Tax & Business Professionals, Inc.


Income and Estate Tax Planning for a Large IRA

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Tax planning for a large IRA can pose a number of complex problems, resulting in part from the subtle 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 of 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, 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 convoluted and complex distribution rules, including rules on mandatory and minimum distributions, that are applicable to IRAs.  As a result of these rules, for example, the planning opportunities and problems differ considerably depending upon whether distributions from the IRA have already begun and on whether the IRA owner has reached age 702.  While these differences will be discussed in greater detail later, for present purposes it is sufficient to note that there are many more planning options and much greater flexibility before distributions are taken from the IRA.

Although there are myriad different ways to plan for a large IRA, there are several fundamental strategies that are employed in all 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.

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.

                                                The Basic Rules

As noted above, 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,@ Chapter 5, pages 21-32 (1997 edition).  The amount and timing of the distributions are determined by the complex IRA rules.  As noted above, the application of these rules varies depending upon whether distributions from the IRA have begun and whether the IRA owner has reached age 702. (See IRS Proposes Revised IRA Distribution Rules for an important update to these rules.)

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 who continues to work is not subject to this required beginning date.  I.R.C. ' 401(a)(9)(C).

                                          Income Tax Treatment

The income tax treatment of distributions turns largely on a complex set of distribution requirements, which dictate what must be distributed and when.  The Internal Revenue Code itself provides only a general set of requirements.  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).

Generally, the tax treatment of an IRA on the death of the IRA owner differs depending upon whether death occurs before or after the so-called Arequired beginning date@ or after distributions have already begun.   Although the Code contains only basic requirements for distributions, the IRS has proposed detailed regulations that outline several different sets of Arequired distributions.@

In the case of death before distributions have begun or before the required beginning date, the general rule is that the IRA must be distributed within five years from the year of death.   See I.R.C. ' 401(a)(9)(B)(ii). There are three important exceptions:

(1)     if there is a Adesignated beneficiary@ as of the date of death (see discussion below), then the distributions may 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 is the designated beneficiary, payment may be made over a period not to exceed the lifetime of the surviving spouse, with payments beginning not later than the later of the end of the year following the year of death or the end of the year in which the IRA owner would have reached 702; and

(3)     a spouse, as designated beneficiary, may 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 (as amended).

If the owner dies after commencement of distributions, then the beneficiary must 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 must be in place on the required beginning date (so that distributions could have begun under that system).

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.  I.R.C. ' 402(c)(9); 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.  Transfer of the IRA to a spouse (or QTIP interest) may qualify for the marital deduction, irrespective of whether the spouse is a designated beneficiary.

If the IRA owner designates a beneficiary ( Adesignated beneficiary@) in accordance with IRS Regulations, either by the time distributions begin 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 may be extended to a period based on the life expectancy of the owner and the designated beneficiary.  I.R.C. ' 401(a)(9)(A).  If no Adesignated beneficiary@ meeting the requirements of the Regulations is appointed by the required beginning date, payout cannot be extended beyond the IRA owner's life expectancy.  (Note: the benefit of this rule is somewhat limited by the Minimum Distribution Incidental Benefit (MDIB) requirement, which can come into play if the designated beneficiary is a non-spouse and is more than 10 years younger than the IRA owner.) See Prop. Regs. ' 1.401(a)(9)-2 (as amended).  The MDIB requirements do not apply after the death of the IRA owner.

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)-1(E) (as amended).  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)-1H.

Generally, a trust or an estate cannot be a Adesignated beneficiary@ under the distribution rules.  See Prop. Regs. ' 1.401(a)(9)-1(D) (as amended).  If a trust is the designated beneficiary and if certain requirements are met, the beneficiaries of the trust rather than the trust are treated as Adesignated beneficiaries.@  Until December 1997, the requirements for a trust to qualify as a designated beneficiary were: (1) the trust must be valid under state law; (2) the trust must be irrevocable; (3) the beneficiaries of the trust must be identifiable; and (4) a copy of the trust instrument must be provided to "the plan."  These requirements had to be met as of the later of (a) the date the trust is named as beneficiary, or (b) the required beginning date (April 1 of the year following age 702 ).  Prop. Regs. ' 1.401(a)(9)-1. 

The IRS recently amended these rules.  See Prop. Regs. ' 1.401(a)(9)-1(D-5, D-6, and D-7) (in Q&A format).  Under the revised rules (or more accurately proposed rules), if a trust meets the requirements set forth in the rules, distributions from the IRA made to the trust will be treated as paid to the beneficiaries and all of the beneficiaries of the trust will be treated as designated beneficiaries of the IRA for purposes of determining the distribution periods.  With the exception of certain modifications in the paperwork requirements (item number 4 on the list above), the main difference from the older rule is that now the trust can be Airrevocable or will, by its terms, become irrevocable upon the death of the employee.@  Prop. Regs. ' 1.401(a)(9)-1(D-5(b)(2)).  Note that while a trust meeting certain specific requirements, see Prop. Regs. ' 1.401(a)(9)-1, 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.

If the goal is to spread the IRA payout over the longest possible period, then it is essential that the designated beneficiary requirements be satisfied not later than at the beginning of distributions or the required beginning date, whichever is earlier.  Because of the MDIB rules, the benefits of this will be limited in the case of non‑spouse beneficiaries who are more than 10 years younger than the IRA owner.

                                      Estate Tax Considerations

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% and approach 55%.

Payment of this tax burden 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 (or a trust of which the surviving spouse would be treated as owner) as the designated beneficiary of the IRA and allowing the spouse to roll the IRA over and use it to claim the marital deduction.    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. 

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 pecuniary bequest or a marital deduction trust under a formula bequest, this can trigger recognition of income on the value of the IRA because it is being used to fund a Apecuniary bequest.@ ' 691(a)(2).  Hence to avoid acceleration of income tax on the IRA it would be necessary to use either a specific or residuary bequest or a fractional share bequest.   In any event, distribution amounts 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 (not a standard revocable living trust or a marital deduction family trust) is probably the better way to go.  To preserve the spousal roll‑over option after the IRA owner's death, the trust would need either to satisfy the QTIP requirements or be revocable by the spouse (or subject to a withdrawal power).  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.

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. 

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.

                                                       Options

Against this cursory overview of the legal considerations, it is possible to evaluate the various options available here.  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 IRA rules, then the entire amount of the IRA would have to be distributed within either 5 years (if distributions had not yet begun) or as quickly as they would have been made under the distribution plan in effect on the date of death.  Of course, if there is no Adesignated beneficiary@ and if distributions begin before death, they would need to be completed over a period not longer than the IRA Owner=s life expectancy.  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, 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;

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 joint life expectancies of the Spouse and his or her Adesignated beneficiaries;@ 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

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, consideration should also be given to 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, because a charity cannot be a Adesignated beneficiary@ within the meaning of the IRA regulations.

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.