Planning for IRA and Retirement Assets

Planning for IRA and Retirement Assets

By: Martin M. Shenkman, CPA, MBA, JD

IRAs And Retirement Plans

Traps and Planning Tips


Estate planning for retirement assets is vital to address for almost everyone. The topic is broad and complex, so this article will only address a handful of issues that you might miss or misconstrue, or have particular relevance in our turbulent economy. The bottom line, review and monitor your retirement planning assets with your investment adviser, accountant, pension consultant, and estate planner on a regular basis to maximize the benefits for both you and your heirs.

$3.5 Million Federal Exclusion and Planning for Your IRA and Retirement Plan

The New $3.5 Exclusion

The applicable exclusion, the amount every taxpayer can bequeath without incurring any federal estate tax, increased to $3.5 million in 2009, from $2 million in 2008. This change has a significant impact on planning and requires every taxpayer (even those with estates well below the taxable threshold) to review their estate plans, ownership (title) of assets, and retirement plan beneficiary designations. The coordination of assets, documents and planning objectives also should be reviewed in light of the impact of the current economic turmoil and its impact on asset values and financial needs.

Example: Your estate was worth $6 million prior to the stock market meltdown. When the estate tax exclusion was $1 million you executed a will that left the then maximum amount that could be given away without a federal estate tax to a bypass (credit shelter) trust to benefit your children from a prior marriage and your new spouse. You named the children as trustees since this was only a small part of the estate. You viewed the bypass trust assets as primarily for your children, since your new spouse would have use of the lion's share of the estate. Your surviving spouse would have the benefit of the $5 million remainder you bequeathed to a marital (QTIP) trust. Your spouse would receive monthly income distributions from the QTIP trust. You estimated a conservative 5% return, so that your spouse would receive $250,000/year. Your estate declined to $4 million in the recent market meltdown. The exclusion is now $3.5 million. Now, on your death, the bypass trust would be $3.5 million, This bypass trust would trigger a $229,200 state estate tax (depending on the state of domicile), and leave only $500,000 for the marital trust for your surviving spouse. Furthermore, the income distributions in the current environment will be nothing near the 5% you had assumed. The result of this could be that your surviving spouse might receive $15,000/year in distributions if the QTIP trust generates only 3% income.

Reviewing Your Plan

Review and modification of your plan, and the handling of your IRA and retirement assets in the revised plan, are essential. Here's a few general thoughts on integrating IRA and retirement plan assets into your overall plan:

  • From a purely tax perspective, (which is not always consistent with personal goals) leaving an IRA outright to your spouse is always best. This provides the surviving spouse the most tax flexibility and benefit. The increased exclusion has no impact on this planning, since the marital deduction for citizen spouses was, and remains unlimited. However, it does change the dynamic of planning overall, as discussed below.
  • Bequeathing an IRA to children or grandchildren can directly permit them to defer or stretch the distributions of those plan assets over their much longer life expectancies. The increased $3.5 exclusion makes it easier to leave large plan balances to children and other non-spousal heirs.
  • Consider any prenuptial or postnuptial, or contractual obligations that might affect to whom or how you bequeath your IRA or retirement assets.

Estate Below Federal Exclusion

If your aggregate estate is under $3.5 million, and you don't believe that planning will be necessary, think again. First, if your will is old and has the common language funding a bypass trust up to the maximum amount that won't cause a federal estate tax, funding that trust following your death will trigger perhaps $229,200 of state estate tax (depending on the state in which you are domiciled). Is it worth incurring that tax cost? It may be advisable to modify the planning and avoid triggering a state estate tax on the first death.

Caution: Don't ignore planning, it can still be important. For example, you might still consider funding a bypass trust with at least the maximum that can pass under state law without an estate tax.

Example: If your combined estate is $3 million, you can still fund $1 million in a bypass trust if you lived in New York without incurring a state or federal tax. This type of planning will help address the potential of your estate growing beyond the federal exclusion amount. It will also help address the possibility of the federal exclusion amount being reduced below the current $3.5 million in order to fund the economic stimulus plan in future years.

Example: If inflation rears its ugly head in future years as the government seeks to pay for the massive bailouts, a $3.5 million exclusion will be effectively reduced substantially in real terms if it is not inflation indexed. This has two important implications, both of which require planning. First, if the purchasing power of assets declines if inflation takes hold, presumptions about what amounts can support beneficiaries could prove dangerously wrong. For example, if the plan assumed that $3.5 million in a bypass could support a surviving spouse and other named beneficiaries, the purchasing power of the revenue generated could be cut dramatically. The second implication is that ignoring planning for what might presently be a non-taxable estate could prove costly. For example, if the aggregate estate is currently $6 million, a simple bypass trust funded on the first death can easily avoid all future estate tax. However, if inflation in fact takes hold, that $5 million estate could increase substantially prior to the first death. Further, the mere $2.5 million anticipated to be in the surviving spouse’s estate could likewise increase in nominal value triggering a tax.

Once you've decided on the approach your planning will take, you need to revise your beneficiary designations accordingly. Knowing your estate is not taxable for federal estate tax purposes enables you to eliminate one of the potentially conflicting IRA and retirement plan issues and focus your planning exclusively on the income tax and personal considerations.

If you do revise your will and estate plan, don’t overlook revising your IRA or plan beneficiary designation to make certain it is consistent with the new plan.

Disclaimer Approach

To maximize flexibility in this uncertain tax world, many advisers recommend the disclaimer approach. Bequeath all assets outright to your surviving spouse, who then, with the wisdom and judgment of hindsight can disclaim just the right amount to fill-up (i.e., fund) a bypass trust under your will. But alas, in our Alice in Wonderland tax world, nothing is simple. However, your surviving spouse can drink the magic elixir, a disclaimer cocktail, and shrink the estate tax to just the right size. The problem with the disclaimer approach is that, just like Alice in Wonderland, it too is little more than a fairy tale because many, perhaps most, surviving spouses simply won’t disclaim.

Example: You and your wife reside in New York, which has a $1 million state estate tax exclusion. Your estate consists of your house valued at $1 million, a $2 million IRA, and a $1 million brokerage account. The house and brokerage account are owned jointly and your wife obtains the title automatically by operation of law upon your death. The IRA lists your wife as primary beneficiary. Assuming your wife disclaims as the primary beneficiary of the IRA, the IRA will pass you a bypass trust under your will. Assume that your wife survives you. Based on the current $3.5 million exclusion, she determines not to disclaim any of your IRA to fund the bypass trust. Her reasoning is that the aggregate estate is only $4 million, not much more than the $3.5 million exclusion. She anticipates spending down the estate over time to meet living expenses. If in fact her assumption proves correct, there will be no federal estate tax, although there will be a moderate New York estate tax on her eventual death. However, more sound reasoning might suggest another approach. The estate may be valued at $4 million only because housing and security values are currently at depressed levels. If markets recover, the estate will almost assuredly exceed the $3.5 million exclusion resulting in a substantial federal and state estate tax. Under this logic your surviving wife should at least disclaim $1 million of the IRA to remove those assets, and future growth in those assets, from her potentially taxable estate. At the $1 million threshold, she will not trigger any state or federal estate tax on your death.

Tip: It is the experience of many estate planning practitioners that surviving spouses almost never disclaim. Address this reality in your planning. You can do this by mandating the funding of a bypass trust. Another approach is to fund a marital trust, which gives the right to an independent trustee to choose the portion of trust assets that will qualify for a marital deduction. You might consider naming as the primary beneficiary of an IRA that does not exceed your state’s estate tax exclusion, a bypass trust.

Funding the bypass trust could be made automatic and mandatory under your plan, rather than dependent on the actions of a grieving, surviving spouse. For example, your will could leave assets to a bypass trust regardless of the actions of your surviving spouse. There are several other alternatives to accomplish the same goal. Assets could be left to a marital (QTIP) trust for which you've named an independent trustee (i.e., not just your spouse). That independent trustee could be given the authority to choose what portion of the trust will qualify for marital deduction treatment. The corollary of this, is that the portion of the trust that does not receive marital deduction treatment becomes your bypass trust. These approaches will assure that the planning will be implemented.

Bypass Funding with IRAs

The above example illustrates another issue. If you use IRA assets, these assets carry an income tax cost that is a considerable negative. Funding a bypass trust with a $1 million IRA is really underfunding your intended objective, because that $1 million is pre-tax dollars (see discussion of IRD, below). It might be preferable to have your house re-titled from "joint tenants" (ownership passes to your wife automatically as surviving tenant) to "tenants in common" (either of you can gift or bequeath your ½ interest as you wish), so that on your death your estate would automatically pass your ½ interest in the house up to the $1 million state estate tax exclusion amount to the bypass trust formed under your will. This would accomplish a number of objectives and provide a number of benefits:

  • Your estate will fund the bypass trust with an asset that will likely appreciate, not depreciate over time. The IRA will depreciate because it will be distributed over your surviving spouse's life expectancy. In contrast, you could bequeath a ½ tenants in common interest in your home to the bypass trust under your will. If this is done, nothing has to be distributed out of that trust. This would permit the growth in value of the house to compound inside the bypass trust. Required Minimum Distributions (MRDs) (see below) apply to the IRA, but do not apply to a bypass trust funded with assets other than an IRA or retirement plan.
  • A traditional IRA is generally funded with pre-tax dollars. Therefore, when distributions are made from such an IRA, income tax has to be paid. Furthermore, there is no step up in the tax basis of an IRA account on your death. So effectively, the bypass trust is really being funded with, say 2/3rd dollars, not whole dollars, because of this tax impact. In contrast, if your IRA is funded (i.e., assets placed in the trust following your death) with ½ interest in your house or with your brokerage account, these assets will receive a step-up (increase) in their income tax basis to their value at the date of your death. Therefore, there will be no income tax consequences to distributions of these assets, except to the extent of post-death appreciation. Therefore, using these assets achieves a better, "fuller", funding of the bypass trust, since these assets do not carry an income tax taint that reduces their value.

Caution: If an interest in your home is used to fund a bypass trust, there will be a step up in tax basis on that interest on the first spouse’s death. However, subsequent gain will eventually be taxable and will not qualify for the home sale exclusion. IRC Sec. 125.

The bottom line is that funding a bypass trust, both as to amount, which assets, and so forth, is quite complicated and has to be addressed for each persons specific needs, goals and expectations. But as for retirement assets, it is important that you realize the impact of the unique tax status these assets have on this decision. IRAs have unique issues and complications in defining fiduciary income that creates even further problems beyond the scope of this article.

Naming a Beneficiary for Your IRA and Retirement Plan

Importance of Naming a Beneficiary

Properly naming a beneficiary for your IRA and retirement plans is a vital planning step to take. Merely filing out and filing a form provided by the plan sponsor is often woefully inadequate. Here’s some points to consider:

  • What payment options are available under the plan? Who are the default beneficiaries if you fail to name one appropriately?
  • What are your health and financial considerations and those of your potential beneficiaries?
  • How dependent will your spouse be on distributions from the plan?
  • How important is it to you to pass plan assets to your heirs?
  • Standard beneficiary designation forms can be woefully inadequate.
  • It is not uncommon for plan sponsors to loose beneficiary designations.
  • Who should be named as contingent beneficiaries (e.g., your surviving children, or a deceased child’s issue)?

Naming a “Designated Beneficiary”

In many, but not all, instances, “a designated beneficiary” should be named for every qualified plan and IRA. “Designated beneficiary” is a term specifically defined in the tax law and includes individuals. It does not include an estate, charity, or a trust unless specific requirements are met (and this is a critical point for you to review and monitor). Incorrectly naming beneficiaries, or failing to name them when you should, could have adverse income, estate and personal tax consequences.

Once retirement assets are paid out to an heir, they are generally subject to income tax. One planning goal is to keep assets inside the plan, thereby deferring income tax for as long as possible (“stretching” your IRA is a common term used to describe this). But this income tax objective is not always the best answer. You might prefer that funds be paid out more quickly to help an heir.

To understand the general rules for what happens if you don’t name a “designated beneficiary”, you must understand the phrase “Required Beginning Date” (RBD). Your RBD is the year in which you turn 70 ½.

If you die prior to your Required Beginning Date and have not named a “designated beneficiary” (“DB”), your plan assets may have to be paid out to your estate over five years. An exception would be if you named a charity, in which case the IRA would be paid out to the charity. If you named no one, your estate would probably be the default beneficiary. A five year payout is generally very unfavorable from an income tax perspective. It contrasts unfavorably to the alternative, had you properly named a designated beneficiary, who could withdraw the plan assets over his or her longer life expectancy. However, if your heirs life expectancies are not significantly shorter then yours, this may not be a detriment.

What if You’ve Named Multiple Beneficiaries

If you name multiple beneficiaries, then the age of the oldest beneficiary will be used to determine the period over which distributions will have to be made. If the ages spread of the beneficiaries is not significant, this may not be problematic. However, if the age spread is significant, then two dates should be considered. Your designated beneficiaries must be determined by September 30th of the year following your death. For an IRA, if there are multiple beneficiaries, your heirs can split that account into separate shares for each beneficiary by December 31st of the year after your death. If this is done, then each beneficiary can use his or her own life expectancy to calculate payouts, which must be started no later than that December 31st date.

Naming a Trust as Beneficiary

When To Name a Trust as Beneficiary

The simplest, and often preferable approach, is to name the individual you want to receive your retirement plan as the beneficiary. But in a myriad of circumstances naming an individual is less preferable than naming a trust for the heir as beneficiary, rather than the beneficiary directly. These might include:

A minor heir.

A spendthrift heir.

Funding a bypass (credit shelter trust) when there are inadequate other assets to fund it.

A second or later spouse, while protecting the children of a prior marriage.

An heir concerned about asset protection.

Unfortunately, naming a trust to protect the beneficiary receiving your IRA or retirement plan assets is not simple. If the trust does not meet specific requirements, this can trigger adverse tax consequences. To explain this, the concept of a “designated beneficiary” will be reviewed in greater detail. Then, the application of the “designated beneficiary” concept to a trust can be addressed.

Consequences of a Trust being Beneficiary

If a trust qualifies as a designated beneficiary, minimum required distributions are generally measured by the life expectancy of the oldest trust beneficiary.

If a trust does not qualify as a designated beneficiary then the distributions must be made as if there was no designated beneficiary. Minimum distributions may have to be taken more rapidly, potentially resulting in adverse income tax consequences. If your trust does not qualify as a designated beneficiary:

  • If you die after your required beginning date, the applicable distribution period is your life expectancy, determined in the year of your death. This is sometimes referred to as being in “pay status”.
  • If you die prior to your required beginning date, the applicable distribution period is five years. This is sometimes referred to as “not in pay status”.

Naming a Trust as a Designated Beneficiary

If you name a trust as beneficiary of your IRA or qualified plan, the trust must qualify as a “designated beneficiary” for your heir to be able to use his or her life expectancy to calculate the minimum required distributions.

Four Requirements

Four requirements must be met for a trust to qualify as a designated beneficiary:

Requirement 1: The Trust must be valid under state law. The fact that the trust does not have any assets, even if that is required for validity under state law, will not be deemed to make the trust fail this requirement.

Requirement 2: The trust must be irrevocable upon the death of the IRA owner.

Requirement 3: Specific documents must be supplied to the trust administrator or IRA Custodian.

Requirement 4: The trust beneficiaries must be identifiable from the trust instrument. “Identifiable’ has not been thoroughly defined by the IRS, it has been interpreted to mean that there must be an ascertainable “oldest” beneficiary whose life expectancy can be the period for determining minimum distributions. The older the beneficiary, the faster your heir (or heirs) other than a spouse will have to withdraw funds from your plan. The faster funds are withdrawn, the sooner they are taxed.

Trap: Identifiable beneficiaries are neither simple nor obvious. If a power of appointment is given to any beneficiary of an accumulation trust, the power of appointment cannot be exercised in favor of persons who would be unknown and older than the oldest beneficiary on the date of the IRA Owner’s death. All potential appointees are treated as beneficiaries and must be individuals. If any potential appointee is not an individual, the trust will not qualify as a designated beneficiary.

Tip: If your goal is to assure that the trust qualifies as a “designated beneficiary”, consider naming a special fiduciary, called a trust protector, who is not a trustee or beneficiary. This person could be given the power to modify the trust to correct drafting errors, typos, ambiguities, or to take steps required to qualify the trust as a designated beneficiary. A charity or your estate are not designated beneficiaries. So if either is listed as a beneficiary, perhaps the trust protector can be given the power to distribute out their share by September 30 of the year following your death to avoid the minimum required distributions (MRDs) being calculated as if there were no beneficiary. Treas. Reg. 1.401(a)(9)-4, Q/A-3. You might want to have this latter power automatically lapse on the beneficiary determination date, which is September 30 of the year following your death as the plan participant. The rationale for that limitation, is that the tax benefits of having a designated beneficiary must be set by that date so that changes after that date would not affect the tax results of plan distributions. Note, although the designated beneficiary has to be determined by September 30 of the year following your death, those beneficiaries are given until December 31 of that year to actually make the first distributions.

Conduit Trust

You can satisfy the requirement of identifying the trust beneficiaries by structuring the trust as a pass through trust, which is often called a “conduit trust”.A conduit trust is a trust that mandates that the beneficiary’s required minimum distributions (“MRDs”), which are received by the trust are paid out to the trust beneficiary each year.

Using a conduit trust may allow your trust to qualify as a designated beneficiary, and to use your primary heir’s life expectancy (ignoring the life expectancies of successor beneficiaries and potential beneficiaries) when calculating the required minimum distributions. Using a conduit trust enables you to provide asset protection for the retirement assets to an heir that would not qualify for the same protection the participant would. This is because an inherited IRA does not have the creditor protection to the inheritor that is afforded to the same IRA when held by the participant. Furthermore, for a minor beneficiary who cannot reasonably be expected to have the maturity to handle the funds, a conduit trust might be essential.

Not all is rosy, however, with a conduit trust. Conduit trusts take effort, both to establish and to administer properly. For this, and other reasons, many estate planning practitioners don’t favor using this approach.

Conduit trusts diminish the asset protection benefits trusts can provide because the funds must be paid out as received (i.e., the required minimum distribution must be paid out every year). This could be detrimental in the event of a divorce, lawsuit, bankruptcy or other adverse circumstances. Furthermore, if a non-spousal beneficiary is the beneficiary of a conduit trust, the plan assets will have to be paid through the trust to that beneficiary over that beneficiary’s life expectancy. This will stretch the payouts over a time period potentially much longer than your life expectancy. So, if your goal is to protect the assets of that heir (and from that heir), a conduit trust might be an appropriate technique. However, if the beneficiary lives to approximately his or her life expectancy, there will be few plan assets preserved for the remainder beneficiaries of the trust. So, if your goal is to protect retirement plan assets for the remainder beneficiaries of the trust, a conduit trust won’t be the optimal approach to use. However, even if it is not optimal, what other choice is there? Using a non-conduit (discussed below) means that there is designated beneficiary and the IRA or retirement assets will have to be paid out either over 5 years (if prior to the participants required beginning date), or over the participant’s life expectancy after the require benefit date.

However, a conduit's trusts cannot automatically use the primary beneficiary’s life expectancy. The life expectancies of all beneficiaries must be taken into account in establishing the required minimum distributions and the oldest beneficiary’s life expectancy will determine the maximum term of distribution. This is why separate shares (separate conduit trusts) might be established for each beneficiary.

Accumulation Trust

You can name another type of trust, which offers better asset protection as a beneficiary called an “accumulation trust”. An accumulation trust provides better asset protection by providing the Trustee discretion to make or withhold distributions depending on the beneficiary’s current situation. However, an accumulation trust cannot qualify as a designated beneficiary so that the stretch payout won’t be recognized.

Minimum Required Distribution (“MRD”) Rules

Abeyance of MRD for 2009 Hides a Trap

The Worker, Retiree, and Employer Recovery Act of 2008 (“2008 Act”) waives the requirement to make minimum required distributions (MRDs) in 2009. If your IRA was pummeled, you might not want to liquidate securities to fund a current distribution. This law permits a one-time waiver to do just that. This rule provides some important flexibility for planning, but also contains a trap that might confuse even the most astute of taxpayers. A quick review will clarify.

When you reach age 70.5, taking minimum required distributions is mandatory. If you turned 70 ½ in 2009, this is the first year for which an MRD is required for your IRA. Normally, you must withdraw each year’s MRD by the end of the calendar year. An exception exists for the first year so that you can postpone the first MRD until Required Beginning Date (RBD), which is April 1 of the following the year.

Example: You turned 70 ½ in June 2008 (even if you think only your hairdresser knows, the IRS does too). You can delay your 2008 withdrawal until April 1, 2009.

How does the 2008 Act affect this? If you turned 70 ½ in 2009, there is no MRD for 2009. But, for all other purposes, your RBD will remain April 1, 2010, even though no distribution is required to be taken by that date.

Trap: What if you were required to take an MRD for 2008, but your postponed it until April 1, 2009? If you turned 70 ½ in 2008, your MRD for the 2008 year must still be taken by April 1, 2009, even though there are supposedly no required distributions for 2009! This is an exception to the special rule just enacted that might easily confuse you, and put you at risk of being overlooked. Considering the 50% penalty for failing to take MRDs, be sure to follow up.

Calculating MRD – Mismatch of Asset and Age Calculations

Setting your clock for daylight savings time? Spring forward, fall back, or something like that? This next rule makes you wonder what the tax folks have in mind when they come up with the rules. Calculating lifetime MRD is pretty easy to do after the 2001 tax law changes. You need to know your age and the balance in your plan. Then, you look up the number to divide your plan balance by (called the “divisor”) in the appropriate IRS table.

Trap: Be careful of the mismatch of asset and age calculations. For the balance in the plan, you use the value at the prior year end, so for 2009, you use the 12/31/2008 account balance. To determine your age, you look forward to what your age will be at December 31 of the current year.

Tip: Age spring forward, assets fall back.

Can Your Required Beginning Date (RBD) Be Later than 70 ½?

For different retirement plans, you might have different RBDs.

Example: You have a corporate plan (401(a), 401(k), and 403(b)), and are working past age 70 ½ (to make up for the great returns you’ve been realizing on your retirement plan investments). You may be able to use the later of age 70 ½, or your actual retirement, to determine your required beginning date (RBD). See below for some exceptions.

If you opted to continue working in light of the current economic situation, and perhaps deferred your retirement, you can wait until April 1 of the year following the year you actually retire. What if you’re merely consulting say 5-10 hours a week for your former employer to keep some income coming in? Can you continue to defer taking MRDs? It is really not clear how to define “retired” for purposes of this test, so there is no solid answer. Perhaps you can consult or work on a part time basis and not be deemed retired.

Trap: The special rule described above does not apply if you are more than a 5% owner of the entity. There are attribution rules which may treat you as owning stock that certain related people actually own. There are attribution rules, which may treat you as if you own the stock. These rules apply to more than just relatives, and are very complex and should not be treated lightly. If there is any change in ownership, there are rules that guide you as to what date at which the more than 5% ownership test is measured. A “5% owner” must use age 70 ½, the general rule, regardless of when you retire.

Trap: For a regular IRA, you must start MRDs at age 70.5 regardless of whether or not you continue to work. Many taxpayers confuse this rule, and believe if they are working and deferring starting their company plan distributions they can also defer starting their required minimum distributions from their IRA. Not! That misconception could trigger a 50% penalty on your required IRA distribution!

Who Takes Your Minimum Required Distribution (MRD) If You Die Before Taking It

Say you’re required to take out $50,000 as your required minimum distribution in 2010 but you die in March without having taken it. The penalty for not taking it in time is only 50% or $25,000! If you die before taking out your required distribution for the year in which you die, who must take it?Your executor might assume that it is his or her responsibility to take that distribution and deposit it into an estate bank account. However, it is the beneficiary of your IRA that must withdraw the Minimum Required Distribution, not your estate. Furthermore, this distribution must be completed by the beneficiary before December 31 of the year of your death. What if you die in December? How will your beneficiaries ever know that they have to take the distribution by year end? Even if they know, will they be able to?

Tip: Take your required distributions early in the year (yes, this does diminish tax deferral on earnings and asset protection if you’re the plan participant). Just in case, leave clear instructions with your agent under your power of attorney and named executor what needs to be done to avoid the confiscatory 50% penalty.

Income In Respect of a Decedent (IRD)

Mismatching Taxpayer Paying Estate Tax on IRD Asset and Taxpayer Getting IRD Deduction

Trap: When you die, your IRA will be included in your taxable estate. That could subject it to a 45% estate tax! Worse yet, consider the impact of estate tax legislation introduced in January 2009 by Representative Pomeroy, with the snappy title “Certain Estate Tax Relief Act of 2009” (H. R. 436). This would permanently freeze the estate tax rate at 45%, phase out the $3.5 million exemption for estates over $10 million, and eliminate the state death tax credit. Bottom line, if you’re living in a high estate tax state, you could face a marginal estate tax rate over 60%! While it is uncertain what form any final legislation will take, the likelihood seems to be that a high marginal estate tax rate will be the result.

Since a traditional IRA represents income that has not been subjected to income tax (ignoring non-deductible contributions), this is called income in respect of a decedent (IRD, just to give you another acronym). IRD is subject to income tax as your heirs receive it. So, the 40% or so that is left after the marginal estate tax bite gets whopped with a 35% or so income tax rate (which will perhaps be increased once some type of economic pulse is again felt).

The tough tax result above is mitigated by making available an income tax deduction on the income tax return for the federal estate tax that was paid. While this can clearly take away some of the tax sting, there is yet another complicated trap for unwary taxpayers.

Who pays the income tax on IRD generated by the retirement account? The beneficiary who inherits the retirement plan recognizes the income (i.e., reports the IRD) and pays the income tax attributable to that IRD upon receipt of distributions from the plan. The IRD deduction for the estate tax paid on this retirement account insures to the benefit of this heir. That is a great result, as it can offset the income tax due on the plan dollars as they are withdrawn. So far so good.

But, while the person who inherits the retirement plan logically benefits from the IRD deduction, that heir may not be the person who actually paid the estate tax that created the deduction. IRC Sec. 691(c).

Example: Paul Participant was survived by two sisters, Betty and Ida. Paul bequeathed his probate estate to his sister Betty and his IRA to his sister Ida. Paul, the plan participant/decedent provided in his will that his probate estate must pay all of the estate tax (it's common in many wills to just have all the tax paid by the residuary estate). The result of this is that Betty bears the burden of the potentially 60% marginal estate tax, but Ida, who inherited Paul’s IRA, will get the IRD deduction from the tax Betty paid!Ida, not her sister Betty who paid the tax, gets the deduction for the estate tax paid on the IRD. This potentially huge tax implication should be planned for. Even if Paul wanted this result when he drafted his will and signed his IRA beneficiary designation, has the change in relative values of his IRA compared to his remaining estate during the recent market meltdown changed the fairness of that result?

The estate tax attributable to the IRA is computed on a marginal, not on an average, basis. The IRD deduction is not subject to the 2% floor that applies to reduce many of your other miscellaneous itemized deductions. IRC Sec. 67(a). Other miscellaneous deductions have to be totaled, then reduced by 2% of your adjusted gross income, and only what’s left (often nothing) can be deducted. Your heirs IRD deduction for estate tax paid on your IRA will escaped this haircut.

Trap: The IRD deduction is, however, subject to phase out of deductions under Code Section 68. This rule provides that total itemized deductions are reduced by 1% of your adjusted gross income in excess of a certain amount. So this may, in fact, reduce the IRD deduction the plan beneficiary can effectively use. There has been some discussion in Washington of strengthening these phase-outs so that this issue may become more problematic.

Tip: The phase out of itemized deductions does not apply to estates and trusts when an estate or trust is named as the beneficiary. Therefore, if you’re dealing with big numbers, you might want to reconsider naming a trust as the beneficiary of your IRA.

Stretching isn’t Always Best - Use the IRD Deduction to Offset Tax and Invest Outside the IRA

Jack LaLane might have had it wrong. Stretching is not always best. There is another approach heirs inheriting plan assets with large IRD tax deductions should consider in this depressed investment climate. While a bit heretical, this concept is at worth at least considering.

Tip: Evaluate cashing in the entire plan or IRA instead of trying to stretch it over your life expectancy. Consider using the benefit you may receive for the IRD deduction to offset the current income tax. Forget about the holy grail of the stretch IRA. The IRD deduction might offset most of the tax cost currently. Then your heir has total flexibility to invest the assets and generate capital gains (although it might appear that capital gains have followed the Dodo bird to extinction). If you believe that the bailout will be paid for by much higher income tax rates in future years, there may be a better approach. It may prove advantageous to generate favorably taxed capital gains years from now, rather than ordinary income taxed at rates that might be much higher than those applying today. Which might be the best deal? Don’t get snookered into the mindset that stretching is the only answer.

How to you handle the IRD deduction? Is it on a FIFO (first in first out) basis, or pro-rata? Can you offset income realized on IRA withdrawals or a FIFO basis or ratable over the value of the IRA as you withdraw it over your life expectancy? There is some controversy as to how this needs to be calculated.


“The devil is in the details.” This saying too often applies to planning that is only 95% completed. If you divorce, there is almost an endless list of details that need to be addressed. Updating IRA and retirement plan beneficiaries are two of those post-divorce details that are frequently not addressed. Many divorcing spouses mistakenly believe that under state law the divorce itself cuts-off all property rights their ex-spouse enjoyed.

But even if state law did terminate your ex-spouse’s right to be a beneficiary, state law may not be controlling as too many disappointed heirs have come to learn.In 2001 the Supreme Court held in Egelhoff v. Egelhoff that ERISA pre-empted state law which provided that the divorced spouse’s rights terminate. 532 U.S. 141, 121 S. Ct. 1322 (2001). In this case, the husband failed to change his group life insurance beneficiary designation and pension beneficiary designation to remove his ex-wife. Although state law provided that the beneficiary designation of the former spouse was automatically revoked on divorce, the Court held that ERISA preempted state law and the ex-spouse received the insurance and pension as she was the named the beneficiary. ERISA says that the terms of the plan control supersede state law. The Supreme Court held that the plan administrator’s ignoring the waiver was appropriate, because the waiver contradicted the beneficiary designation made by decedent under the plan's documents. There continue to be a stream of cases since then addressing the same issue, demonstrating that this remains a vital, yet frequently overlooked detail.

Tip: Skip reading the cases. If you divorce, change every beneficiary designation.

Tip: The number of people involved in non-married relationships is substantial. State law won’t cut off the right of a non-married partner if the relationship ends. There is no counterpart in state law to address the issues dealt with for married couples whose relationships end.

60-Day Rollover Traps

You know the drill, you have 60-days within which to consummate an IRA rollover, or the tax guillotine falls. In 2001 Congress gave the IRS the flexibility to offer the olive branch of leniency if a hardship gave rise to missing this deadline. You would have had to demonstrate and explain the reason for the “oops” and meet a “good cause” standard. If failing to grant an exception would violate “equity or good conscious”, the IRS would grant you a waiver. Death, disability, incarceration, etc. are all passing explanations. Olive branches aren’t cheap or simple to get, and it’s getting tougher. You must apply to IRS for private letter ruling to request this leniency (a lower fee schedule applies for these rulings as compared to the general ruling fee schedule). Most of the reasons taxpayers gave the IRS have been based on financial institution error, or financial adviser error. For the IRS to grant you a waiver, they are requiring that the financial adviser or institution to write a letter to the IRS acknowledging that the error was in fact the adviser’s or the institution’s error.

Alternate Valuation Date and IRAs

The alternate valuation date (“AVD”), unfortunately will be a common aspect of most probates. The AVD rule, contained in Code Section 2032, permits the estate to value assets as of the date six months after death, instead of at the date of death which is the general rule. With the stock market and housing meltdowns, many estates will be worth less, at this later date. Assets that are distributed to heirs, or sold, between the date of death and the date AVD are generally valued as of that intervening date.

If the estate elects to use the AVD, what happens with an IRA? If a child (or other non-spouse beneficiary), for example, transfers her deceased parent's IRA into an inherited IRA, is that a disposition that then requires the IRA be valued at that transfer date? Or is that merely regarded as a change in form and that the IRA continues as is so that the AVD a full six months later can be used? While it is not clear what the result is (surprisingly the IRS has never issued guidance) most people believe that it should not be treated as a distribution. Instead, the inherited IRA should be treated in a manner similar to a joint bank account where transfer is not deemed a disposition under Code Section 2032. Rev. Rul. 59-213, 1959 C.B. 244.

Roth IRAs

Inherited Roth IRAs are Subject to Minimum Required Distributions (MRDs)

A key principal of Roth IRAs, as contrasted with regular IRAs, is that there is no requirement to take distributions from a Roth IRA. After all, why should the IRS care when you distribute your Roth money, since it is generally not taxable. Surprisingly, for many heirs, this non-distribution rule does not apply to an inherited Roth IRA. So, after your death, the beneficiaries of your Roth IRA must start taking MRDs, but if the requirements are met their distributions will remain income tax free. Even more surprising to some really unhappy heirs, even though distributions from an inherited Roth IRA are income tax free, if those MRDs are not taken, the 50% penalty applies!

Roth 401(k)s are Subject to Minimum Required Distributions (MRDs)

The general rule again, is that you do not have to take required minimum distributions (MRDs) from Roth IRAs. But, alas, another trap exists, and the confusing terminology might make you trip up on this quirk.

Trap: If you have a Roth 401(k) account, that account will be subject to MRDs! Roths aren’t, but Roth 401(k)s are! Remember, both inherited Roth IRAs, and “normal” IRAs that are inherited, are all subject to MRDs.

You have two choices: You can roll over your Roth 401(k) into a Roth IRA before you attain age 70 ½, since you will have MRDs by your required beginning date (RBD). This is the later of: 1) April 1 of the year following the year in which you reached age 70 ½: or 2) April 1 of the year after you retire from the employer sponsoring your plan (and you’re not more than a 5% owner of that employer entity). If the rollover is not completed, you will have to begin taking MRDs from your Roth 401(k) or face penalties.

This requirement to pay required minimum distributions from a Roth 401(k) is an exception to the general rule that you don’t have to take MRDs from Roths.

IRA to Roth Conversion Before Market Tanks May Be Unwound

So your conversion didn’t bring the tax enlightenment you sought. All is not lost. Converting to a Roth IRA is a great planning technique for many taxpayers. When you convert your traditional IRA to a Roth, you have to pay income tax on the taxable portion of the plan. The goal of the conversion process is to pay the tax now, and have all future growth avoid income tax within the Roth. To make this conversion viable, you should have adequate resources outside of your IRA with which to pay the income tax triggered on the conversion. Also, your investment time horizon must be long enough for the conversion to make sense (which could be looking to be real long in the current market environment). But what if you converted when the Dow was at 11,000, thinking that was a market bottom, and the Dow is not at 6,500? The income tax may have been incurred for naught! Don’t despair, repair!

Tip: You may be able to reverse the conversion, put the money back into your regular IRA. This would avoid the income tax that, armed with hindsight, is no longer worthwhile incurring. So, if you converted and then market tanked, reverse the conversion. The latest you have is until October 15 of the following year (i.e., the final due date of the prior year’s tax return) to re-characterize the transaction. PLR 200628032. (4/19/06). Be careful, however, private letter rulings, such as the one on which this tip is based, while indicative of IRS views, only legally bind the IRS to that treatment for the taxpayer that actually received the ruling.

Asset Protection – Not Available for Inherited IRAs

A key aspect of an IRA is that it should be protected from claimants and in bankruptcy. This protection is a very valuable aspect of maintaining an IRA, and in fact, a reason so many participants should be funding even non-deductible IRA accounts. Did you hear that Doctor Marcus Welby prescribed non-deductible IRAs for this very purpose?

While many people thought an inherited IRA should have the same protections — after all it is an IRA — a string of court decisions have held otherwise. Thus, an inherited IRA, other than spousal IRAs, are not really “IRAs”, as that term is contemplated since the heir cannot make contributions to them. Therefore, since it is not an IRA under IRC Sec. 408, it is not exempt from claims of creditors. Other planning, such as naming a trust for your intended heir as beneficiary, might be warranted.


IRA and retirement plans pose a host of complex, and often, on the surface, contradictory rules and challenges for your estate planning. The confluence of income tax, estate tax, probate, asset protection and retirement plan implications makes this a virtual minefield for you and your heirs. This report has provided a brief review of just some of the myriad of traps. The lesson is clear. Planning for IRA and retirement plan benefits should be reviewed and monitored on a regular basis to address changes in your circumstances, changes in the conditions confronting your intended heirs, changes in the law, and new planning concepts. The interplay of the many important planning goals these factors can affect could make not heeding this advice potentially disastrous.

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