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Spreading
the Wealth
by James Lange,
CPA, Attorney at Law
Reprint from September 1997 issue of
Financial Planning Magazine.
Clients with substantial qualified
retirement plans have an unparalleled opportunity to benefit their
families. By taking advantage of the
Providing
For Everyone
The first goal for most couples with
long marriages is to provide for the financial well-being of the
surviving spouse. Couples will then want to provide for their children;
only after the spouse and children are accounted for do most couples
consider their grandchildren. Tax savings and even long-term growth
are usually secondary considerations. For many estates, leaving
the IRA to the children or grandchildren will not serve the first
goal, which is protection of the surviving spouse. Predicting how
much the surviving spouse will need to live comfortably is not an
exact science, so it's often difficult to know if there is enough
in an estate to justify naming children and/or grandchildren to
IRA accounts.
It's usually best to err on the
side of being conservative-over providing rather than under providing
for the surviving spouse. Naming children and/or grandchildren
beneficiaries of IRAs is appropriate only for estates of $1 million
or more. However, there is no precise cutoff amount to determine
which clients are appropriate candidates for this strategy because
each client has different retirement and planning needs. Some clients
with estates valued at $500,000 or greater may find choosing their
children or grandchildren as beneficiaries to at least a portion
of their IRA preferable.
Just how much can clients earn tax-deferred?
Assume that between them, Mr. and Mrs. Wise have more than enough
resources to support the surviving spouse comfortably after the
death of the first spouse. Additionally, Mr. Wise has a $300,000
IRA, which he divides into three separate $100,000 IRAs, naming
three different beneficiaries to each account. He names his 5-year-old
grandchild as beneficiary to one $100,000 IRA, his 35-year-old child
to the second IRA and his 68-year-old wife to the third IRA.
Mr. Wise dies before reaching age 70
1/2 and before receiving distributions from his IRA. The beneficiaries
all opt for taking the minimum distribution allowed. Each beneficiary
will be able to receive the following cumulative distributions over
his or her lifetime from the inherited IRA.
Over 70 years, the results are staggering.
The grandchild's distributions will total over $3.3 million; the
child's distributions, $730,000; and the spouse's distributions,
$208,000. The reason the grandchild's total distributions are so
dramatic lies in the amount of time that the funds can be invested
in the tax-deferred environment.
The rate of return on the investment
will affect dramatically the total distribution realized by the
beneficiary. A 7% average annual rate of return brought the grandchild
$3.3 million. At a 9% rate of return, the total distributions for
the grandchild are nearly $11 million. At a 5% rate of return, the
grandchild's distributions drop to $1 million.
retirement distribution rules, clients
can defer income taxes for up to 70 years. Maximizing estate-planning
opportunities means making the best-but not always the most traditional-choice
of beneficiary to a qualified retirement plan. Qualified retirement
plans include IRAs, 401(k)s, 403(b)s, pension plans, profit-sharing
plans, Keoghs, Simplified Employee Pension Plans (SEPs) and a combination
of the above or others. Though differences among the plans exist,
for our purposes they are treated in a similar fashion. I will refer
to the variety of qualified retirement plans as IRAs.
Choosing grandchildren instead of a
spouse or children as beneficiaries to an IRA increases the number
of years proceeds can grow tax-deferred. The difference between
naming a grandchild versus a spouse the sole or part beneficiary
of an IRA often translates into millions in additional funds.
Optimal
Method Of Allocating Resources In An Estate
Look at an estate like a pie that will
be divided among the spouse, the children and possibly the grandchildren.
Dividing the pie in the optimal manner and utilizing the retirement
distribution rules substantially increases the overall value of
the estate to the heirs and, over time, gives everyone a bigger
piece.
Traditionally, the named beneficiary
of an IRA is the surviving spouse. After-tax or non-IRA funds in
excess of the surviving spouse's needs are usually left to children
and grandchildren, often by way of a testamentary trust. The traditional
division of using non-IRA money to fund the unified credit amount
($600,000) often fails to make the most of family wealth. In the
appropriate circumstances, families will benefit if the IRA owner
names children or grandchildren or a trust as beneficiaries of at
least a portion of the IRA. The grandchildren will be required to
withdraw funds from the IRA at a much slower rate than the surviving
spouse. The reason the grandchild may keep the funds in the IRA
longer is because of the minimum distribution rules. Withdrawing
less means there will be more principal that will continue to grow
tax-deferred.
Minimum
Annual Distributions
Had Mr. Wise lived, the Internal Revenue
Service would have required him to take his first distribution on
or before April 1 of the year after he reached age 70 1/2. If Mr.
Wise elected to receive the distributions based on his actuarial
life expectancy, his minimum first-year withdrawal would be determined
by dividing the amount in the IRA by the applicable federal factor.
In this case, the calculation would be $300,000 divided by 16 for
a minimum distribution of $18,750, or $6,250 per $100,000 in the
IRA. As Mr. Wise ages, his minimum distribution would increase because
his life expectancy would decrease. If Mr. Wise dies before his
distributions start, younger beneficiaries-assuming the proper election-will
be required to take out less money per year than would older beneficiaries.
If Mr. Wise died, the minimum required annual distributions for
each beneficiary over time are shown on the chart below.
Since the grandchild has such a long
life expectancy, he could take minimal distributions in the early
years and larger distributions in later years. The child would have
to take larger annual distributions than the grandchild, but less
than the spouse's minimum distributions.
Change
Of Rules If Owner Starts Receiving Distributions
The rules, however, for the distribution
of the inherited IRA change if the IRA owner dies after his required
beginning date (April 1 of the year following the year he turned
70 1/2). Substantial deferral opportunities still exist for beneficiaries
even if the IRA owner dies after his required beginning date. But
the opportunities are not nearly as favorable as in the case of
the IRA owner dying before the required beginning date.
Skip
Generations To Avoid Tax
Generation-Skipping Transfer Tax (GSTT)
is a special tax levied in addition to the regular estate tax. The
GSTT applies, for example, when a grandfather leaves money to his
grandchild. A $1 million exemption, however, is available to offset
otherwise taxable generation-skipping transfers. Naming a grandchild
as the beneficiary of an IRA of less than $1 million is a good way
to provide the most support for a grandchild and permanently avoid
one level of estate tax. Though there are traps with the GSTT for
the unwary, proper planning could save one level of estate taxes
for transfers up to $1 million, and the IRA is an ideal method of
leaving money to grandchildren.
Disclaimer
Provisions in the Will
If your client falls in the middle
area where they have enough money that there is a federal estate-tax
problem (over $600,000)-but not so much that they can easily provide
for their spouse and children, consider disclaimer provisions.
Disclaimer provisions add flexibility
to an estate plan. Even with a simple will, a spouse always has
an option to disclaim a bequest. A spouse can make a qualified disclaimer,
in effect saying, "I don't want the property or part of the
property that was left to me." The next in line according to
the will, usually the children, will receive the property.
With a disclaimer-type will, the spouse
has a choice of either disclaiming into a trust where he or she
retains a right to the income or disclaiming completely, giving
the children the money. The disclaimer-type will gives the most
options and power to the surviving spouse. The terms of the trust
establish that the spouse receives the income for life and the ability
to invade principal for health, maintenance and support. Upon the
spouse's death, the property is left to the children.
The provisions of the trust may be
almost identical to the unified credit shelter trust provisions,
or Qualified Terminable Interest Property (QTIP) provisions, if
desirable. The added option of the surviving spouse retaining the
income and the right to invade principal for health, maintenance
and support could be invaluable for the family. This disclaimer-type
will is ideal if the spouse doesn't need the principal, but may
need the income.
The advantage of disclaiming the money
either into a trust (but not qualifying for a QTIP) or disclaiming
the entire interest to the children is that the property will not
be in the second spouse's estate, thus saving estate taxes on the
second death. The disadvantage of disclaiming is that after doing
so, the spouse loses rights to the property, though with a disclaimer-type
will the spouse can retain the income from the property.
Disclaimer-type wills have all the
benefits of simple wills and classic A/B trust-type wills, but leave
ultimate flexibility with the surviving spouse. The surviving spouse
will make the decision of whether-or how much-to disclaim within
nine months after the death of the first spouse. The spouse can
disclaim as much or little as he or she would like. Also, the spouse
can disclaim certain assets and not disclaim others.
Another advantage of the disclaimer-type
will is that the surviving spouse is able to assess financial needs
after a death before determining an appropriate action. Estate planners
call this "getting a second look." The disadvantage is
that the first spouse may not want to give the surviving spouse
that much control. For example, a disclaimer-type will would be
a bad choice for a second marriage where there are children from
a first marriage, because it gives the surviving spouse the option
to keep all the money at the expense of those children. While the
concepts of disclaimers are good for many married couples with long
marriages and complete trust, they are clearly not for everyone.
Disclaimer
Provisions in the Named Beneficiary of the IRA
If giving the surviving spouse the
flexibility to disclaim assets is an appropriate strategy for your
client, consider naming a trust as the contingent or secondary beneficiary
to the IRA. The IRA owner still retains control of the plan while
alive. In addition, the beneficiary designation of an IRA is revocable
until death. The funds in the IRA could be used to qualify for either
the marital deduction or to fill the unified credit shelter amount,
or both. Naming a trust as beneficiary to an IRA is particularly
important if the estate does not have other assets that qualify
for the unified credit amount. More importantly, this type of trust
will not immediately accelerate income taxes on the amounts in the
IRA and can be used to fund the unified credit equivalent and the
unlimited marital deduction.
Alternately, if the spouse is the first
beneficiary, a trust will be the contingent beneficiary. The spouse
then has the option of disclaiming to the trust. The terms of the
trust-practically the same as under the will-assure that the surviving
spouse receives the income for life and the right to invade principal
for health maintenance and support. At the surviving spouse's death,
the money is distributed to the children.
The most important widely cited authority
for allowing a trust to be the beneficiary of an IRA and still preserve
the marital deduction is Revenue Ruling 89-89 (1989-2 C.B. 231).
The Revenue Ruling also describes all the steps the planner and
the executor utilized to achieve the desired result. Private Letter
Ruling 9317025 provides additional guidance on the intricate rules
of drafting a trust where the trust is the named recipient of an
IRA. The grantor was the primary beneficiary and the spouse was
the secondary beneficiary. This is an example where the Trustee,
on the grantor's death, can spread remaining payments from the IRA
over the spouse's life expectancy.
If the trust is properly drafted and
the appropriate elections are made, this is an effective way of
giving the surviving spouse ultimate flexibility. Using this
disclaimer strategy postpones the tough decisions of allocating
money between surviving spouse and children until after the first
spouse dies. An estate planner, however, must meticulously follow
special language and rules to make this technique work.
Plans
For Spousal Rollovers vs. Naming Children Or Grandchildren
For younger clients whose primary goal
is long-term tax deferral, it may be best to name a spouse the beneficiary
of the IRA. The surviving spouse then has the option of rolling
over the IRA into their own IRA and not receiving any distributions
until the surviving spouse reaches 71 1/2. If the spouse is 50 years
old, there will be an additional 22 years of tax deferral.
The disadvantage of naming a surviving
spouse to try to get additional tax deferral is that the IRA will
be included in the surviving spouse's estate. In this case, the
savings due to the tax deferral may be surpassed by an increase
in the estate taxes at the time of the surviving spouse's death.
Inherited
IRA vs. Outright Gift
Compare the choice of leaving a 5-year-old
grandchild $100,000 in an IRA to leaving $100,000 in an account
that is not tax-deferred. Assume that the grandchild withdraws the
same amount from both accounts at the same time over the years.
The withdrawal amount is the required minimum distribution from
the IRA. Distributions are identical, but the grandchild with the
outright gift will run out of money 14 years earlier than will the
grandchild with the IRA. The grandchild with the IRA receives an
additional $1.5 million after income tax over the next 14 years
after distributions from the outright gift end.
Critical
Choices and Elections
To develop the optimal estate plan,
there are several crucial choices and elections that IRA owners
and their beneficiaries must make. Timing is essential. A successful
estate plan requires that the right choices and elections be made
at the right time by both the IRA owner and the beneficiary.
When the IRA beneficiary misses the
election to receive the minimum annual distribution, the opportunity
is lost forever. The IRA beneficiary will have to withdraw all of
the money out of the IRA within five years instead of over the beneficiary's
lifetime.
Before an IRA owner receives any distributions,
he or she is faced with an election to withdraw funds using the
"life expectancy recalculation" method or the "term
certain" method. The life expectancy recalculation method usually
works best if the IRA owner survives for many years. By naming a
younger beneficiary, the IRA owner reduces the amount of the minimum
distributions. The term-certain method usually works best if there
is a shorter period between the time of the IRA owner's first distribution
to the time of the IRA owner's death.
If the IRA owner fails to make an election
or makes the wrong election, there may be a considerable acceleration
of tax and reduced total distributions. Special care in examining
the controlling qualified retirement plan document is needed. The
recalculation election is available only if it is specified in the
plan or the qualified retirement plan agreement.
In both examples, choosing the wrong
election ruins the master plan for deferring taxes, potentially
exposing the family to disastrous financial consequences. To make
matters more confusing, the regulations do not offer a prescribed
form in which to make several of the recommended elections, so it
is important to be specific when spelling out the intent of the
election. Additionally, estate planners may want to send the election
via certified mail, return receipt requested, to the financial institution
holding the IRA for documentation purposes.
Before
Changing Beneficiaries
If the inherited IRA is the grandchild's
primary source of income, then the minimum distribution amounts
may be insufficient to meet basic needs. The grandchild is permitted
to take distributions above the minimum amount without paying the
premature distribution penalty. The tax-deferral benefits, however,
may be significantly reduced. When the grandchild withdraws significantly
more than the minimum distribution, it often defeats the plan for
long-term tax deferral. Leaving tax-deferred dollars to the grandchild
makes sense as long as he or she will not need to deplete the fund
within the first 25 years after the death of the IRA owner.
Requirements
for Spousal Consent
Naming children, grandchildren or trusts
as beneficiaries of qualified retirement plans can maximize family
wealth. The decision to use this as an estate-planning tool may
have to be a family decision rather than a decision of the owner
of the plan. Federal law requires that spouses explicitly waive
their right to receive benefits from most qualified plans before
any other beneficiary can be designated. This requirement does not
apply to IRAs.
Estate
Tax On Excess Accumulation In An IRA
In addition to estate taxes, a 15%
tax is levied on excess accumulations in qualified plans, including
IRAs. The excess in the plan is the balance exceeding the value
of an annuity paying $150,000 per year as adjusted for inflation
based on the decedent's life expectancy immediately prior to death.
Example: Mr. Wise, now age 72, dies
with a 401(k) plan valued at $500,000 and a 403(b) plan of $500,000.
Multiply the factor 5.7261 (IRC 7520) times $150,000, which equals
$858,915. The excess accumulation is $141,085 ($1 million minus
$858,915). The excess accumulation tax is $21,163 (15% times $141,085).
This tax is not subject to the unified
credit shelter amount. The surviving spouse can make an IRC 4980
A(d)(5) election to defer paying the excess accumulation tax. The
spouse's estate, however, can be forced to pay a higher tax on the
second death if the surviving spouse has his or her own IRA or if
the inherited IRA grows. Once an estate is subject to the excess
accumulations tax, the IRA is never again subject to the tax.
Another concern is the excise tax on
excess distributions from an IRA while the client is alive. The
planning complications are hair raising. Planners involved with
an estate plan with a substantial IRA should consider the pitfalls
and opportunities of the estate tax on excess accumulations and
excess distributions.
Is
My State Different?
State income tax and state transfer
taxes are factors in choosing IRA beneficiaries. State taxes, however,
are so small in scope compared to the federal tax, they are not
a critical factor. One facet of the estate plan that should be considered
is making sure that all the disclaimer provisions and distribution
provisions of any trust created are valid under the laws of the
client's state residence and consistent with the document controlling
the client's plan whether it be a Keogh, 403(b), profit sharing
plan, IRA, etc.
Conclusion
Under the right circumstances, clients
with substantial IRAs can utilize the retirement distribution rules
to defer income taxes for many years after their death. Disclaimer
type wills and disclaimer type beneficiary designations should be
considered by planners who want to retain flexibility in estate
plans. The combination strategies of deferring income taxes and
using disclaimers is something planners should consider to meet
the needs of married clients with large IRAs.
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