' 401(a)(9)(C).
Distributions from an IRA are usually taxable to the recipient. As a general rule, distributions must begin not later than the required beginning date and continue over the life of the IRA owner or over the lives of the IRA owner and a Adesignated beneficiary.@ See I.R.C. ' 401(a)(9)(A). To understand the significance of the new minimum distribution rules, proposed in 2001, it is useful to understand the earlier rules that were replaced by the 2001 version.
Although the Code contains only basic requirements for distributions, in 1987 the IRS proposed a complex set of regulations that outlined several different sets of rules for Arequired distributions.@ Under the 1987 rules, the tax treatment of an IRA on the death of the IRA owner could be dramatically different depending upon whether death occurred before or after the so-called Arequired beginning date@ and on whether distributions had already begun.
While the IRA owner was alive, the required distributions after the age of 70½ could be determined under any one of three different computational methods, so long as the method was selected before the RBD. Failing to choose a method before the RBD forced the owner to use the default method. Once the computational method was selected, the actual computation of the required distribution was still a complex task.
After the IRA owner’s death, different rules were applicable depending upon whether distributions had actually begun and whether the IRA had reached the RBD. In the case of death before distributions had begun or before the required beginning date, the general rule was that the IRA had to be distributed within five years from the year of death. See I.R.C. ' 401(a)(9)(B)(ii). There were three important exceptions:
(1) if there was a Adesignated beneficiary@ as of the date of death (see discussion below), then the distributions could be made over the life of the designated beneficiary, beginning in the year following the year of the owner=s death;
(2) if the surviving spouse was the designated beneficiary, payment could be made over a period not to exceed the lifetime of the surviving spouse, with payments beginning not later than the end of the year following the year of death or the end of the year in which the IRA owner would have reached 70 1/2, whichever is later; and
(3) a spouse, as designated beneficiary, could treat the IRA as his or her own and avoid payout altogether until the spouse reaches 702.
See I.R.C. ' 401(a)(9)(B)(iii)-(iv); Prop. Regs. ' 1.401(a)(9)-1 (1987 version, as amended).
If the owner died after commencement of distributions, then the beneficiary had to receive his or her interest in the IRA at least as rapidly as specified by the method of distribution in effect on the date of death. I.R.C. ' 401(a)(9)(B)(ii). Hence, in order for the payout to be extended over the lifetime of a designated beneficiary, the designated beneficiary had to be in place on the required beginning date (so that distributions could have begun under that system).
Under the 1987 rules, if the IRA owner designated a beneficiary ( Adesignated beneficiary@) in accordance with the IRS Regulations, either by the time distributions began or by April 1 of the calendar year following the year in which the owner reaches the so-called required beginning date (age 702), then the payout could have been extended to a period based on the joint life expectancy of the owner and the designated beneficiary. I.R.C. ' 401(a)(9)(A). (The benefit of this rule was somewhat limited by an even more complex rule relating to the Minimum Distribution Incidental Benefit (MDIB) requirement, which could come into play if the designated beneficiary was a non-spouse and was more than 10 years younger than the IRA owner.) The MDIB requirements did not apply after the death of the IRA owner.
If no Adesignated beneficiary@ meeting the requirements of the Regulations was appointed by the required beginning date, payout could not be extended beyond the IRA owner's life expectancy. Similarly, if the designated beneficiary died or if the IRA owner wanted to select a different or additional beneficiary, if the IRA owner was past the RBD, no changes were possible.
On January 17, 2001, the IRS published in 66 Federal Register 3928 (January 17, 2001) a new set of proposed rules, Prop. Regs. § 1.401(a)(9)-1 et seq., relating to IRA distributions that substantially simplify and modify a number of the 1987 rules. Among the important changes, the 2001 rules significantly alter the rules for computing the minimum required distributions from the IRA. The 2001 rules also drastically modify the rules relating to the designation of beneficiaries and the rules governing the consequences of beneficiary designation on the minimum distribution requirements.
Under these new rules, all distribution requirements are keyed to a uniform life expectancy table rather than to the individual life expectancies of the IRA owner or the beneficiary. In most cases, the uniform table will reduce the minimum distribution requirement for most owners and beneficiaries.
No longer will it be necessary to designate a beneficiary before the required beginning date (usually age 70½). Now, the beneficiary can be determined as late as the end of the year following the IRA owner’s death.
No longer will it be necessary to deal with the question of recalculating life expectancies each year. More post-death distributions can now be spread over a larger number of years in more situations than was permissible under the 1987 rules. The net effect of these changes is not only to simplify the process of complying with the IRA rules but also to allow greater flexibility in planning and using IRAs.
From a planning perspective, one of the most significant effects of the new proposed rules is the change in the time at which the designated beneficiary is determined. As noted above, under the 1987 rules, if the beneficiary was not designated by the date at which distributions were required to begin (soon after age 70½), the options for IRA distributions were greatly reduced. Similarly, it was not possible to change the beneficiary after that date, even if the previously selected beneficiary died.
Under the 2001 rules, however, the designated beneficiary is determined as of the end of the year following the death of the IRA owner. Therefore, beneficiary designations can be changed up to the date of death, because the designation of the beneficiary no longer affects the computation of the minimum required distribution. Moreover, certain post-death events, such as disclaimers and survival contingencies can now be taken into account in determining who is the ultimate “designated beneficiary.”
There are two key features to the operation of the new rules – (1) computing the RMD and (2) determining the options after the IRA owner dies.
Distributions must begin as of the required beginning date (just as under the old rules), but the required minimum distribution is now based on the IRA owner’s life expectancy under a uniform table. The uniform table effectively assumes a life expectancy similar to that of the joint life expectancy of the IRA owner and a beneficiary ten years younger. This is why, in most instances, the RMD’s will be lower under the new rules than under the old rules. Also, there is only one, simplified method for computing the RMD.
For example, suppose an IRA owner under the old rules had an IRA worth $100,000 on December 31, 1999, and had no designated beneficiary as of the RBD. For the first year of distributions, when the owner was 71, the RMD would have been $6,536 ($100,000 divided by a life expectancy of 15.3. Under the new rules, the minimum distribution in year 2001, assuming the same account value, would be $3,953 ($100,000 divided by 25.3, the “life expectancy” value under the uniform table). Under the rules, it makes no difference whether a beneficiary had been designated or not.
There is one significant exception to the uniform, simplified approach to computing RMDs. If the IRA owner’s spouse is more than 10 years younger than the IRA owner and if the spouse is the sole beneficiary of the IRA, then the RMD may be computed using the actual joint life expectancy of the IRA owner and the spouse. Usually, this will result in lower minimum distributions than even the uniform table.
For example, assuming the same facts as the foregoing example, except that the IRA owner’s spouse is 12 years younger than the IRA owner in year 2001, the RMD based on the uniform table, as in the foregoing example, is $3,953. The actual joint life expectancy of the IRA and the spouse, however, is 26.7 (determined under standard life expectancy IRS tables), which produces a minimum distribution of $3,745 ($100,000 divided by 26.7).
If the IRA owner dies before beginning distributions (i.e., the required beginning date), there are two basic alternatives:
If there is a designated beneficiary, over the life expectancy of the beneficiary;
If there is no designated beneficiary, over a five-year period.
If the IRA owner dies after beginning distributions (i.e., the required beginning date), there are two basic alternatives:
If there is a designated beneficiary, over the life expectancy of the beneficiary;
If there is no designated beneficiary, over the remaining life expectancy of the IRA owner immediately before his or her death.
Thus, even where the IRA owner dies without a designated beneficiary, in many instances the value of the IRA can be distributed over a period of years (determined by the IRA owner’s life expectancy immediately prior to death), rather than all in the year after death, as the 1987 rules required. Conversely, if there is a designated beneficiary, determined as of the end of the year after the IRA owner’s death, then the RMDs are based on the beneficiary’s own life expectancy, using the standard IRS life expectancy table. If the beneficiary fails to take the first RMD by the end of the year following the year of the IRA owner’s death, the entire account must be distributed within 5 years.
The 2001 rules also retain, and in some instances clarify, a number of the basic principles of the 1987 rules. For example, the 2001 rules clarify certain questions about designating trusts as beneficiaries, although they retain the same basic approach as the 1987 rules (as amended in 1997). Similarly, while keeping some of the provisions of the old rules on the rights of a surviving spouse to treat the IRA as his or her own, the new rules do make several important clarifications and modifications.
As a general rule, under both the 1987 and the 2001 rules, the surviving spouse is the only designated beneficiary of an IRA who may roll over the decedent's IRA into his or her own IRA. Prop. Regs. ' 1.408-8, Q & A-4(b). This spousal right to rollover a deceased IRA owner=s IRA applies regardless of whether distributions have begun or not.
Under the 1987 rules, in some cases it was possible for the surviving spouse to make this election where the spouse was the sole beneficiary of a trust that was the designated beneficiary of the IRA. Under the 2001 rules, however, this may no longer be possible. The 2001 rules state:
In order to make this election, the spouse must be the sole beneficiary of the IRA and have an unlimited right to withdrawal amounts from the IRA. This requirement is not satisfied if a trust is named as beneficiary of the IRA even if the spouse is the sole beneficiary of the trust. Prop. Regs. § 1.408-8 (Q&A-5(a)).
Thus, under the 2001 rules, it now appears that if a trust is a beneficiary, even if the surviving spouse is the sole beneficiary of the trust, the spouse may be prevented from making the election to treat the IRA as his or her own. It is not clear whether the spouse can make this election if there are contingent beneficiaries whose right to the IRA depends upon the prior death of the spouse. This uncertainty complicates the planning process.
While the 2001 rules changed the time for determining whether a beneficiary had been designated, they do not significantly alter a number of other requirements relating to who may be a designated beneficiary or the effect of designating multiple beneficiaries.
If there are multiple beneficiaries meeting the requirements of a Adesignated beneficiary,@ the payout period is determined with reference to the beneficiary with the shortest life expectancy. See Prop. Regs. ' 1.401(a)(9)-5 (Q&A-7). With proper planning it is, however, possible to create Aseparate accounts@ for each of the beneficiaries which, subject to the MDIB rules, may somewhat extend the payment period by allowing the computation of the life expectancies to occur separately with respect to each share. See Prop. Regs. ' 1.401(a)(9)-5(Q&A-7(a)(2)).
Generally, only an individual, not a trust or an estate, can be a Adesignated beneficiary@ under the distribution rules. See Prop. Regs. ' 1.401(a)(9)-4(Q&A-2). The 2001 rules incorporate certain proposed amendments to the 1987 rules that, in certain situations, permit the beneficiaries of a trust, rather than the trust itself, to be treated as Adesignated beneficiaries.@ For this exception to apply, four requirements must be met:
(1) the trust must be valid under state law;
(2) the trust must be irrevocable or must become irrevocable on the death of the IRA owner;
(3) the beneficiaries of the trust must be identifiable from the trust instrument; and
(4) a copy of the trust instrument must be provided to the plan administrator.
Prop. Regs. § 1.401(a)(9)-4 (Q&A-5).
Thus, while the beneficiary of a trust meeting the foregoing requirements can qualify as a Adesignated beneficiary@ of an IRA, an estate cannot. Hence, under no circumstances should an estate be named beneficiary of an IRA.
The new rules also mark several important procedural changes in the IRA rules. Now, for the first time, IRA trustees and custodians will be required to report to the IRS the amount of the minimum distribution requirement, although the details on how this will be implemented have not yet been released.
Officially, the IRS says the new proposed regulations will be effective beginning January 1, 2002. IRA owners and beneficiaries, however, may elect to apply the new rules in year 2001 for purposes of computing required distributions or they may continue to apply the old rules. Of course, the 2001 rules are technically only “proposed” at this stage, and their content could change before they are finalized. It is, however, clear that beginning in 2001, IRA owners can rely upon them in computing the RMD for year 2001.
If the goal is to spread the IRA payout over the longest possible period, and thereby earn the greatest income tax deferral, the 2001 rules will be of considerable assistance. As was true under the 1987 rules, obtaining the greatest deferral requires having a “designated beneficiary.” The new rules offer greater flexibility in achieving this objective.
First, as noted above, the designated beneficiary is not determined under the 2001 rules until the end of the year following the year of the IRA owner’s death. As a result, the IRA owner can make changes in the designation of the beneficiary as long as he or she lives. Second, certain post-death events can affect this. Suppose, for example, that the IRA owner is not sure whether the surviving spouse will need access to the funds in the IRA, so while she is alive, she designates her husband as the principal beneficiary of the IRA, but also names her children as contingent beneficiaries. If, on the IRA owner’s death, the husband feels confident that he does not need the IRA funds to maintain his life style, so he executes a qualified disclaimer (see IRC § 2518) of his interest in the IRA. As a result of the disclaimer, the interest in the IRA will then pass to the children. Not only will this likely save income taxes if they opt for the maximum deferral (because the children will have longer life expectancies), but it could also result in estate tax savings by keeping the IRA out of the husband’s taxable estate.
The value of an IRA is included within the owner=s gross estate for estate tax purposes. See I.R.C. ' 2039(a). In the case of a large IRA, the effective estate tax rate on the IRA can easily exceed 50%.
On June 7, 2001, President Bush signed the "Economic Growth and Tax Relief Reconciliation Act of 2001." This law contains complex provisions phasing out the estate tax over a ten-year period, only to have the entire estate tax reappear one year later. It is still too early to determine what if any impact this new law will have on planning for IRAs. For the next few years, at least, most of the same estate tax planning considerations will continue to be important.
Payment of the estate tax burden associated with IRAs can be delayed by making sure that the IRA is transferred to the surviving spouse under the estate tax marital deduction. In order to comply with the marital deduction requirements, if the IRA is to qualify for the marital deduction, it must be transferred either to the surviving spouse directly (as designated beneficiary) or indirectly through either a QTIP interest or trust that is revocable by the spouse.
As a general proposition, maximum flexibility and tax deferral is obtained by naming the surviving spouse as the sole designated beneficiary of the IRA and allowing the spouse to roll the IRA over and use it to claim the marital deduction. Apparently, under the 2001 rules, this roll-over right could be lost if a trust is named the designated beneficiary. There are essentially three ways to insure that the amount of the IRA will qualify for the marital deduction: (1) naming the spouse as beneficiary; (2) making the IRA payable as an annuity or in installments directly to the spouse; or (3) making the IRA payable to a marital deduction-type trust, i.e., a trust whose assets would qualify for the marital deduction. This latter approach could, however, jeopardize the roll-over.
As noted above, under the new rules is not clear whether naming contingent beneficiaries -- who would, for example, take the IRA in the event of the death of the spouse -- would impair the spouse’s right to roll over the IRA into his or her own IRA. It would seem surprising if the new rules, designed to promote flexibility, would lead to this result, but the answer is not clear. Generally, “contingent” beneficiaries whose rights depend upon the death of another beneficiary are not treated as “designated beneficiaries” under the rules (see Prop. Regs. § 1.409(a)(9)-3(Q&A-3), but the IRS has not made clear whether this principal also applies to the spousal roll-over right.
Regardless of how the marital deduction is satisfied, the transfer itself must be done by either a specific bequest, a residuary bequest, or a fractional share formula bequest in order to avoid triggering adverse treatment under the rules applicable to income in respect of a decedent. IRA accounts are usually treated as items of income in respect of a decedent (AIRD@) under I.R.C. ' 691. See Rev. Rul. 92-47 , 1992-1 CB 198. If the IRA assets are used to fund either a specific monetary bequest or some types of marital deduction trusts, this can trigger recognition of income on the value of the IRA. ' 691(a)(2). In any event, distributions from the IRA received either by the estate or a beneficiary are items of IRD, and there will be an income tax deduction for the amount of estate tax paid with respect to such items. I.R.C. ' 691(c).
Usually, the maximum flexibility will be achieved where the spouse is named the beneficiary of the IRA and then the spouse has the option to select the preferable method of distribution. Unless there is some concern about giving the surviving spouse access to the full amount of the IRA, this is probably the best alternative.
If qualifying the IRA for the marital deduction (without triggering recognition of IRD) is the main concern, the most conservative course is to have the spouse be the designated beneficiary. This approach has the benefit of maintaining maximum flexibility with minimum risk of inadvertently foreclosing one of the spouse's options. If there is a clear reason for not giving the spouse the IRA outright, then a separate IRA trust is probably the better way to go, although this may forfeit the spousal roll‑over option. This separate trust approach would avoid the IRD problem and still allow the IRA to qualify for the marital deduction. Using a separate trust can also allow designating alternative beneficiaries and the like, in the event that the spouse does not survive the IRA owner.
If the surviving spouse exercises the option of treating an inherited IRA as his or her own and rolls it over into the spouse=s own IRA under Prop. Regs. ' 1.408-8, then the IRA distribution rules and requirements apply to the spouse as if the original IRA owner were never involved. For example, the amount of the inherited IRA could be distributed over the lifetime of the spouse and a designated beneficiary, such as a child.
As noted above, because of the new rules, it is possible to name the spouse as the principal beneficiary but then name others, such as children or grandchildren, as contingent beneficiaries. This approach allows the spouse to disclaim all interests in the IRA and allow it to pass to the contingent beneficiaries. Unfortunately it is not clear at present whether doing this will affect the spouse’s right to treat the IRA as his or her own.
There are a number of other estate-tax related issues that arise in conjunction with a large IRA. One is the question of allocation of the estate tax burden. Payment of the estate taxes attributable to an IRA, whether incurred on the death of the original owner or a spouse, can pose some unusual issues under state estate-tax apportionment rules and may result in unintended consequences. This is one reason that some careful practitioners recommend that a large IRA be held through a Atrust IRA@ rather than through the more common Acustodial IRA@ used by most IRA providers. By using a specially constructed IRA trust, issues such as the payment of estate taxes can be directly addressed.
Care must also be exercised with respect to the payment of estate taxes from the IRA. While it appears possible to use IRA assets to pay the estate taxes associated with the inclusion of the IRA in the taxable estate, payment of other taxes or debts of the IRA owner from the IRA could cause the IRA owner’s estate to be treated as a “beneficiary” of the IRA.
The trust IRA, as opposed to the more common custodial IRA, also provides a number of other advantages in the context of a large IRA. These include the ability to deal with issues like disability or incompetency of the IRA owner, control of the investment decisions, control of distribution practices, and the ability to divide the IRA into separate shares for purposes of the IRA distribution rules, which can be very important if there are substantial age differences in the designated beneficiaries, if one of the beneficiaries is a charity, or if the beneficiaries include grandchildren.
In addressing any particular situation, a number of factors should be considered. The size of the IRA and the IRA Owner=s health are important variables that must be adequately taken into account. As a baseline for comparison purposes, let=s consider a Aworst case@ scenario. Suppose the IRA Owner were to take a lump sum distribution of the IRA and then die shortly thereafter. In that event he would incur federal and state income tax on the full value of the IRA, with a combined effective federal and state tax rate that could approach 40%, and the after-tax value of the proceeds would be includable in his estate for estate tax purposes, thereby potentially subject to another tax on the order of 50% to 55%. The combined effect of the income and estate tax could reach 70% of the current value of the IRA.
If the IRA Owner were to die with no Adesignated beneficiary@ appointed in accordance with the new IRA rules, then the entire amount of the IRA must be distributed within either 5 years (if distributions had not yet begun) or over the remaining life expectancy of the IRA owner, determined immediately before death.
These considerations indicate that, no matter what else happens, the IRA Owner should be sure to have in place a properly Adesignated beneficiary.@ If neither the IRA Owner nor his spouse is likely to need the IRA for living expenses or medical expenses, then there appears to be little benefit to taking distributions from the IRA before it becomes necessary. All that will do is accelerate the payment of income tax, since the proceeds of the distributions will likely remain in the IRA Owner=s estate for estate tax purposes, particularly if death occurs within a few years.
In many instances, it may be doubtful whether there can be any significant reduction in the potential estate tax attributable to the IRA unless the IRA Owner were either: (1) to take substantial lifetime distributions and then spend the money; or (2) to make significant charitable contributions of the IRA proceeds (or a portion thereof). This is true whether the IRA Owner begins taking distributions from the IRA or not. In some cases, the only significant ability to affect the estate tax is to make sure that the IRA qualifies for the marital deduction, which will thereby permit deferral of the estate tax until the death of the IRA Owner=s spouse, assuming that the IRA Owner is likely to predecease his or her spouse. Even with usual life expectancies, the estate tax burden can often be postponed, using the marital deduction, for as much as 25 to 30 years.
From the income tax standpoint, other than by making a charitable contribution of the IRA, deferral of the payment of tax would appear to be the best strategy, if the IRA funds are not likely to be needed for living expenses or medical expenses during the lifetimes of the IRA Owner and his or her spouse. In that event, the following strategy might be employed:
1. Delay beginning any distributions as long as possible (until the RBD);
2. Designate the IRA Owner=s spouse (or a suitably designed trust) as principal Adesignated beneficiary@ of the IRA (contingent designated beneficiaries should also be considered);
3. Plan for the IRA Owner=s spouse to rollover the IRA (or any remaining amount) into the spouse=s own IRA, which could be a Roth IRA;
4. Have the IRA Owner=s spouse appoint the IRA Owner=s children or grandchildren as his or her Adesignated beneficiaries;@
5. Begin distributions from the Spouse=s IRA based upon the uniform table in the 2001 rules; and,
6. Provide for division of the IRA into separate shares for the spouse=s designated beneficiaries, so that in the event the spouse dies before distributions are begun, the IRA can be distributed over the various lifetimes of the designated beneficiaries.
Taken together these strategies would produce the maximum estate tax deferral and spread the payment of the income tax over the longest possible period. Deferring the payment of any estate taxes might have particular advantage at the moment since there appears to be interest in Congress for additional estate tax relief in the next few years.
Implementation of any plan for handling a large IRA requires careful attention to both the IRS requirements and estate tax considerations. Close coordination between the IRA documentation and the IRA Owner=s estate planning documents is essential.
Because of the potential estate tax implications of a large IRA, usually, the first objective is making sure that the IRA can qualify for the marital deduction. There are a number of different ways to accomplish that, but making the spouse or a suitable trust the designated beneficiary of the IRA is paramount. In many instances, it is appropriate to consider converting the IRA from a standard custodial IRA into a trust IRA. Some of the advantages of this approach are mentioned above. There are several ways to handle this logistically, depending upon the terms of the current IRA and the policies of the current IRA custodian.
If the IRA Owner is otherwise so disposed, using the IRA to fund charitable bequests can save estate taxes, but this requires careful planning and drafting, particularly if the charitable bequest is less than all of the IRA. In that event, a trust IRA and a Aseparate accounts@ approach are essential.
Thought should also be given to structuring any eventual transfer of the IRA to the surviving spouse. While it is generally simpler and safer to give the spouse the IRA outright, it is possible to structure this in a manner consistent with the IRA Owner=s other estate planning documents. For example, if the IRA Owner otherwise prefers to use a trust or QTIP interest to satisfy the marital deduction, the same approach can be employed with the IRA, although there may be some loss of flexibility and the loss of the ability of the spouse to roll the IRA over into her own IRA. Whatever the approach, it is imperative that the IRA not be used to fund a formula marital deduction bequest or a pecuniary bequest, as that will trigger recognition of income in respect of a decedent. It is also important that any trust or QTIP interest that involves the IRA must be carefully drafted so as to comply with both the IRA rules and the marital deduction requirements.
The Pension Protection Act of 2006 made two significant changes in the distribution rules applicable to IRAs. First, the prior right of a spousal beneficiary to roll-over an inherited IRA into the spouse's own IRA has now been extended to certain other types of plans. In other words, after January 1, 2007, a spouse beneficiary who inherits a 401(k) account now has the option to roll the distribution over into the spouse's own IRA rather than being forced to take or continue receiving distributions as required under the original plan. In order to take advantage of this rule, the assets must be transferred from the original IRA to the second IRA in a trustee-to-trustee transfer.
Second, the 2006 Act also authorized up to $100,000 in tax-free withdrawals from IRA's for payments to certain charities for individuals who are at least 70 and 1/2 years old. This rule applies in 2006 and 2007. The new rule allows an IRA owner to exclude from income up to $100,000 of IRA distributions in both 2006 and 2007 if the IRA funds are contributed directly to one of the so-called 50% charities -- i.e., charities that, subject to certain exceptions, qualify for the 50% of AGI deduction limit. The amounts distributed to charity also count toward satisfying the IRA's minimum distribution requirements for the year.
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