Guest Article

Integration of Individual Retirement Account Balances Into the Client's Estate Plan: Beneficiary Designations, Payout Options and Payout Elections

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by Andrew J. Krause Myers Krause & Stevens, Attorneys at Law
5811 Pelican Bay Blvd., Suite 600
Naples, FL 33963-2794

Integrating a client's Individual Retirement Account (hereafter "IRA") balances into the client's estate plan requires consideration of many issues and is often the greatest challenge to the client's advisors. Accurate advice and timely, coordinated action by the client with respect to the client's beneficiary designation and payout elections under the rules and regulations is essential to accomplishing the client's objectives. Absent timely analysis and action, some planning options expire and the client is stuck with ad hoc results under the particular provisions of the IRA agreement between the client and each financial institution involved.

This article, including the "Control Matrix" (exhibit A), should be an aid in the tax and estate planning process. However, the most important point to understand is the necessity of thorough analysis, planning and action prior to the client's "required beginning date" (hereinafter "RBD"). Generally, the RBD for an IRA owner is April 1 of the calendar year following the calendar year in which the IRA owner attains age 70-1/2.[1]

For the most part, clients have been poorly served by their advisors in this type of planning, partly because the laws and regulations are far too technical and confusing, but largely because clients have relied on their stock broker or personal banker (for free advice) and engaged in an uninformed and incomplete decision making process. Competent professional advice is hard to find, expensive, and often not sought until after key planning options expire (i.e., after the client's RBD).

The main problem for the client is his unawareness of the need for professional help. Rarely has the lawyer, accountant, certified financial planner, or trust officer assumed the responsibility for this complex planning. Clients and their beneficiaries are becoming increasingly aware of the complexity and are suffering the irreversible results of an IRA owner's failure to act in a timely manner.

The most common and simplest tax and estate planning for a client's IRA balances is to name the client's spouse as the direct beneficiary. Oftentimes, however, this is clearly inconsistent with the client's objectives and represents either abdication of the planning responsibility or short-sighted tax planning. This simple and easy answer of naming the spouse as beneficiary is presumably inappropriate advice for a client who (1) for specific non-tax reasons, has utilized a QTIP marital deduction trust as part of the client's estate plan or (2) has insufficient other assets to coordinate in the planning to reduce estate taxes or generation-skipping transfer taxes. This is where the Control Matrix (exhibit A) might be helpful.

Background information. One cannot properly advise a client as to the most suitable approach for integrating the client's IRA balances into the client's financial and estate planning without reviewing the client's existing wills, trusts, and asset ownership, and at the very least knowing: (1) the client's age; (2) the client's required beginning date; (3) the institutions with which the client has IRAs (custodian or trustee); and (4) for each IRA, the current (i) balance; (ii) beneficiary designation and age; (iii) payout election; and (iv) governing IRA agreements, including the applicable beneficiary and payout provisions by default (i.e., absent a timely and valid designation or election by the IRA owner). Whether a grandfather election was made by the account owner and whether the IRA is otherwise exempt from the 15% excise tax on excess distributions or excess accumulations is also a factor, among others.

Timely Planning is Critical. With the proper background information at hand, the integration of the IRAs into the client's estate plan can begin. However, a threshold question is whether the client has already reached his or her RBD. If the client has not, then the advisor can be a hero and proceed to present all of the planning options; otherwise, the advisor is quite likely to be the bearer of bad news and have to explain the irrevocable elections deemed made and the possibly horrible income tax consequences for the proceeds of the IRA at the client's death. [2] Perhaps sophisticated tax planning using a testamentary charitable remainder trust (or other deferred giving vehicles) can provide a solution to the horrible income tax consequences and save the day where the proceeds would otherwise be taxed all as taxable income relatively soon after the client's death. [3]

Every IRA owner and his planner need to know that prior to the owner's RBD the client's desired beneficiary upon death has to be determined (and related planning implemented) and decisions made and carried out with respect to: (1) the desired "payout election"; and (2) whether recalculation of life expectancy should apply for the IRA owner and/or a spouse beneficiary. Once the IRA owner reaches his RBD, as earlier referred to, the time expires for certain planning otherwise permitted to avoid payout limitations and related adverse tax consequences.

A thorough discussion of the tax rules and regulations under IRC section 401(a)(9), which govern the required minimum distributions (hereafter "RMD") from IRAs and the specific payout elections, is beyond the scope of this article. [4] But to avoid tax disasters for a client as well as potential malpractice, the planner has to understand the rules and regulations, and particularly (1) the deadline for certain action, namely the client's RBD; (2) the difference between a "beneficiary" [5] (whether by written action of the client or by default pursuant to the governing plan provisions) and a "designated beneficiary" [6]; (3) the payout required for an IRA as of the client's RBD as well as following the client's death [7]; and (4) how this is affected by: (a) whether the client has timely [8] effected a "designated beneficiary"; (b) whether recalculation of life expectancy applies [9] and to whom; and (AC) the applicable provisions of the underlying IRA agreement (of each financial institution) which apply absent specific and timely action in writing by the IRA owner.

Also beyond the scope of this article is a detailed discussion of how to name a QTIP trust as the beneficiary of an IRA and qualify the account balance for the marital estate tax deduction. [10] Despite the complexity, there is no question that it can be done successfully. [11] In addition, where a QTIP trust is contemplated as the IRA beneficiary, then it should be determined whether the QTIP trust will be sufficient if simply arising under the IRA owner's revocable trust at his or her death or whether an otherwise inactive irrevocable trust with the applicable QTIP marital trust provisions would be most appropriate. An irrevocable trust can be used to improve the results under the RMD rules through the ability to use the spouse as a designated beneficiary to minimize the RMDs to the IRA owner prior to death and to the trust after the owner's death.

Consequence of Untimely Planning. An example of the tax disaster many IRA owners presently face is where the IRA owner is already beyond his RBD and as of his RBD: (1) his beneficiary was a revocable trust or his estate (either by design or by default under the governing provisions of the institutional IRA agreement); and (2) his irrevocable election concerning life expectancy is "annual recalculation" whether by express election or by default. [12]

Let's assume the IRA owner in the situation described above dies a widow or widower at age 80 with an IRA balance of $300,000. How rapidly must the account be distributed after the IRA owner's death? And how much income tax will have to be paid? The results are horrible because the account balance is required to be paid in full, all as taxable income, by the end of the calendar year following the year of the IRA owner's death. [13] If the IRA owner's estate incurs a federal estate tax then a deduction under IRC section AC) will be of some help, but any account proceeds taxable to the estate or revocable trust will be taxed largely at the 39.6% marginal rate, that being the rate applicable to trusts and estates on taxable income exceeding $7,500 under IRC section 1(e).

The larger the account balance, the larger the potential tax problem and the greater the need for timely advanced planning.

A Lost Planning Option. This result in the hypothetical above could have been avoided had the client's lawyer or other responsible advisor done a thorough analysis and taken action prior to the client's RBD. For example, prior to the client's RBD the client could have simply filed a timely election (with the IRA custodian or trustee) specifying that the client's life expectancy shall not be recalculated each year in determining the denominator of the payout fraction which determines the required minimum distribution. In that event, the account balance would have been payable over a fixed number of years, generally 15.3 or 16 years, [14] regardless of whether the IRA owner remains alive after his RBD. If the IRA owner elected a fixed number of years payout and died prior to age 86, say at age 80, the IRA balance would be payable to his estate or revocable trust over the six years remaining (i.e., 1/6, 1/5, 1/4, and so on). [15] On the other hand, if the IRA owner in the example lives beyond age 86, then he will outlive his IRA.

Generally, unless otherwise provided by the governing instrument or the IRA owner, the balance of the account should be vested and could be withdrawn at any earlier time by the surviving beneficiary. [16]

The Qualified Irrevocable Trust Alternative. Alternatively, or coincidentally, the client's advisors could have planned the IRA owner's desired beneficiary prior to the client's RBD in a way to provide a more flexible payout. For example, if instead of the IRA owner naming his estate or revocable trust as beneficiary of his IRA, the IRA owner could have revocably named as beneficiary a qualified irrevocable trust, designed pursuant to Proposed Treas. Reg. section 1.401(a)(9)-1, D-5. The irrevocable trust would provide for the same beneficiaries and shares that would otherwise exist under the client's will or revocable trust.

Let's consider an IRA owner whose will or revocable trust provides his estate is to pass to his descendants, per stirpes. Utilizing a qualified irrevocable trust and naming it as the IRA owner's beneficiary prior to the IRA owner's RBD, the IRA owner's payout options are greatly enhanced. According to the Proposed Regulation D-5, the oldest then living descendant of the IRA owner would be the IRA owner's "designated beneficiary" and the denominator of the payout fraction for determining the IRA owner's required minimum distribution at age 70 becomes 26.2 instead of 16 (and 25.3 instead of 15.3, if applicable). In this scenario, the IRA owner would typically elect, prior to his RBD, to have recalculation of life expectancy apply to avoid having to reduce the 26.2 denominator by a full one each year he remains alive. Furthermore, and often of greatest significance where the designated beneficiary is a child or grandchild, in the year following the IRA owner's death the IRA balance can continue to be paid out over the applicable life expectancy of the designated beneficiary, which is recomputed based on the designated beneficiary's adjusted age without continued limitation by the "minimum distribution incidental death benefit rule," [17] (hereafter "MDIB") and theoretically could be as long as 76 years. Typically, the number of years would be based on a child's adjusted life expectancy of 35 years or so, as opposed to the life expectancy of a grandchild or great-grandchild.

The Fortuitous Option. Where the IRA owner dies after his or her RBD and is survived by a spouse who is named the IRA beneficiary, then the failure to plan (or erroneous planning) before the IRA owner's RBD apparently can be overcome by the surviving spouse properly electing to treat the IRA as his or her own, [18] and (1) naming or having a beneficiary with a life expectancy (i.e., a designated beneficiary); and/or (2) electing for herself whether her life expectancy is to be recalculated each year. See PLR 9311037 and PLR 9534027, which permitted the spousal election described, based upon Prop. Reg. section 1.408-8, Q&A, 4. The author suggests that a PLR be obtained before advising a client to proceed in this fashion, until it becomes clear by regulation or revenue ruling that this is permitted.

By now it should be clear that an IRA owner is wise to plan and coordinate his beneficiary designation and payout election (including the recalculation election for him and/or his spouse) all prior to his RBD.

Estate Planning and the Control Matrix. With that in mind, now let's review the Control Matrix and consider the options in planning to integrate IRA balances into the IRA owner's estate plan. The Control Matrix should be of assistance to tax and estate planners who undertake to clarify the client's tax planning and control objectives and then seek to determine how best to accomplish in light of the planning options available and the consequences of each option.

The Control Matrix should be viewed simply as an initial aid in determining the relative consequences of a client's beneficiary designation options for their IRAs when the estate plan is for the client's surviving spouse to receive some benefit from the IRA after the IRA owner's death.

The Control Factor. If the client's spouse is named as the outright beneficiary as of the client's death, then clearly the client has lost all control over where any balance in the IRA will pass after the surviving spouse's death. However, as suggested by the Control Matrix, the various tax consequences of naming a spouse as outright beneficiary are generally favorable relative to naming the client's estate, revocable trust, or irrevocable trust as beneficiary.

It is easy for one to conclude that generally the spouse should be named the outright beneficiary, at least until one realizes that the "control" factor goes far beyond simply whether the client feels it is necessary to restrict who the IRA balances may pass to after his or her surviving spouse dies (e.g., that the balance should pass to children from a prior marriage).

As the experienced estate planner knows very well, IRAs passing outright to the client's surviving spouse are beyond the client's dispositive control and thus would not be available for effective use of either the client's $600,000 unified credit exemption equivalent or the client's $1,000,000 exemption for generation-skipping transfer tax planning. This is often a consideration unless the clients' have sufficient other assets. In addition, where the client's spouse is the outright beneficiary, the surviving spouse's total control also means total responsibility for decisionmaking concerning (1) advisors; (2) investments; (3) account balance distribution elections and planning for income tax purposes; (4) new beneficiary planning; and (5) budgeting. Clients often prefer to relieve their spouse of these burdens.

The level of sophistication of a client's spouse may be reason alone for a client to want to protect the IRA balances and exercise "control" to that end. Where the control objective is paramount, the use of a trust will be an option, and an irrevocable trust named as the IRA beneficiary at the client's death will often be the best option because the irrevocable trust can provide a "designated beneficiary." The irrevocable trust agreement could also serve as the main vehicle for the client's tax and estate planning as of the client's death, as well as serving other purposes, including functioning as a "Crummey" annual exclusion giving trust.

With respect to use of an irrevocable trust, it is critical to understand and explain to the client that until death the client remains free to (1) change his or her IRA beneficiary designations; and (2) fully withdraw or rollover the account balance. In other words, if the client's objectives change, the irrevocable trust can be abandoned. Otherwise, the client's estate through his will, separate revocable trust (where appropriate), and beneficiary designations could simply pass at the client's death to the irrevocable trust.

Thus, from a control standpoint, whether for (1) protection of a an unsophisticated or incapacitated spouse (or other "designated beneficiary"); (2) effective estate tax or generation-skipping transfer tax planning; or (3) assurance that any IRA balances at the spouse's death will pass to the client's children, favorite charity or other predetermined beneficiary, the use of a trust will be essential, and use of an irrevocable trust will often be the best option to accomplish the client's objectives.

Estate planning lawyers are ideally situated to assist the clients with integrating the client's IRA balances into their estate plan. With timely, careful planning, disastrous income tax consequences can be avoided and the client's dispositive objectives can be met.

Exhibit A

Control Matrix

Considering Possible IRA Account Beneficiary Alternatives Before or When Approaching the Required Beginning Date (i.e., Before April 1 of year After Age 70-1/2 Year), Where Client's Spouse is to be Provided For.

                       BENEFICIARY ALTERNATIVES

                       Spouse              Revocable         Irrevocable
                                           Trust or          Trust [Note]
                                           Estate

PLANNING CONCERNS

Control By             Unfavorable         Favorable         Favorable
Owner

Income Tax Deferral    Most Favorable       Generally        Generally
                       Perhaps Including    Unfavorable To   Favorable But
                       Rollover By Spouse   Disastrous       Be Careful

Estate Tax Marital     Neutral But Be       Neutral But Be   Neutral But Be
Deduction              Careful              Very Careful     Very Careful

15% Excess Distri-     Neutral              Generally        Neutral But Be
bution Tax                                  Unfavorable      Careful
During Life

15% Excess Accumu-     Favorable Where      Unfavorable      Unfavorable
lation Tax At          Spousal Election     Because          Because
Death                  To Defer Tax Is      Apparently No    Apparently No
                       Desired              Spousal Defer-   Spousal Defer-
                                            ral Option       ral Option

Note: Naming the irrevocable trust as "beneficiary" of the IRA is not irrevocable, as owner can always change the beneficiary until death and ignore the irrevocable trust if it is no longer the beneficiary. The IRA owner might consider naming an appropriate irrevocable trust as beneficiary to enable use of the owner's spouse's life expectancy in determining the required minimum payout to the owner while living and the payout of the balance to the trust at the owner's death. The owner would consider this in order to use the life expectancy of a spouse (or child) without passing the ownership or control to the spouse (or child) upon the owner's death.

Where the IRA owner's life expectancy is to be recalculated, then generally the client would elect not to recalculate spouse's life expectancy, otherwise if spouse dies first, the trust would receive all of the account balance soon after IRA owner's death.

Footnote 1. See Internal Revenue Code of 1986, as amended, (hereafter "IRC") section 401(a)(9)(AC).

Footnote 2. As a result of the rules and regulations under IRC section 401(a)(9), absent specific, complicated planning before a client's RBD, clients who have their spouse, revocable trust or estate as their beneficiary will be limited in their payout options and often will be stuck with recalculation of life expectancy(ies), and it will often be that the IRA balance is required to be distributed in full by the end of the calendar year after the client's death. See Prop. Reg. section 1.401(a)(9)-1, D, AC), and E-8.

Footnote 3. See Private Letter Ruling 9237020 (June 12, 1992) involving an IRA payable to a charitable remainder unitrust for a child; and Private Letter Ruling 9253038 (October 5, 1992) involving a charitable remainder unitrust for a spouse. The charitable remainder trusts incurred no tax liability for receiving income in respect of a decedent and the IRA owner's estate received a charitable estate tax deduction. For a discussion of the topic, see Hoyt, "Charitable Gifts From Donors' Retirement Plan Accounts," Trust and Estates, August (1994), at 26.

Footnote 4. For a discussion of the technical rules, see Ice, "Distribution and Estate Planning For Deferred Compensation and IRA Benefits," ACTEC 1995 Annual Meeting.

Footnote 5. An IRA beneficiary is an individual or entity legally entitled to the balance of the IRA upon the owner's death. There is no statutory definition of "beneficiary."

Footnote 6. An IRA "designated beneficiary" means an individual whose life expectancy may be used in determining the RMD and payout period for the IRA owner and the beneficiaries. See IRC section 401(a)(9)(E) and, particularly, Prop. Reg. section 1.40 1(a)(9)-1, Q&A, D, E and F.

Footnote 7. IRC section 401(a)(9)(A) and (B) and the regulations thereunder.

Footnote 8. See Prop. Reg. section 1.401(a)(9)-1, D-2(a)(1).

Footnote 9. Absent an election out of recalculation or an IRA agreement provision to the contrary, recalculation of life expectancy for the IRA owner and his or her spouse is required, Prop. Reg. section 1.401(a)(9)-1, AC).

Footnote 10. Krause and Franklin, "QTIP Trusts as IRA Beneficiary: Is There An Alternative to 89-89?" Trusts & Estates, (November 1992).

Footnote 11. Ibid.; and see Rev. Rul. 89-89, 1989-2 C.B. 231.

Footnote 12. See footnote 9.

Footnote 13. See footnote 2.

Footnote 14. The payout period for an IRA based solely on the owner's life expectancy (because no designated beneficiary exists), will be 15.3 or 16 years. The period is 15.3 years when IRA owner's 71st birthday falls in the same calendar year the IRA owner attains age 70-1/2. See Reg. section 1.72-9, Table V, and Prop. Reg. section 1.401(a)(9)-1, Q&A, E-1(a).

Footnote 15. Prop. Reg. section 1.401(a)(9)-1, Q&A, F-1(a) and (d).

Footnote 16. "Of course, the beneficiary could elect to accelerate payments of the remaining interest." See "After Death Distribution Rules" section of Committee Reports on P.L. 98-369, TRA 1984, Paragraph 2601 CCH (1988) 893A.

Footnote 17. The MDIB requirement does not apply to distributions after the employee's death. Prop. Reg. section 1.401(a)(9)-2, Q&A, 3.

Footnote 18. See Prop. Reg. section 1.408-8, Q&A, 4. But compare section 1.408-8, Q&A, 6 (first two sentences); and note apparent inconsistency of this treatment under the proposed regulations with the express statutory rules for distribution following death before and after the RBD and the effect of this regulation in going far beyond the favorable treatment of a spouse beneficiary under section 401(a)(9)(B) under which more favorable treatment for some surviving spouses exists, but is expressly limited to where the IRA owner died before his or her RBD; also, consider apparent inconsistency with both 401(a)(9)(B)(iv) as limited by Prop. Reg. section 1.401(a)(9)-1, Q&A, C-5 and Prop. Reg. section 1.401(a)(9)-1, Q&A, E-7(a) and (AC).

Reprinted with permission from The Florida Bar Journal, copyright 1995.