Facing a Hobson’s Choice.

t’s a situation almost every CPA will find familiar. Harry and Betty have combined taxable estates of $1,350,000, including a jointly owned residence valued at $300,000, Harry’s IRA valued at $675,000 (Betty is the designated beneficiary) and a jointly owned investment portfolio valued at $375,000. If Harry dies first, the IRA cannot be used to fund a bypass trust unless the trust—or Harry’s estate—is named as beneficiary. Since the couple can’t use a bypass trust, Betty’s taxable estate would be valued at up to $1,350,000. The resulting estate taxes could be as much as $270,750 (based on the unified credit amount available in 2000). If Harry did name his estate or a trust as his IRA beneficiary, the result could be significant adverse income tax consequences.

Clients like Harry and Betty face a classic dilemma inherent in many estate plans. Their combined estates are large enough to require them to pay estate taxes, but each spouse has insufficient separate assets—other than retirement benefits—to fund a bypass trust that could minimize or eliminate the tax bill. What’s a client to do?

By understanding the relevant income and estate tax rules that apply to qualified retirement benefits and IRAs, CPAs will be better able to see the apparent Hobson’s choice their clients face and assess the available alternatives.

INCOME TAX CONCERNS

Under federal law, amounts accumulated in a qualified retirement plan or an IRA must be distributed according to the minimum distribution rules in IRC sections 401(a)(9) and 408(a)(6). Taxpayers who fail to make required distributions pay a 50% excise tax on the amount they should have distributed.

The two sets of minimum distribution rules stipulate a required beginning date (RBD) for distributions. Under IRC section 401(a)(9)(C)(ii)(II), the RBD for non-Roth IRAs is April 1 of the calendar year following the year in which the participant reaches age 70 1/2 . The RBD for qualified retirement plans depends upon whether the participant owns more than 5% of the employer. If the answer is yes, the RBD is April 1 of the calendar year following the year in which the participant reaches age 70 1/2 . If a participant does not own more than 5%, the RBD is April 1 of the calendar year following the later of the year in which he or she reaches age 70 1/2 or the year in which he or she retires. No RBD applies to Roth IRAs.

Death before reaching RBD. If a participant dies before reaching his or her RBD, the proceeds of a qualified plan or non-Roth IRA generally must be distributed by December 31 of the calendar year that contains the fifth anniversary of the participant’s death (the five-year rule) unless the participant had named a designated beneficiary (DB). (Proposed regulations section 1.401(a)(9)-1 C-2A.) Since Roth IRAs do not have an RBD, all amounts must be distributed within the five-year period to avoid the excise tax—unless a DB was named.

If a client had named a beneficiary, distributions instead can be made in annual installments over a period not exceeding the DB’s life expectancy, but only if the distributions begin by December 31 of the year after the partcipant’s death. (Section 401(a)(9)(B)(iii).) Since amounts received from a non-Roth IRA or a qualified retirement plan are subject to income tax, stretching the distribution period can result in significant income tax savings. CPAs should recognize that helping a client identify and name a DB is, therefore, very important. A participant should name one before reaching his or her RBD. After that date, it’s too late to extend the payout period.

Since the distribution of benefits is based upon a DB’s life expectancy, the named beneficiary generally must be an individual or a group of individuals, such as the participant’s children. (As discussed later, under limited circumstances a trust can be named as DB and the trust beneficiary with the shortest life expectancy [usually the surviving spouse] is used as the measuring life.) A group of individuals is acceptable if it is possible to identify the member with the shortest life expectancy. In the case of the participant’s children, the oldest child’s life expectancy will be used to calculate the required minimum distribution under proposed regulations section 1.401(a)(9)-1 E-5A(1). An estate does not qualify as a DB and it usually is not prudent to make such a designation because the five-year rule would apply.

Death of participant on or after RBD. If a participant lives to the RBD, he or she must begin taking distributions. If the participant fails to name a DB or names a beneficiary that does not qualify, the heirs must take distributions over the participant’s remaining life expectancy. If a participant names a DB, distributions must be taken over the joint life expectancy of the participant and the DB, according to section 401(a)(9)(A)(ii). Most participants name their spouse as the DB, so distributions are made over the joint life expectancy of the participant and his or her spouse.

Example. Jennifer has a $400,000 IRA balance. If she lives to age 70 1/2 , she must begin taking distributions on her RBD—April 1 of the year following that in which she turns 70 1/2 . If Jennifer dies after she has begun distributions without naming a DB, her heirs will have to continue taking distributions over Jennifer’s remaining life expectancy. If Jennifer names her husband Ed as her DB, Jennifer’s IRA distributions will be based on their joint life expectancy.

A participant can name children or grandchildren as the DB. Although a special rule treats the DB as being no more than 10 years younger than the participant, regardless of actual age, when calculating the minimum required distributions (see proposed regulations section 1.401(a)(9)-2), naming a child or grandchild probably will result in a greater deferral since the life expectancy of a child or grandchild usually is greater than that of a spouse. On the other hand, naming a spouse has other tax benefits, because a surviving spouse can roll over benefits into an IRA (see discussion below). It’s important for CPAs to consider the deferral issues when advising a client on naming a DB before the participant attains the RBD since it is not possible to achieve greater deferral by naming a new DB after that date.

Example. Jennifer names her 29-year-old granddaughter as her DB. Despite the more than 40-year difference in their ages, special rules would treat the grandaughter as being no more than 10 years younger than Jennifer in computing minimum distributions over their joint life expectancy.

ESTATE TAX ISSUES

While naming an individual or a group of individuals as the DB can lead to greater income tax deferral than if none is named, naming certain beneficiaries (other than a trust, as discussed later) can, in fact, create undesirable estate tax consequences.

One of the fundamental concepts in designing an estate plan is to make proper use of the unified estate tax credit. In 2000, the credit can shelter up to $675,000 in assets from estate or gift taxes. Proper estate planning thus enables a married couple to shelter up to $1,350,000 in assets.

Example. Assume the wife, the first spouse to die, has $675,000 of assets at death and leaves all of it outright to her husband (as opposed to in trust)—who also has $675,000 of assets. Since the assets had been distributed outright, when the husband eventually dies all of his remaining property will be included in his estate and subjected to estate tax. If his estate includes the total $1,350,000, the estate tax would be $270,750 based on the unified credit amount available in 2000.

The couple can eliminate estate taxes if the first spouse directs her assets that can be sheltered by the unified credit ($675,000) into a trust that “bypasses” the husband’s estate. (The trust is sometimes referred to as a bypass or credit shelter trust.) The husband generally still has access to the income and principal of the trust, but the money in the trust at his death is not included in his estate, saving up to $270,750 in estate taxes. An individual can direct any assets into a bypass trust except those the surviving spouse will receive under law or contract, such as a jointly owned personal residence or qualified retirement plan, IRA or life insurance benefits that name the surviving spouse as beneficiary.

Naming a trust as DB. In Harry and Betty’s case, Betty is the DB of Harry’s $675,000 IRA, so these assets can’t be put into a trust. The remaining IRA benefits distributed to Betty would be included in her estate at her death, resulting in up to $1,350,000 of taxable assets. (The remainder of Harry’s assets are jointly owned and similarly ineligible for a bypass trust.)

In case Harry predeceases Betty, the couple can eliminate estate taxes by naming a bypass trust as the beneficiary of Harry’s IRA. Under federal law, a bypass trust can be named the beneficiary and still qualify as a DB provided the following five requirements under proposed regulations section 1.401(a)(9)-1 D-5A are met:

• The trust must be valid under state law.

• The trust must be irrevocable or become irrevocable at the participant’s death.

• All beneficiaries of the trust must be individuals.

• The beneficiaries of the trust must be identifiable from the trust instrument.

• Certain disclosure must be made to the IRA or qualified retirement plan administrators.

If these requirements are not met, then the benefits will still bypass the surviving spouse’s estate, but the five-year rule will apply if the participant dies before his or her RBD. All benefits then must be distributed to the trust by the end of the year that contains the fifth anniversary of the participant’s death. If the requirements are not met and the participant dies on or after his or her RBD, distributions must be made to the trust over the participant’s remaining life expectancy.

While the first, second and last requirements are easy to understand, the third and fourth requirements need further explanation. The trust beneficiaries must be easily identified and must be individuals so the life expectancy of the oldest beneficiary—in this case Betty—can be used as the measuring life to compute the minimum required distributions to the trust. Except for certain contingent beneficiaries discussed below, an entity such as a charity or an estate cannot be a beneficiary since trust beneficiaries must be individuals and an estate or charity does not qualify as such. The IRS has implied that it will aggressively review trusts named as beneficiary of retirement benefits to determine whether an estate is a potential trust beneficiary.

The trustee’s ability to distribute funds to an estate to help it pay estate taxes, debts or administrative expenses (a typical provision) can potentially disqualify the trust as a DB since the estate is a potential beneficiary. (See PLR 9809059.) To reduce exposure on this issue, CPAs should recommend that any trust named as beneficiary of retirement benefits contain language prohibiting distribution of any collected retirement benefits to an estate under any circumstance.

Although individuals generally must be beneficiaries of a “designated beneficiary” trust, naming a charity will not disqualify a trust if the right to the benefits is contingent on the “premature” death of a prior beneficiary. (See proposed regulations section 1.401(a)(9)-1 E-5 A(e).) Generally, this means a charity can be named as a contingent beneficiary to receive money only if a prior beneficiary dies before the end of his or her life expectancy.

THE HOBSON’S CHOICE

While naming a trust as beneficiary provides for efficient use of a couple’s unified credits, it generally results in three income tax disadvantages.

1. Retirement and IRA benefits are considered “income in respect of a decedent” (IRD). As such, they generally are included in the recipient’s gross income upon receipt. IRD paid to a trust is typically taxed at higher rates than IRD paid to an individual. For instance, in 2000 a trust’s taxable income over $8,650 is taxed at 39.6%, while a surviving spouse must receive income in excess of $288,350 before the 39.6% rate applies.

2. Income taxes paid by the trust will reduce the amount that “bypasses” the surviving spouse’s estate. If the survivor paid the taxes out of his or her own funds, the amount paid would reduce the assets included in the taxable estate upon his or her death.

3. Spousal rollover opportunities may be lost. A spouse named as the DB of an IRA or qualified retirement plan can elect to roll over the amounts received into his or her own IRA within 60 days of receipt under proposed regulations section 1.408-8 A-4(b). The spouse can then name a DB and delay distributions until his or her own RBD. Retirement assets payable to a revocable trust and distributed to the spouse through the marital share can be rolled over if the spouse retains “complete control and dominion” over the assets and has the unlimited right to withdraw them (see PLR 9836029). Retirement assets payable to a bypass trust are not eligible. Note: The spousal rollover will not help if the surviving spouse needs the distributions and is less than age 59 1/2 . Participants generally have to pay an early withdrawal penalty of 10% on most amounts distributed before age 59 1/2 .

ASSESSING THE ALTERNATIVES

Assuming the participant’s IRA or qualified retirement plan is needed to support the surviving spouse and may also be needed to fully fund the bypass or credit shelter trust, the participant generally has three options, which are described below. The most efficient tax alternative would be to name a child as the DB. This would defer income taxes since the required minimum distributions would be based in part on the child’s life expectancy. The participant would also minimize estate taxes since the benefits would be removed from the surviving spouse’s estate. Most families, however, want the surviving spouse to have access to the benefits if needed.

Name a qualified bypass trust as the DB. Retirement benefits can bypass the surviving spouse’s estate, as discussed above. Even though the benefits are paid to a trust, the surviving spouse can still use the income and principal generated by the trust assets, if needed. However, unless all family members are in high tax brackets, the trust probably will pay higher income taxes on the benefits than a spouse or child would. Moreover, opportunities for a spousal rollover are forfeited, at least to the extent retirement assets are used to fund the bypass trust share as opposed to the marital share. CPAs should recommend that the formula allocating assets between the two direct the trustees to fund the marital share with retirement benefits and the bypass trust share with non-retirement assets to the extent possible, to minimize the income tax disadvantages.

Name the spouse as the DB. This option will not minimize estate taxes. As discussed above, however, the surviving spouse can roll over the benefits into his or her rollover IRA and name the children as the DB, thereby minimizing income taxes. Amounts the spouse receives are taxed at individual income tax rates that in most families are lower than the trust tax rates that would apply under the first option. This option minimizes income taxes at the expense of potentially higher estate taxes.

Name the surviving spouse as DB with possible disclaimer. If his or her financial situation has changed, the survivor can disclaim the retirement benefits when the first spouse dies. This option lets the surviving spouse take a second look at estate assets shortly after the death of the first spouse. If the decedent had named a bypass trust as contingent beneficiary in the event of a disclaimer, this step would achieve the benefits described above.

In broad terms, here are the requirements for a surviving spouse to disclaim assets (see IRC section 2518 for more details).

• The surviving spouse generally must make the disclaimer in writing within nine months of the decedent’s death.

• The surviving spouse must not have accepted any benefits from the retirement plans or IRA.

• The disclaimed benefits must pass as a result of the disclaimer and without any direction on the part of the surviving spouse.

The last point is important. If the surviving spouse disclaims, he or she cannot be the trustee of the recipient trust and hold discretionary distribution powers over the disclaimed benefits unless the powers are limited to an ascertainable standard—trust assets can be applied only for the health, education, support or maintenance of beneficiaries. (See regulations section 25.2518-2(e).) On the other hand, the surviving spouse should not be given the discretion to use trust assets to discharge a legal obligation to support his or her children since this could trigger inclusion of such assets in the survivor’s estate. (See regulations section 20.2041-1(c).)

Although disclaimers are a useful tool, they introduce other complications that are beyond the scope of this article, especially where interests in qualified pension plans are at issue. If a client anticipates using a disclaimer, he or she may want to consider the steps necessary to ensure the disclaimer will be effective, such as executing a waiver of qualified pre-retirement survivor annuity (QPSA) rights required under The Retirement Equity Act of 1984.

Assuming there are no children from a prior marriage, the tradeoff of the first option is the possibility of fewer assets available during the surviving spouse’s lifetime (due to potentially higher income taxes) vs. reduced estate taxes. The first option may be preferable if the surviving spouse has sufficient other assets to absorb the increased income taxes. If not, the second option may be preferable. Moreover, if the survivor is expected to need the bulk of the benefits, any estate tax disadvantage to the second option is minimized, since the surviving spouse’s estate is taxed only on the benefits that remain at his or her death. If the surviving spouse understands how to properly disclaim assets and there is a chance he or she will need all or part of the retirement benefits, the best option may be for the benefits to be paid to the surviving spouse. The survivor could then disclaim them should his or her financial situation change.

A TOUGH CHOICE

Assessing the tradeoffs when planning for qualified retirement plan and IRA benefits is a complex task. The discussion here touched on only some of the basic issues; CPAs should rely on it for general and not specific guidance. Each of the alternatives is appropriate for different cases and the facts and circumstances involved in a client’s particular situation must be carefully considered before choosing one. In the final analysis, CPAs should recommend clients consult with an attorney to implement any estate planning recommendations regarding qualified plans and IRAs.