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MRDefenses
by: James
Lange, CPA, JD
Everything you always
wanted to know about estate planning with the new minimum required
distribution rules.
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As appeared in the March 2001
issue of Financial Planning magazine, Copyright
2001 by Thomson Financial Investment Marketing Group. |
The recent changes in the minimum distribution
rules are a blessing not only for IRA owners and retirement plan
participants, but also for their beneficiaries, who will now be
able to stretch their inheritances over the course of their own
lifetimes. The new laws are very straightforward; for most cases
they reduce the minimum required distribution (MRD) for the IRA
owner or retirement plan participant, leaving more for his or her
beneficiaries to inherit. Obviously this will have significant estate
planning ramifications. This article will focus on the changes in
the distribution rules for beneficiaries of IRAs after the death
of the IRA owner.
In the past, it was always advisable
for an investor to spend after-tax funds before tapping into an
IRA, 403(b), 401(k), 457 or other qualified plan account. The long-term
impact was that the IRA owner who spent after-tax assets first had
a lot more money and purchasing power. The reason for the additional
wealth was that the plan participant was able to invest the money
that otherwise would have gone to pay taxes.
This strategy is even more advisable
now. IRA owners with sufficient income from Social Security and
other after-tax assets will not need more than their MRD, so their
beneficiaries stand to inherit even more. This assumes the beneficiary
does not have an immediate compelling use for the inherited IRA,
would prefer to continue investing the inherited IRA in the tax-deferred
environment and realizes that by following the maxim, "don't pay
taxes now, pay taxes later," he or she will be thousands, perhaps
millions of dollars better off in the long run.
Now, let's take a look at some of the
specific estate planning aspects of the new rules.
Spousal beneficiary. The new
law is not substantially different from the old law when the IRA
owner predeceases the spousal beneficiary. A surviving spouse who
is named as the beneficiary of an IRA may (and in most cases is
well advised to) roll the inherited IRA into his or her own IRA,
then name his or her own beneficiary.
For example, let's assume that under
either the old or new rules, John names his wife, Mary, as his beneficiary.
After John dies, Mary rolls his IRA into her own and names their
son, Al, as beneficiary. Before she reaches age 70 1/2, Mary is
not required to take a MRD. By April 1 of the year following the
year she reaches age 70 1/2 -- that is her required beginning date
(RBD) -- she must begin taking her MRD based on her life expectancy
and the life expectancy of someone deemed 10 years younger than
she, as defined by the new Uniform Withdrawal Table or the old MDIB
Table.
Under the old rules, upon Mary's death,
Al could, with the proper election, take distributions based on
his life expectancy. (Technically, Al's life expectancy at Mary's
RBD minus 1 year for each year he survives.) If Al is 40 and has
a life expectancy of 42.5 (according to IRS tables on life expectancy),
then his MRD would be the balance in the IRA on Dec. 31 of the prior
year divided by 42.5. The following year, the MRD would be the balance
in the account as of Dec. 31 of the prior year divided by 41.5,
and so on. Thus, Mary got a good stretch and Al was also able to
partially stretch the tax deferral over his life expectancy.
This strategy would not change much
under the new rules. There are minor differences between the ways
Al calculates his life expectancy under the old and new rules, but
other than eliminating the requirement to make the election for
the stretch, and a few other subtle but not earthshaking distinctions,
the new law is not substantially different than the old when the
IRA owner predeceases the spousal beneficiary.
Non-spouse beneficiary. Here
we begin to see some significant changes. Under the old rules, only
under certain favorable circumstances was it possible for a non-spousal
beneficiary to stretch their required distribution from an inherited
IRA over their lifetime. Under the new rules, it is possible to
achieve this stretch for almost all situations.
Neither the old rules nor the new rules
allow a non-spouse beneficiary to roll the inherited IRA into their
own IRA. That means that if a non-spouse beneficiary inherits an
IRA, he or she will be required to take minimum distributions on
the inherited IRA based on his or her life expectancy, just like
Al had to take a MRD after his mother Mary died.
Under the old rules, the critical planning
date for determining a MRD, both while the IRA owner was alive and
after he died, was April 1 of the year following the year the IRA
owner turns 70 1/2. After that date, the IRA owner could not do
anything to slow down their MRD while they were alive. In addition,
subject to some exceptions, after the IRA owner died, the beneficiary
could not slow down the MRD.
For example, assuming the old rules,
consider this situation: John names Mary as the primary beneficiary
of his IRA on or before April 1 of the year following the year he
turned 70 1/2. But Mary predeceases John, who then names Al as primary
beneficiary. Al's MRD would be rapidly accelerated and in some cases,
the full amount would be taxable the year following John's death.
The old rules were a mess. There were
too many variables affecting the distribution of the IRA at the
owner's death. Factors that had to be considered were: the IRA owner's
age when he died, the primary beneficiary's age when the IRA owner
hit his or her RBD, the IRA owner's marital status, methods chosen
for calculating life expectancies (possibly four combinations of
recalculation and term certain), the order of death between the
IRA owner and the primary beneficiary, and whether the beneficiary
makes the proper election after the original owner dies.
The key to practically all these variables
under the old rules was to determine the status of the account on
April 1 of the year following the year the owner turned 70 1/2.
Therefore, even John's MRD while he was alive was determined with
reference to the named beneficiary as of his RBD. If he named Mary,
who was roughly his age, the MRD would have been calculated using
a joint life expectancy of approximately their actual ages. On the
other hand, if John named Mary but she predeceased him after John
reached his RBD, then Al would have an accelerated income tax bite
upon John's death. Also under the old rules, if John wanted to lower
his MRD, he could name Al as the primary beneficiary before his
RBD. That would have significantly lowered his MRD while he was
alive and when he died, Al could have elected to stretch the IRA
over his life expectancy. But even here precautions had to be taken
to protect the surviving spouse.
For very wealthy clients who desired
a stretch IRA for the beneficiaries, I used to recommend naming
a child or grandchild as the primary beneficiary of the IRA, with
the idea of reducing the MRD while the owner was alive, but more
importantly to get the benefit of the stretch after the IRA owner
died. One of the big problems of this approach, however, was that
the spouse was not the primary beneficiary of the IRA and that,
in order for this strategy to work properly, the beneficiary had
to make an affirmative election to take their MRD over their life
expectancy. Now, both of those problems are a thing of the past.
Note: Many existing 401(k) plans will
not allow a stretch IRA for non-spouse beneficiaries but will require
the entire plan proceeds be distributed the year after the IRA owner
dies. (This isn't an IRS restriction; it is a restriction within
the company's plan itself.) This is a marvelous reason to get clients
to roll over their 401(k) into an IRA that could be a candidate
for assets under management.
New rule for beneficiaries.
The new law does not look back to the status of the account as of
the IRA owner's RBD to determine the MRD. Under the new rules, the
age of the beneficiary on Dec. 31 of the year following the year
the IRA owner died is the calculating age. So, in the above example
where Al had an extreme acceleration of income taxes because of
the status of the account at John's RBD, the result under the new
rules is that Al will be able to stretch the IRA over his own life
expectancy without having to make a formal election.
Under the new rules, almost any beneficiary
can achieve a stretch based on their own life expectancy. The deciding
factor is the life expectancy of the beneficiary of the IRA on Dec.
31 of the year following the year the IRA owner died.
Since virtually everyone will be able
to enjoy the stretch after the IRA owner's death, you now have the
flexibility to recommend to your client that they name anyone as
their IRA beneficiary without any impact on their MRD. Therefore,
you no longer have to be concerned with the impact of the beneficiary
designation of the IRA for the purpose of the clients' MRD while
the client is alive, just as long as a beneficiary is named.
Multiple beneficiaries. The
old rules were wicked when the IRA owner had named several beneficiaries
by his RBD. Assume that John had one IRA with the following beneficiary
designations:
- 1/4 to my mother, age 95;
- 1/4 to my wife, age 68;
- 1/4 to my son, age 40; and
- 1/4 to a trust for my granddaughter,
age 5.
Then, assume that John dies just after
passing his RBD. Naturally, all heirs want the longest stretch allowed
by law. The usual result (although some attorneys argued the point)
was that all the beneficiaries were required to take their distributions
based on John's mother's life expectancy. In other words, there
was a needless and enormous acceleration of income taxes and probably
extreme anger at the planner or attorney giving John the advice.
Under the new rules you may separate
the account after death. For the above example, you would carve
out four different accounts sometime between the IRA owner's date
of death and Dec. 31 of the year following the year he or she died.
Thus, John's mother would take distributions based on her life expectancy.
His wife Mary would roll the IRA into her own IRA. Al would have
a separate, inherited IRA and would take distributions based on
his life expectancy, and the trust for the granddaughter (assuming
it is a qualified trust) could take distributions based on her life
expectancy.
This change will make it much more
advantageous to have a beneficiary designation that reads "my children
equally, per stirpes." The owner will know that each child
will be able to take a MRD based on his or her own life expectancy
and not the life expectancy of the oldest child. We add the "per
stirpes" to protect the interests of the third-generation child
or children (i.e., the IRA owner's grandchild) of a predeceased
second-generation child. If the designation only states "my children
equally," only the second-generation children who are alive will
inherit the IRA. If your client's child dies with children of their
own, without the per stirpes language, those children would be disinherited.
With the language "per stirpes," the grandchildren will stand
in the place of their deceased parent.
With the above information as background,
let's now take a look at a case study. John, who is 68, has an IRA
balance of $2 million. Mary, who is 65, has non-IRA investment assets
valued at $200,000. John's Social Security income is $16,000; Mary's
is $8,000. Their annual spending in today's dollars is $80,000 plus
income taxes.
The quantitative analysis assumes an
inflation rate of 4% and an investment rate of return of 8%. Unless
otherwise stated, John dies in 2002, Mary in 2021. Of course, the
client has no special knowledge of life expectancy when they are
in the planning process.
Query 1: Who should John name as IRA
beneficiary?
Query 2: Should John make a Roth IRA
conversion?
John's first goal in estate planning
is to provide for Mary's security and protection. If he predeceases
her, the entire proceeds of the IRA will be available for Mary's
use. At John's death, the conventional course is for Mary to roll
his IRA into her own, naming Al as her beneficiary. If Mary is a
U.S. citizen, she will enjoy an unlimited marital deduction, and
there will no income or federal estate taxes due at John's death.
However, if John names Al as the beneficiary
of his IRA, upon John's death Al will be able to take minimum distributions
based on his life expectancy. Al's MRD would be lower than Mary's
MRD after John's death, (at least after Mary turned 70 1/2) and
more money would stay in the tax-deferred environment for the family.
If John names a qualified trust for a grandchild, the amount of
deferral dramatically increases. (See Exhibit 1.)
If John predeceases Mary and she is
named as the primary beneficiary of the entire IRA, and then when
Mary dies she names Al as her beneficiary, under current estate
tax laws there will be a significant estate tax when the family
settles Mary's estate. There will not be sufficient funds outside
the IRA to pay for the estate tax. Al will have to invade the inherited
IRA to pay the estate tax and that invasion will trigger an income
tax. The result will be the notorious combined income and estate
tax on at least a portion of the IRA. A discussion of the related
income in respect of a decedent (IRD) is beyond the scope of this
article. However, if some money were left to a combination of children
and grandchildren at the first death, those amounts would not be
part of the second estate at the second death.
There may be a problem with naming
a child or grandchild as primary beneficiary. If John names Al or
his grandchild, Susie, as his beneficiary, or even as a beneficiary
for a portion of the total, that means Mary will not benefit from
that part of the IRA. While the desire to save income taxes is compelling,
most individuals have a deeper concern for the security and protection
of their surviving spouse.
Furthermore, naming Al or Susie for
more than one unified credit shelter amount (currently $675,000)
would also subject John's estate to an enormous estate tax at the
first death because the child or grandchild would not qualify for
the unlimited marital deduction.
What about naming a "B" trust as the
beneficiary for one unified credit shelter amount and leave the
rest to the spouse? We could set up a B or unified credit shelter
equivalent trust where Mary gets the income and at her death the
proceeds go to Al. This would keep at least $675,000 (the current
unified credit shelter amount) out of the estate of the second to
die. This would also do a good job of providing for the surviving
spouse. The problem is that at Mary's death, there would be a rapid
acceleration of taxes for Al on the amount remaining in the B trust.
Rather than using his own life expectancy to calculate his MRD from
the inherited remainder of the trust, he would be required to use
his deceased mother's life expectancy.
Furthermore, at the time of this writing
there is great uncertainty in whether and how much estate tax reform
will come in the future. Is there a way to reconcile these competing
forces?
The new law invites "disclaimer
planning" opportunities. Now more than ever, disclaimer planning
will be a significant strategy for individuals with substantial
IRAs. Let me introduce cascading beneficiaries with disclaimer options.
Consider the following:
- The primary beneficiary of the IRA
would be the surviving spouse.
- The secondary (or first contingent)
beneficiary could be a trust where the surviving spouse gets the
income and, at his or her death, the proceeds go to the children
equally (a "B" or unified credit or exemption equivalent trust).
So far, this is identical to one of
my standard old rule plans where I did not name children or grandchildren
as primary beneficiaries on separate IRAs.
Now, I am suggesting:
- The third beneficiary (or second
contingent beneficiary) would simply be the children equally "per
stirpes."
- The fourth (or third contingent
beneficiary) could be a special trust for the grandchildren (either
all grandchildren or just the children of the children that would
disclaim).
Under the old rules you could have
had cascading beneficiaries, but it was not helpful in terms of
slowing down the MRD of the beneficiary. The critical date for determining
a distribution pattern was the IRA owner's RBD, April 1 of the year
following the year the IRA owner turned 70 1/2.
Under the new rules, the critical date
is Dec. 31 of the year following the year the IRA owner dies. The
extended time frame allows a family to leave options open for getting
the longest stretch IRA. However, if circumstances dictate, it also
preserves the safety net for the natural heir of the IRA owner (i.e.,
the surviving spouse). The cascading beneficiary idea combined with
a partial Roth IRA conversion will maximize the value of an IRA
or retirement plan for many IRA owners and their families.
Under the cascading scheme, the surviving
spouse could either keep everything or disclaim all or a portion
to a B trust. Alternately they could disclaim all or a portion to
their children. The children, if they desired, could keep the inherited
IRA and take MRD based on their life expectancies. If the children
were themselves in a strong financial position and did not need
the inherited IRA, they could disclaim to their children (the IRA
owner's grandchildren), who could then take MRD over their quite
long life expectancy. Exhibit
2 provides a flowchart of the cascading beneficiary scheme.
To optimize the benefits to the entire
family (again, using the example above), one approach through postmortem
disclaimer or through pre-death planning would be to name Susie
on a separate IRA of $675,000, and Mary for a separate IRA of $1,325,000.
This strategy would get $675,000 and the growth on that amount between
John's and Mary's death out of Mary's estate (keeping a careful
eye on the account if it approaches $1 million to avoid the generation-skipping
tax). In addition, the present value of the cash flows of the minimum
distribution, particularly to Susie, would be enormous. Upon John's
death, Mary would then name Al as the beneficiary of her IRA. Finally,
there would be no estate tax at John's death.
However, optimizing wealth is not a
good idea if the money is not directed in accordance with the client's
desires. Most people want to provide for their spouse, then their
children and only after that, for their grandchildren.
There is no magic formula for determining
how much money to assign each beneficiary, either while John is
alive or even after he dies. While it is possible to make the quantitative
differences more dramatic with higher allocations to Al or Susie,
the following allocation, given the current assumptions, seems reasonable
as a starting point. Without question, the client's personal wishes
must be taken into consideration. The client will benefit from a
clear explanation of the information in this article, but ultimately
the decision rests with him or her. Please consider the following
a starting point that could be accomplished through original pre-death
planning or postmortem planning through disclaimer:
IRA 1: $1.5 million, Mary as beneficiary.
IRA 2: $400,000, Al as beneficiary.
IRA 3: $100,000, Susie as beneficiary.
The lower two plots on Exhibit 3 quantify
the advantage of splitting the IRA up into three separate accounts,
either before John's death or after John's death through a series
of disclaimers. Without question the value of the total estate in
the future is significantly greater by taking advantage of the longer
life expectancies and hence lower MRD of younger beneficiaries.
While it is beyond the scope of this
article to provide a detailed analysis of the benefits of a Roth
IRA conversion, converting a portion of the IRA to a Roth IRA would
benefit this client and his family. The portion converted to a Roth
IRA would:
1. provide income tax free growth for
the entire family.
2. stop minimum distributions for John
and Mary regardless of which spouse dies first.
3. make the minimum distributions for
Al and Susie income tax free.
Accepting the premise that an IRA conversion
is appropriate, the next question is how much should be converted
and when should the conversion occur? One excellent software program
that does far more than just recommend an optimal amount for the
Roth IRA conversion is Brentmark's Roth IRA Analyzer. However, it
seems that all the computer programs have significant limitations.
It is not prudent to recommend a Roth IRA conversion based solely
on the results from any of the currently available software programs
but, to their credit, they do provide a reasonable starting point
for the analysis.
Using a combination of Brentmark's
Roth IRA Analyzer, an intricate Excel spreadsheet developed by the
author and Steven T. Kohman, CPA, and additional criteria, it would
seem reasonable for the client to consider making a $500,000 Roth
IRA conversion. The client would pay the income tax on the Roth
IRA conversion with the $200,000 of after-tax dollars in Mary's
name.
Currently, to qualify for the Roth
IRA conversion, an individual's modified adjusted gross income must
be less than or equal to $100,000. The problem is that, depending
on the income from Mary's investments, John's MRD will probably
throw him over the $100,000 limitation. John has a one-year window
to make the conversion before his Social Security and MRD will likely
take him over $100,000 in modified adjusted gross income. Therefore,
in this example John makes the entire $500,000 Roth IRA conversion
in the year before he is required to take his first MRD. Unfortunately,
he dies of a heart attack the following year when he sees the tax
bill for converting $500,000 from his traditional IRA to a Roth
IRA (roughly $200,000).
Two extremely important factors:
1. Will the conversion place the taxpayer
in a higher income tax bracket and, if so, how much higher and how
long will it be before reaching the break-even point given the higher
tax bracket? Please note that without going into a higher tax bracket,
the break-even point for a Roth IRA conversion, assuming we are
using after-tax funds to pay the taxes measured in total purchasing
power, is one day.
2. The sooner the client makes the
conversion, the sooner the minimum distributions are eliminated
and the sooner the money can start growing income tax free. (Though
in many cases it makes sense to do a series of smaller conversions
staying in a lower income tax bracket over a number of years. In
this case study, the client has only a one-year window of opportunity
before his income exceeds $100,000).
See Exhibit 3 for the results from
combining the dual strategies of naming different beneficiaries
for John's traditional IRAs and assuming the $500,000 Roth IRA conversion.
The top two plots in Exhibit 3 demonstrate
that, after giving the Roth IRA time to grow, the estate's value
is significantly greater than the values reflected in the bottom
two plots (without the Roth conversion).
If our analysis had incorporated today's
estate tax structure, the increased value of both leaving money
to Al or Susie on the first death and the Roth IRA conversion would
have considerably strengthened the argument for leaving money to
children and grandchildren and converting money to a Roth IRA.
Though the new law does not really
speak to Roth IRAs, it will substantially impact Roth IRA conversions.
1. More clients will be eligible for
the conversion. With a lowered MRD, more clients will fall under
the $100,000 limitation that will now allow them to qualify for
the Roth IRA conversion.
2. Roth IRA conversions will be slightly
less desirable. The Roth IRA itself is no less desirable than it
was before. The conversion, however, is less desirable because maintaining
the status quo of owning a traditional IRA is a better choice than
it has ever been. The IRA owner will have a lower MRD. The heirs
will get a stretch. Virtually all the traps and nightmares about
massive income tax acceleration are a thing of the past.
The new reduced MRD for IRA owners
and beneficiaries is extremely favorable and simplifies planning
significantly. Consider contacting your clients to:
- inform them of the changes,
- encourage them to take advantage
of their reduced MRD, and
- recommend that they roll money out
of their 401(k)s (with acceleration of income rules) into IRAs.
The new law invites "cascading beneficiary"
disclaimer planning that will protect the interest of the surviving
spouse while retaining options for enormous tax deferred growth
after the death of the IRA owner. With the lowered MRD, more IRA
owners will qualify for Roth IRA conversions. IRA owners are advised
to review their retirement and estate planning strategies regarding
the own MRD, their named beneficiaries of the IRA and whether they
should consider a partial Roth IRA conversion.
Keynote Speaker
I am available for speaking engagements.
I present dynamic seminars for financial planners, CPAs, attorneys,
bankers and insurance professionals. I also present excellent
seminars suitable for individuals actively involved in planning
for retirement. If you are looking for a keynote speaker for
your next meeting, please call for a "planner's packet"
and to talk with me. Visit my speaking
engagement page for more information.
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