An IRA (or retirement account) owner faces a maze of intersecting income and estate tax issues, retirement fund rules and strategic investment questions when planning how to pass on an account at death—even to a spouse. Beyond the alphabet soup of technical jargon pervading this area, core planning considerations include spouse’s age, health and financial habits; distribution control; IRA size; creditor protection; tax savings; legacy planning; and how taxes will be paid.
Take Dan and Linda. Dan “plans” on predeceasing Linda but is perplexed about how to pass on his IRA. First, he must complete the IRA “beneficiary designation” thoughtfully. Without one, the worst options become the only options. At Dan’s death, the default “five-year deferral” rule would apply so the entire IRA would be distributed and taxed over five years. The highest income tax rates usually apply, since annual income is inflated with each installment. His best options follow.
Designate Linda as outright beneficiary. Then Linda can “rollover” Dan’s IRA into her own. This strategy provides maximum estate and income tax benefits. The “marital deduction” shelters the IRA from Dan’s estate tax, since the IRA passes exclusively to Linda. By choosing this option, Linda will delay receipt of mandatory IRA distributions and defer income tax.
Assuming Dan dies before age 70.5, the age for mandatory required distributions (variously called MRDs, MDRs or RMDs), and Linda elects rollover treatment, Linda has several payment options. If she’s older than Dan, she can defer distributions until December 31 of the year Dan would have turned 70.5 years. If Linda is younger than 70.5 when Dan dies, she can defer taking payments until she’s 70.5. If she’s already 70.5 or older and Dan was receiving MRDs, she must begin taking Dan’s MRDs by December 31 in the year following Dan’s death.
Linda’s MRDs are calculated using her life expectancy (LE) at Dan’s death, established under IRS tables. The IRA value is divided by this LE factor, as readjusted annually, resulting in the MRD.
On rollover, Linda can also name younger beneficiaries to receive the balance after her death, letting them elect to stretch-out remaining IRA distributions over their LEs.
However, if Dan doubts Linda will properly follow through, fears she might fritter away assets, blow deferral opportunities or name someone other than his children as successor beneficiary(ies), he should consider naming a trust as beneficiary.
Establish a conduit trust beneficiary. Dan can name a conduit trust as his IRA beneficiary, with Linda as lifetime beneficiary and their heirs as remainder beneficiaries. All IRA distributions then pass through the conduit trust to Linda. Conduit trust provisions are best built into a family revocable trust. Because Dan’s share of the revocable trust assets at his death are typically divided into post-death irrevocable sub-trusts, the trustee would use the IRA to fund either a conduit exempt trust or marital trust, depending on the family trust terms and estate tax rules applicable at Dan’s death.
Although Dan’s beneficiary designation could designate the revocable trust, letting the trustee allocate IRA assets to either of Dan’s irrevocable sub-trusts, the safest strategy is for Dan to specifically name the marital or exempt trust. Dan needs to make sure the selected sub-trust within the family trust contains the proper conduit trust provisions, ensuring it will satisfy the qualified IRA trust rules and meet exempt or marital trust requirements.
If Dan elects to use his IRA to fund the exempt conduit trust, the IRA will pass free of estate tax at both his and Linda’s deaths. Depending on other factors, funding the exempt trust solely with the IRA is generally not the best planning technique, as it will likely be exhausted during Linda’s life (since payments to her are based on her LE). Theoretically, unless also funded with non-IRA assets, nothing will remain to bypass further estate tax, or pass on to heirs.
Dan may also fund the marital trust with his IRA, deferring estate tax on the IRA until Linda’s death. To qualify for this deferral, the marital conduit trust must be drafted to meet the qualified terminal interest property rules, making it a QTIP trust. The control option afforded by using a marital conduit trust may protect IRA assets from creditors and from a spouse’s spendthrift ways, but it offers little to “stretch out” growth potential using the successor beneficiaries’ LEs.
Another structure for a marital trust is use of a “unitrust.” Linda’s distributions would be calculated as a fixed percentage of marital trust corpus, including the IRA. Annual distributions are calculated by multiplying the fixed rate times the annually recalculated value of trust assets. To qualify for the marital deduction deferral from estate tax, the unitrust payout rate must not be less than 3 percent or greater than 5 percent. At Linda’s death, any unitrust remainder is subject to estate tax. Heirs will continue to receive the unitrust fixed payment amount at Linda’s death. Depending on trust assets, the spouse’s payments may be greater or lesser than the MRD-based payments guaranteed through a conduit marital trust. [For another discussion about passing IRAs to a non-conduit QTIP, please see “The Non-Conduit QTIP Trust,” Wealth Wise, Jan. 2011].
Use an accumulation trust as designated beneficiary. The MRD is calculated using the LE of the oldest trust beneficiary, including remainder beneficiaries. Both Linda’s age and heirs’ ages are thus considered. If Linda is the oldest beneficiary, trust distributions are calculated using her LE. The trustee can decide to withhold IRA distributions from Linda, accumulating receipts. This option provides greater control over distributions than a conduit, and may provide opportunity for long-term growth, but the undistributed IRA distributions are taxed to the trust. Due to narrower brackets, a trust’s income tax rates generally exceed individual tax rates. This tax bite may be a significant deterrent, depending on the IRA owner’s overall objectives.
These rules are fraught with complexities—sound legal, tax accounting and investment advice is critical to making the best choices.
