Protecting Your IRA From Income and Estate Taxes, Choose the Best Distribution Method and Beneficiary

Estate Planner Mar-Apr 2001

An individual retirement account (IRA) is one of the most common tools used to assure financial independence after retirement because of its tax deduction for contributions and the tax-deferred growth. But the rules regarding distributions and beneficiaries can be confusing, and a wrong decision can result in both a loss of flexibility and Uncle Sam taking a huge bite out of your nest egg — especially after your death.

In addition, the Treasury Department this year substantially revised the 1987 proposed regulations governing the required minimum distribution rules from IRAs and qualified retirement plans, both after age 701/2 and after death. So whether you are opening a new IRA or reviewing your existing account, you need to carefully consider these two key issues.

1. Taking Distributions

You generally cannot take distributions from your IRA before age 591/2 without incurring a 10% penalty. But you also will face a penalty if you don’t take minimum distributions soon enough — 50% of the amount you should have withdrawn but didn’t. Distributions must start by your required beginning date, which is April 1 of the calendar year after you reach age 701/2.

The 2001 proposed regulations make it simpler for you and your plan administrator to understand and apply minimum distribution rules. Under the 2001 and 1987 proposed regulations, you determine the required minimum distribution by dividing your account balance by the distribution period.

For lifetime required minimum distributions, the 2001 proposed regulations provide a uniform distribution period for all participants of the same age. An exception applies if the sole beneficiary is your spouse and he or she is more than 10 years younger than you. If this is the case, you can use the longer distribution period measured by the joint life and last survivor life expectancy of you and your spouse.

Use the uniform distribution table to determine your required minimum distribution for each year based on your current age and account balance as of the end of the prior year. You no longer need to elect to recalculate or not recalculate your life expectancy.

After your death, the distribution period is generally the remaining life expectancy of your designed beneficiary. Your beneficiary’s remaining life expectancy is calculated using the beneficiary’s age in the year following the year of your death, reduced by one for each subsequent year.

2. Naming a Beneficiary

Although this appears to be a simple decision, the obvious choice — your spouse or your children — may not be the best. Remember that at your death, your IRA will be subject to federal estate tax as well as income tax to the IRA beneficiary. But with proper planning and a smart beneficiary choice, you can reduce this tax liability.

Under the 2001 proposed regulations, your designated beneficiary is determined as of the end of the year following the year of your death — rather than as of your required beginning date or the date of your death as required under the 1987 proposed regulations. Thus, any beneficiary eliminated by distribution of the benefit — or through a disclaimer during the period between your death and the end of the year following the year of your death — is disregarded in determining your designated beneficiary.

If at the end of the year following the year of your death you have more than one designated beneficiary and the account hasn’t been divided into separate accounts or shares for each beneficiary, the beneficiary with the shortest life expectancy becomes the designated beneficiary. This approach is consistent with the 1987 proposed regulations.

Let’s take a look at your choices for beneficiaries and examine how the recently proposed regulations affect them:

Spouse. Designating your spouse as your IRA beneficiary provides him or her the most access to the funds. If your spouse survives you, he or she can roll over the benefits into an IRA in his or her own name and withdraw as much or little as he or she needs. Your spouse can then name your child as beneficiary and calculate minimum distributions using the joint life expectancy of himself or herself and the child. When your spouse dies, the remaining IRA balance will be distributed to your child over the remainder of your spouse’s and child’s joint life expectancies. This method can stretch out IRA distributions and thus extend tax-deferred growth in the account.

Children. If you name your child the beneficiary of an IRA, he or she cannot take ownership of it like a spouse can. In calculating distributions to a nonspouse beneficiary, the 1987 proposed regulations distinguished between whether you died before or after your required beginning date. Under the 2001 proposed regulations, the same rules for distributions after your death apply regardless of whether you died before or after your required beginning date.

In the absence of a plan provision or election of the five-year rule, the life expectancy rule applies in all cases in which you have a designated beneficiary. If you die after your required beginning date, your designated beneficiary, whose life expectancy is used to determine the distribution period, is determined as of the end of the year following the year of your death — rather than as of the date of your death.

If you die before your required beginning date, the proposed regulations now allow a waiver of any excise tax resulting from the life expectancy rule during the first five years after the year of your death if your entire benefit is distributed by the end of the fifth year following the year of your death.

Credit shelter trust. Naming a credit shelter trust as beneficiary allows you to maximize your estate tax savings on your IRA. Your gift and estate tax exemption ($675,000 in 2001, but up to $1 million by 2006) will protect the account from estate taxes on your death, and the trust language will keep it out of your spouse’s taxable estate. Yet your spouse can still have access to the funds.

To clarify the 1997 amendment to the 1987 proposed regulations, the 2001 proposed regulations provide examples in which a testamentary trust is named as your beneficiary. In addition, the look-through trust rules still apply.

Charity. Naming a charity as beneficiary may offer the best tax results. Designating a charity will result in a charitable deduction for estate tax purposes for the full value of the IRA. Because the charity is tax exempt, income tax will also be avoided when the IRA is distributed. Of course, this is only a viable option if your spouse and children will not need the IRA assets.

No designated beneficiary. If you elect to recalculate your life expectancy and die without a designated beneficiary, the 2001 proposed regulations provide that your remaining account balance must be distributed within your remaining life expectancy recalculated immediately before your death. Previously, the 1987 proposed amendments required that your remaining account balance be distributed in the year after your death. Yet the five-year rule automatically applies if you don’t have a designated beneficiary as of the end of the year following the year of your death.

Protect Your Nest Egg

If your IRA is subject to both estate tax (with rates as high as 55%) and income tax (with rates as high as 39.6%), it will be severely depleted after your death. That’s why it’s critical to defer and minimize these taxes. The 2001 proposed regulations simplify how you apply the minimum distribution rules.

To learn more about planning with your IRA, turn to page 6 and request a complimentary copy of our Estate MiniPlanner “Are Your Retirement Benefits Safe From Creditors?” And please don’t hesitate to call us for assistance. We’d be glad to help you navigate this complex area.