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Maximizing
IRA Benefits
by
James Lange, CPA, Attorney at Law
Reprint
from September 1997 issue of Financial Planning Magazine.
Many
Americans have accumulated significant amounts of wealth in their
retirement plans. Now they must decide what to do with it.
Retirees
who have prudently contributed the maximum amount allowed to their
Individual Retirement Accounts and retirement plans are now rewarded
with significant accumulations in the tax-deferred environment.
The question follows: What should they do now?
Generally,
paying taxes in the future is better than paying taxes now. To the
extent an IRA owner can afford it, deferring distributions from
the IRA as long as possible is also more advantageous. Although
some differences exist, this article refers to all IRAs, TIAA/CREF
accumulations, 401(k)s, SEPs, Keoghs, SIMPLE plans, 403(b)s, 401(a)s,
and defined contribution plans as an IRA for simplicity.
Assume
that an IRA owner has access to both an IRA and to after-tax investments.
Should the IRA owner make withdrawals from the IRA or spend the
after-tax funds first? In most cases, spending the principal from
the after-tax investments first is preferable to taking taxable
distributions from the IRA. (Please see Exhibit.)
EXHIBIT
Consumption
of $87,000 Annually Using
IRAs and After-Tax Savings
This
example demonstrates the advantage of using after-tax savings
before making distributions (over the minimum required amount)
from an IRA. It reflects a $1,000,000 balance in the IRA account
and a $300,000 balance in the after-tax account. Please assume
consumption for a 65-year-old IRA owner is $87,000 per year
after taxes. The gray area reflects use of the IRA funds before
spending the after-tax savings. The light blue area reflects
using the after-tax savings before withdrawing funds from
the IRA.
Result
The
example shows that the retiree will run out of money just
after reaching age 81 if funds are spent from the IRA account
first. If, however, the retiree first spends the money from
the after-tax funds, then he or she will still have nearly
$385,000 at that time.
Conclusion
Generally,
for an investor with accumulations in both an IRA and after-tax
investment accounts, a greater benefit accrues by spending
the after-tax savings first and allowing the money in the
IRA to grow tax-deferred for as long as possible. |
One
situation, however, where it may be wise to make premature withdrawals
from the IRA is when there will be significant estate taxes, and
the IRA holds the only funds available to pay the taxes. In certain
cases, it may be wise to take premature distributions, pay the income
tax, and gift after-tax proceeds to the beneficiaries. Methods of
leveraging gifts with Grantor Retained Annuity Trusts (GRATS), Charitable
Retained Annuity Trusts (CRATS), second-to-die life insurance policies,
family limited partnerships, and other techniques may be appropriate
for wealthy individuals. This strategy of prematurely incurring
income taxes on IRAs and gifting after-tax proceeds will, in limited
circumstances, be beneficial by not only reducing the amount of
the estate, but also by providing the beneficiaries with funds to
pay the estate taxes.
Retirement
Options—Should Employees Annuitize?
Another
question facing retirees is: Annuitize or not? Annuitizing IRA accumulations
means essentially surrendering all or a portion of the IRA in exchange
for receiving regular payments in the future. IRA owners who annuitize
often choose to receive payments for the remainder of their and
their spouses’ lives. One problem with annuitizing is that
the money is rationed out over the years without regard to the IRA
owner’s needs. If IRA owners do not need the money, then annuitizing
needlessly accelerates the payment of income taxes on the IRA. Furthermore,
if more than the annuity amount is needed, then the IRA owner is
just plain out of luck.
A
larger problem is that annuitizing is not an effective means of
providing for an IRA owner’s heirs. By annuitizing, the IRA
accumulation will vanish upon the IRA owner’s death unless
he or she chooses the surviving spouse or guaranteed period options.
Choosing these options will, however, reduce the amount of money
that the IRA owner will receive in annuity payments.
In
essence, annuitizing is a gamble. Since the annuity is based on
life expectancy, IRA owners are gambling that they will outlive
their actuarial life expectancies. Thus, if they have reason to
believe that they would not survive their actuarial life expectancies,
then annuitizing would probably be a mistake.
If
IRA owners and/or their spouses think, however, that they are going
to substantially outlive their actuarial life expectancies, then
annuitizing would probably work well. It is also reassuring that
with an annuity, no matter how long a person lives, he or she can
be assured of an income stream.
For
IRA owners who lack particularly strong opinions about whether they
are going to outlive their life expectancies, a reasonable strategy
to consider is annuitizing a small portion of their IRAs. Annuitizing
a portion, but not all of the IRA, is a method of diversifying retirement
assets.
Usually,
however, significant annuitization is not recommended. Our analysis
indicates that IRA owners and beneficiaries will receive significantly
more money if the IRA owner chooses not to annuitize. In addition,
not annuitizing will allow significant income tax deferral possibilities
for IRA beneficiaries. To learn more about the potential benefits
of leaving IRAs to beneficiaries, please see my article "Spreading
the Wealth," published in the September 1995 issue of Financial
Planning.
Required
Beginning Date
The
Required Beginning Date (RBD) is the date when the IRA participant
must begin to receive annual distribution amounts withdrawn from
his or her retirement accumulations. Under the Small Business Job
Protection Act of 1996, the RBD is now the later of April
1st of the calendar year following the year in which the participant
(1) reaches age 70½, or (2) retires. Use of the later retirement
date for the RBD is not available to IRA owners or owners of five
percent or more of the company sponsoring the retirement plan.
Taking
Distributions from the IRA
Assuming
that an IRA owner would like to retain funds in the tax-deferred
environment but does not want to incur a penalty, he or she will
take the minimum required distribution. The minimum distribution
rules are based on the joint life expectancy of the IRA owner and
the IRA owner’s named beneficiary. The minimum distribution
is calculated by utilizing actuarial life expectancy tables dictated
by the Internal Revenue Service—as reflected in Appendix E
of Publication 590, which is likely to be revised next year. Most
IRA owners name their spouse as their beneficiary.
For
example, assume that an IRA owner, Mr. Wise, is age 71, which, according
to the IRS tables, gives him a life expectancy of 15.3 years. The
tables indicate that his 65-year-old spouse has a 20-year life expectancy.
Their joint life expectancy to determine the minimum distribution
amount is 22.8 years. Thus, the minimum required distribution for
the first year if Mr. Wise has $2 million in his IRA is $87,719
($2,000,000 ÷ 22.8).
For
subsequent year calculations, the two methods used to calculate
the minimum distribution option are the recalculation method and
the term certain method. These are different methods for determining
the life expectancies of both the IRA owner and the primary beneficiary.
Under the term certain method, on each anniversary of the RBD, one
year is subtracted from the IRA owner’s original life expectancy.
The recalculation method allows the IRA owner to recalculate his
or her life expectancy every year. Note that as we age one additional
year, our life expectancy decreases, but not by a full year. Using
a higher life expectancy will result in a lower minimum required
distribution.
To
complicate matters further, an IRA owner may choose to recalculate
one life and apply term certain to the other life. Contrary to popular
belief and the natural intuition of IRA owners who would like to
withdraw the minimum amount, the recalculation method for both spouses
is often not the best choice. The reason it may be prudent to use
the recalculation method for the IRA owner and the term certain
method for the beneficiary is that, if the beneficiary predeceases
the IRA owner, then the beneficiary’s life expectancy is recalculated
to zero. However, this recalculation will force more rapid distributions
from the IRA while the owner is alive.
Designated
Beneficiaries
If
an IRA owner names a non-spouse beneficiary (usually the children),
then according to the Minimum Distribution Incidental Benefit (MDIB)
rule, no more than a ten-year differential is allowed between the
IRA owner’s age and a non-spouse beneficiary’s age in
computing their joint life expectancy (although the actual age differential
is usually more than ten years). An IRA owner can name a spouse,
however, who is more than ten years younger than the IRA owner and,
for purposes of the required minimum distribution, include the spouse’s
age in determining their joint life expectancy.
Minimum
Required Distributions after the IRA Owner’s Death
Upon
Mr. Wise’s death, Mrs. Wise could roll over the plan into her
own IRA. Mrs. Wise could then use her own and her newly named beneficiary’s
life expectancy to calculate her required minimum distribution.
Alternatively, if she was older than her deceased spouse, then she
could continue to utilize her deceased spouse’s distribution
schedule.
For
a non-spouse beneficiary, the general rule is that the beneficiary
must take distributions at least as rapidly as the deceased IRA
owner. If, however, certain conditions are met and the proper elections
have been made, then the beneficiary will be able to use his or
her own age to determine the required minimum distribution. The
life expectancy of the non-spouse is determined as of the date the
IRA owner reached age 70½, reduced by one year for each year thereafter
(i.e., the term certain method).
Taxpayer
Relief Act of 1997
In
August 1997, President Clinton signed new tax legislation that will
have profound changes with far reaching implications for retirement
and estate planning. For wealthy investors with significant balances
in their IRAs, the legislation is almost too good to be true. I
had to pinch myself.
First,
the new legislation permanently eliminated both the excess distribution
and excess accumulation taxes. Avoiding these taxes was the major
reason that some financial planners have recently recommended prematurely
withdrawing funds from IRAs. Since avoiding these two taxes is no
longer necessary, there is little motivation to withdraw funds from
an IRA before the IRA owner needs the money (except for the gifting
strategy previously discussed).
More
importantly, the legislation created a new type of IRA. The "Roth
IRA," named after Sen. William V. Roth, Jr. (R-Del.), will
become effective in 1998 for contributions of after-tax money for
married people who have less than $160,000 in income. The money
will grow free of tax and withdrawals will be tax-free,
if the funds are held for five years and the IRA owner is 59½ when
distributions begin. Premature withdrawals are also tax-free if
used to purchase a first home (up to $10,000 only). Early indications
suggest that the Roth IRA will be irresistible for eligible taxpayers
who can afford to make the contribution. In effect, all income
and capital gains earned within the IRA are not taxed, which
is better than current, regular IRAs where the income and capital
gains are only tax-deferred. Another favorable feature is that the
minimum distribution rules will not apply to Roth IRAs nor will
income taxes be due upon the owner’s death.
In
as early as 1998, current IRA owners with an adjusted gross income
of less than $100,000 can convert their regular IRAs into Roth IRAs.
This conversion is something every IRA owner should seriously consider.
Converting, however, requires that income taxes be paid on the entire
IRA (less nondeductible contributions) during the year of conversion.
This unseemly conversion strays from the general principle that
it is usually better to pay taxes later than pay taxes now. In most
of the scenarios that we analyzed, however, the retiree will enjoy
substantial benefits from the conversion. The huge future income-tax
savings will more than offset the current income tax bite. As an
incentive, if the conversion is made before January 1, 1999, then
payment of the income taxes resulting from the IRA conversion can
be spread over four years. Prudence dictates caution for making
this conversion without understanding all of the implications.
Plan
Benefits Trust Beneficiary
If
the total marital estate is more than $600,000 (which under the
new law increases in increments to $1 million in the year 2007),
then a special trust called a Plan Benefits Trust (PBT) can be created
and designated as the second or contingent beneficiary to the IRA.
The purpose of the PBT is to fund the unified credit shelter trust.
This
PBT is created in addition to any trusts that might be established
in a will. The terms of the PBT provide the surviving spouse with
income for life, and, subject to the trustee’s discretion,
the ability to access principal for health, maintenance, and support.
Upon the surviving spouse’s death, the remaining assets are
distributed to whomever the IRA owner chooses, usually the children
or special minor trusts depending on the age and maturity of the
children. If the survivors make the proper election, then the income
tax on the money in the PBT can be deferred.
One
of the main purposes of the PBT is to save $240,000 (or potentially
much more) in estate taxes for the IRA owner’s children, while
also protecting his or her surviving spouse. The PBT is especially
beneficial to IRA owners whose major asset is their IRA. Conventional
thinking dictates that it is not ideal to fund the unified credit
shelter trust with IRA money. For many IRA owners, however, the
IRA is required to fully fund the unified credit shelter trust.
Since a person’s will usually does not control the proceeds
of the IRA, the PBT is necessary to utilize the credit shelter trust
and maximize the estate tax savings to the heirs upon the surviving
spouse’s death.
Disclaimer
Strategy
Naming
a trust (i.e., the PBT) as the primary beneficiary of the
IRA, however, is not the best choice in most circumstances. It is
preferable, instead, to name the surviving spouse as the first beneficiary
and the PBT as the contingent beneficiary. The surviving spouse
could then either choose to retain all of the IRAs proceeds or disclaim
the proceeds of the IRA into the PBT. If the spouse is named as
the first beneficiary, then he or she will also have the option
of rolling over the retirement funds into his or her own IRA. Another
advantage of naming the spouse as the primary beneficiary is that
the spouse will not be burdened by a trust. In addition, there may
be other funds available to fund or partially fund the $600,000
unified credit shelter amount that would make the PBT unnecessary.
A final option is that the surviving spouse could keep a portion
of the IRA and disclaim the remaining assets into the PBT.
The
advantage of the surviving spouse being able to disclaim the full
interest of the IRA into the PBT results from the potential savings
of $240,000 or more in estate taxes for the children when the surviving
spouse dies. The decision of whether the surviving spouse should
inherit the IRA outright or whether the family would be better served
by utilizing the PBT is often a tough decision. Many couples with
long-term, trusting marriages where both spouses have the same children
will prefer to let the surviving spouse make the decision after
the first death when more relevant financial information is available.
The mechanism to accomplish this goal is to name the surviving spouse
as the primary beneficiary and the PBT as a contingent beneficiary.
Rather
than making restrictive decisions when guessing at future circumstances,
the disclaimer/trusts strategy allows an IRA owner’s spouse
to make these important decisions with more defined and current
information. When will more information be known? At the time of
the IRA owner’s death. Additionally, the spouse will have nine
months after the IRA owner’s death to make a qualified disclaimer.
It is the ability to make a disclaimer of the benefits of the IRA
that creates an optimal estate plan. Disclaimers have long been
an important part of estate administration. Recently, sophisticated
planners have been using the disclaimer as part of the planning
process before a death occurs. Disclaimer planning, however, is
probably not appropriate for second marriages where each spouse
has his or her own children.
For
tax and administrative reasons, the plan’s beneficiary designation
should not refer to the IRA owner’s estate or a trust in the
will. The PBT should be a stand-alone document drafted in conjunction
with the will or living trust. The will and PBT can specify that
the unified credit shelter trust be funded with both IRA and after-tax
assets. The best choice of assets to fund the trust—if future
circumstances indicate that the trust needs to be funded—can
be made at the time of the IRA owner’s death, not now when
less information is known.
If
the IRA owner likes the disclaimer strategy, then disclaimer-type
wills in addition to disclaimer-type retirement beneficiary designations
are recommended. In both cases, everything is left primarily to
the spouse, thereby allowing the surviving spouse to disclaim as
much or as little as he or she wants into a trust for the spouse’s
benefit. The drafter of the documents should provide for coordination
of the PBT and the disclaimer trust under the IRA owner’s will.
Under most circumstances, we prefer utilizing an integrated fractional
formula in both the will and PBT to define the amount that will
fund the trust. Note that as the amount of the unified credit shelter
trust increases with the new legislation, the integrated formula
will fully fund the trust without the necessity of drafting new
wills.
Review
Existing Wills and PBTs
A
potentially enormous problem with existing wills and PBTs that do
not utilize disclaimer strategies is that as the unified credit
shelter trust amount increases, more money than either spouse intended
will be used to fund the trust. For multi-millionaires, the automatic
increase in funding the trust will be convenient. For married couples
with taxable estates between $600,000 and $2 million, however, funding
the trust at the expense of providing the surviving spouse a comfortable
amount of money outside the trust could be a significant burden
to the surviving spouse, especially since the trust is not available
for discretionary spending. If too much money is in the trust, then
the lifestyle of the surviving spouse could be dramatically restricted.
Most clients agree to fund unified credit shelter trusts only upon
realizing the potential estate tax savings which will occur after
the death of the second spouse. The disclaimer-type wills and PBTs
do a better job of providing for the surviving spouse by providing
him or her with the option to fund or partially fund the trust.
For clients who already have integrated disclaimer-type wills and
PBTs, however, no changes are necessary.
Conclusion
Retirees
have a wealth of options regarding their IRAs. In most situations,
the IRA owner and the beneficiary will be well-served by retaining
as much money as possible in the tax-deferred environment. One possible
exception to this rule is to make premature distributions under
a gifting strategy. IRA owners should also at least consider converting
their regular IRAs into Roth IRAs. Annuitizing is a conservative
strategy, but often appropriate for a portion of the IRA funds.
Finally, IRA owners should consider establishing a coordinated estate
plan that would incorporate disclaimer-type wills and disclaimer-type
beneficiary designations.
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This
article originally appeared in the September 1997 issue of Financial
Planning, The Official Magazine of the International Association
For Financial Planning. The layout and other changes have been adapted
for reproduction.
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