Winter 2008 Newsletter
INHERITING AN IRA: An Overview of the Distribution Rules for IRA Accounts
By: Pamela Buskirk
Tax-deferred retirement accounts, such as Section 401(k) accounts, Section 403 (b) accounts, and Individual Retirement Accounts (“IRAs”), have become an increasingly large part of many individual’s estates. Thus, planning for distributions from an individual’s retirement accounts is a vital part of his or her overall estate and financial planning. However, many estate planning attorneys and financial advisors have difficulty following the intricacies of the required minimum distribution rules. While the rules are technical, they can be broken down into fairly manageable parts.This article discusses the basic aspects of distributions from retirement accounts, with a focus on traditional IRA accounts.
IRAs and other tax-deferred retirement plans are unique because unlike most inherited property (which is not subject to income tax), withdrawals from retirement accounts are taxed as income to the recipient. They are taxed because the investments in the account are allowed to grow tax-free, and such growth represents income that the government has not previously subjected to income tax. Thus, one major goal when dealing with retirement accounts is to allow the participant or the participant’s beneficiaries (if the participant dies before receiving all distributions) to defer this income tax for as long as possible by postponing withdrawals from the account .Since these accounts often outlive the participant and are passed to the participant’s spouse and/or children,their unique structure presents an opportunity to extend tax deferral into the next generation.
A. Designated Beneficiary. A “Designated Beneficiary”is an individual who is named by the participant as a beneficiary of the plan.1 A person that is not an individual (e.g., the participant’s estate, a trust, a business, or a charity) may not be a Designated Beneficiary.2 If a person other than an individual is designated as a beneficiary, the participant will be treated as having no Designated Beneficiary, even if there are also individuals designated as beneficiaries.3 In other words, a beneficiary that is not a Designated Beneficiary erases all other Designated Beneficiaries. However, there is an exception to this rule for certain types of trusts, which is discussed in greater detail below.
B. Required Minimum Distribution (“RMD”). The RMD is the minimum amount required to be distributed for each calendar year once the participant has reached his or her required beginning date. It equals the amount obtained by dividing the account balance by the “applicable distribution period.”4 The“applicable distribution period” during the participant’s lifetime is his life expectancy or the joint life expectancy of the participant and his surviving spouse if the surviving spouse is the sole Designated Beneficiary.5 For periods after the participant’s death, the “applicable distribution period” is either 5 years or the life expectancy of the Designated Beneficiary.
C. Required Beginning Date. The “Required Beginning Date” is the date on which the participant must take his first RMD. It is April 1 of the calendar year following the calendar year in which the participant reaches age 70 ?.6
II. BASIC DISTRIBUTION RULES
A. Participant’s Death On or After the Required Beginning Date.
If distributions of the participant’s account have begun, and a participant dies before his entire interest has been distributed to him, the remaining distributions are made as follows:
•If participant has a Designated Beneficiary, distributions are made over the longer of (i) the Designated Beneficiary’s life expectancy; or (ii) the participant’s life expectancy.
•If participant does not have a Designated Beneficiary, distributions are made over the participant’s life expectancy, using the age of the participant as of his birthday in the calendar year of his death, reduced by one for each calendar year that elapses after the calendar year of the participant’s death.7
B. Participant’s Death Before the Required Beginning Date. Generally, if a participant dies before his Required Beginning Date, his entire interest is to be distributed in accordance with the 5-Year Rule.8 However, there are two exceptions – the 5-Year Rule does not apply if either the Surviving Spouse Rule or the Life Expectancy Rule applies.9
1. The 5-Year Rule. Under the “5-Year Rule,” the participant’s entire account balance must be distributed within 5 years of the participant’s death, regardless of who receives the distribution.10 Distributions under this rule may be very costly since all possibility of extended tax deferral essentially has been lost. If a participant dies before the required beginning date without a designated beneficiary then the only method available for distribution is the 5-Year Rule.11
2. The Surviving Spouse Rule. If the surviving spouse of the participant is the sole Designated Beneficiary, the applicable distribution period is measured by the surviving spouse’s life expectancy using the surviving spouse’s birthday for each distribution calendar year after the calendar year of the participant’s death up through the calendar year of the spouse’s death.12 Thus, the spouse’s life expectancy is recalculated each year. After the surviving spouse’death, the applicable distribution period for successor beneficiaries is the life expectancy of the spouse using the age of the spouse as of the spouse’s birthday in the calendar year of the spouse’s death, reduced by one for each calendar year that has elapsed after the calendar year of the spouse’s death.13
Distributions to the surviving spouse who is the sole Designated Beneficiary must begin on or before the later of (1) the end of the calendar year immediately following the calendar year in which the participant died, or (2) the end of the calendar year in which the participant would have attained age 70 ?.14 Since distributions under the Surviving Spouse Rule allow the beneficiary to take distributions over his or her own life expectancy and to defer taking those distributions until the year in which the participant would have attained age 70 1/2, this results in significant deferred growth. Alternatively, the surviving spouse may elect to rollover the participant’s account balance into her own IRA, as discussed in the case study below.
3. The Life Expectancy Rule. Under the Life Expectancy Rule, the participant’s interest is distributed over the life of the Designated Beneficiary, and the distributions must commence no later than one year after the participant’s date of death.15 This Life Expectancy Rule is often referred to as a “stretch distribution” because a beneficiary is “stretching” the distributions over his own life expectancy. The applicable distribution period is the beneficiary’s remaining life expectancy determined using the beneficiary’s age as of the beneficiary’s birthday in the calendar year immediately following the calendar year of the participant’s death.16 In subsequent calendar years, the applicable distribution period is reduced by one for each calendar year that has elapsed after the calendar year immediately following the calendar year of the participant’s death.17 If a participant has multiple Designated Beneficiaries, then the Designated Beneficiary with the shortest life expectancy will be the Designated Beneficiary for purposes of determining the applicable distribution period (i.e., the RMD is based upon the life expectancy of the oldest beneficiary).18 However, see below for a discussion of separate accounts.
C. Plan Provisions Determine Use of 5-Year Rule vs. Life Expectancy Rule. To determine whether the5-Year Rule or the Life Expectancy Rule applies to a distribution, one must look to the plan’s provisions. A plan may adopt a provision specifying either that the 5-Year Rule will apply to certain distributions after the death of a participant even if the participant has a Designated Beneficiary or that all distributions will be made in accordance with the 5-Year Rule.19 Additionally, a plan may adopt a provision that permits participants (or beneficiaries) to elect on an individual basis whether the 5-Year Rule or the Life Expectancy Rule applies to distributions after the death of a participant who has a DesignatedBeneficiary.20 If a plan does not adopt either of these provisions, distributions must be made as follows:
(1) If the employee has a Designated Beneficiary, distributions are made in accordance with the Life Expectancy Rule.
(2) If the employee does not have a Designated Beneficiary, distributions are made in accordance with the 5-Year Rule.21
III. BENEFICIARIES DETERMINED AS OF SEPTEMBER 30.
The determination of a “designated beneficiary”under RMD rules is based on the beneficiaries designated as of the date of the participant’s death, who remain beneficiaries as of September 30th of the calendar year following the calendar year of the participant’sdeath.22 Consequently, any person who was a beneficiary as of the date of the participant’s death, but is not a beneficiary as of that September 30, is not taken into account in determining the participant’s Designated Beneficiary for purposes of determining the RMD distribution period after the participant’s death.23
If a participant names both an individual and a charity, estate, or any other entity as the participant’s primary beneficiaries, the availability of a “stretch distribution” payment option for the individual beneficiary will be eliminated. Thus, if the individual beneficiary wishes to remove any “non-individual”beneficiaries, this must be accomplished by September 30 following the year in which the participant dies. A beneficiary may be removed by either(i) a disclaimer by the beneficiary of his/her/its interest; or (ii) a distribution to the beneficiary of his/her/its share of the account.
IV. SEPARATE ACCOUNTS
If a participant has multiple Designated Beneficiaries, then the RMD is based upon the life expectancy of the oldest beneficiary.24 However, a participant’s account may be divided into separate accounts with different beneficiaries for each separateaccount.25 If such separate accounts are created, the distribution rules will apply separately to each separate account.26 In other words, the RMD will be calculated based on the life expectancy of the oldest beneficiary of each separate account.
The separate accounts must be established prior to December 31 of the year following the year of the participant’s death.27 To establish separate accounts,the beneficiaries’interests in the account must be fractional (not pecuniary), and some affirmative act must establish the separate accounts (i.e., a physical division of a single account into completely separate accounts or the use of separate account language on the beneficiary designation form).28 Creating separate accounts can help minimize taxes and maximize the deferral on inherited retirement accounts. For example, if a participant designates his son, age 50, and his grandson, age 20, as the beneficiaries of his account, each could use his own life expectancy if separate accounts are established for each beneficiary by the December 31st deadline.For the grandson, this means potentially stretching out his distributions for 63 years (the grandson’s life expectancy), instead of taking the distributions over the son’s life expectancy of only 34.2 years.29
V. TRUSTS AS BENEFICIARIES
A trust cannot be a Designated Beneficiary, even if named as a beneficiary, because it is not an individual.30 However, if a trust that is named as a beneficiary meets the requirements below, the beneficiaries of the trust (not the trust itself) will treated as having been designated as beneficiaries by the participant:
(1) Trust must be valid under state law;
(2) Trust must be irrevocable or become irrevocable at the participant’s death;
(3) Trust beneficiaries must be identifiable from the trust instrument (beneficiary does not need to be named in the trust so long as he/she is identifiable); and
(4) Certain documentation (e.g., trust instrument or list of all beneficiaries) must be pro-vided to the plan administrator or IRA custodian by October 31 of the year following the participant’s death.31
In addition, all of the beneficiaries of the trust must be individuals whose ages can be identified.32
If a trust meets these requirements, and if more than one individual is a beneficiary of the trust, the trust beneficiary with the shortest life expectancy (i.e., the oldest beneficiary) will be the Designated Beneficiary for purposes of determining the applicable distribution period.33 Contingent trust beneficiaries must be taken into account in determining which beneficiary has the shortest life expectancy and whether an entity other than an individual is a beneficiary (which would result in the participant being treated as having no Designated Beneficiary).34 Including contingent beneficiaries in this determination can create a problem when a trust contains a“default takers” clause (e.g., assets go to heirs or charity if all beneficiaries named in trust die unexpectedly) because it is possible that trust assets may pass to a relative that is older than the beneficiaries named in the trust, and the RMD would then be based on that older relative’s life expectancy.35
To avoid this type of problem, the Regulations set forth a type of “safe harbor trust” whose beneficiaries the IRS will treat as Designated Beneficiaries. This type of trust, a so-called “conduit” or “see through”trust, requires that all amounts distributed from the participant’s account to the trust must be paid directly to the income beneficiary of the trust upon receipt by the trustee.36 The income beneficiary is treated as the sole beneficiary for purposes of determining the designated beneficiary and any residuary or contingent beneficiaries are disregarded.37 Unfortunately,distribution of all of the income to trust beneficiaries as required by conduit trusts does not always meet a client’s estate planning objectives. Practitioners’should carefully weigh the income tax benefits of using conduit trusts against the overall objectives of the client’s estate plan.
VI. CASE STUDIES
A. Case Study 1
Assume Husband has a $500,000 traditional IRA account and Wife is the designated beneficiary. Husband dies in 2008 at the age of 80, survived by Wife, who is 71. Since Husband was 80 when he died, he started to receive distributions from his IRA.The distributions to Wife will be made based on the longer of either Wife’s life expectancy or Husband’s life expectancy. Since Wife is 9 years younger than Husband, her life expectancy is longer than Husband’s life expectancy, and distributions to her will be made based on her life expectancy.
B. Case Study 2
Assume the same facts as above but that Husband dies in 2008 at age 55, survived by Wife who is 51. Wife, as the surviving spouse, has two options with regard to the IRA account. She either may roll over the IRA into her own IRA, or keep the amount in Husband’s IRA and receive the required distributions.
If a participant’s surviving spouse is the sole Designated Beneficiary of the participant’s IRA, upon the participant’s death, the surviving spouse can roll over the plan assets into a new or existing IRA of her own. Code Section 402 and its regulations pro-vide that if a distribution attributable to a participant is paid to the participant’s surviving spouse, the surviving spouse is treated as the participant for purposes of the rollover rules.38 A surviving spouse is the only person who has the option of rolling over the retirement account into his or her own IRA.39
Here, Wife is the surviving spouse and the sole Designated Beneficiary of Husband’s IRA. Thus,upon Husband’s death, Wife may roll over the $500,000 of plan assets into a new or existing IRA of her own. A rollover will allow Wife to “treat the IRA as her own,” meaning that she may defer withdrawals from the account until she turns 70 ?, use her own life expectancy to determine pay outs, and name new Designated Beneficiaries if she so chooses. Since Wife is only 51 years old, her access to the IRA will be restricted until she reaches age 59 1/2.
If Wife names the children as her Designated Beneficiaries, when she dies, the children will acquire the IRA from their mother. However, they cannot rollover their shares of the IRA into their own IRAs like their mother was able to do. Their shares of the IRA will be considered an “inherited IRA,”40 which is not eligible for a rollover.41
The required minimum distributions to the children will be made in accordance with either the 5-Year Rule or the Life Expectancy Rule, depending on the plan provisions. If the Life Expectancy Rule is used, the RMD’s will be based upon the life expectancy of the oldest beneficiary (or upon the life expectancy of each beneficiary if separate accounts are established).
(2) No Rollover
If Wife does not rollover the $500,000, it will remain in Husband’s IRA account. Since Husband died before the Required Beginning Date, Wife can wait until the year Husband would have attained age 70 ? before distributions must begin because she is the surviving spouse and sole Designated Beneficiary.42 Depending on the plan provisions, distributions would then be taken over 5 years or the life expectancy of Wife, with Wife’s life expectancy recalculated each year.43
Assuming Wife dies after the distributions from the account commence, then the benefits will continue to be distributed to the successor beneficiaries (which Wife can name) over Wife’s life expectancy, using the age of Wife as of Wife’s birthday in the year of Wife’s death, reduced by one for each calendar year that has elapsed after the calendar year of Wife’sdeath.44 If Wife dies before her distributions commence then the benefits will be distributed over the designated beneficiary’s life expectancy.45
SUMMARY OF PAYOUT OPTIONS AND DEADLINES
Participant’s Death Before Required Beginning Date
Participant’s Death After Required Beginning Date
Pamela Buskirk is an associate in the Trust, Estate & Tax Planning practice group at Odin, Feldman & Pittleman, P.C. in Fairfax, VA. She is admitted to practice law in the Commonwealth of Virginia.
1Treas. Reg. § 1.401(a)(9)-4, A-1 (2007).
2Treas. Reg. § 1.401(a)(9)-4, A-3 (2007).
4Treas. Reg. § 1.401(a)(9)-5, A-1(a) (2007).
5Treas. Reg. § 1.401(a)(9)-5, A-4(a)-(b) (2007).
6I.R.C. § 401(a)(9)(C)(i) (2007).
7Treas. Reg. § 1.401(a)(9)-5, A-5(a) (2007).
8I.R.C. § 401(a)(9)(B)(ii) (2007).
9I.R.C. § 401(a)(9)(B)(iii)-(iv) (2007).
10Treas. Reg. § 1.401(a)(9)-3, A-1(a) (2007).
12Treas. Reg. § 1.401(a)(9)-5, A-5(c)(2) (2007).
14I.R.C. § 401(a)(9)(B)(iv) (2007); Treas. Reg. § 1.401(a)(9)-8, A-3(b)(2007).
15I.R.C. § 401(a)(9)(B)(iii) (2007).
16Treas. Reg. § 1.401(a)(9)-5, A-5(c)(1) (2007).
18Treas. Reg. 1.401(a)(9)-5, A-7(a)(1) (2007).
19Treas. Reg. § 1.401(a)(9)-3, A-4(b) (2007).
20Treas. Reg. § 1.401(a)(9)-3, A-4(c) (2007).
21Treas. Reg. § 1.401(a)(9)-3, A-4(a) (2007).
22Treas. Reg. § 1.401(a)(9)-4, A-4(a) (2007).
24Treas. Reg. § 1.401(a)(9)-5, A-7(a)(1) (2007).
25Treas. Reg. § 1.401(a)(9)-8, A-2(a)(2) (2007).
27Treas. Reg. § 1.401(a)(9)-8, A-2(a)(2) (2007).
28Keith Herman, Coordinating Retirement Accounts With Estate Planning 101 (What every estate planner needs to know), ABA General Practice, Solo & Small Firm Division, July 2006, available at http://www.americanbar.org/newsletter/publications/law_trends_news_practice_area_e_newsletter_home/coordinatingretirement.html.
29Life expectancies are determined using the Life Expectancy Tables published by the IRS in Publication 590, Individual Retirement Arrangements (2007).
30Treas. Reg. § 1.401(a)(9)-4, Q&A-5(a) (2007).
31Treas. Reg. § 1.401(a)(9)-4, A-5(b) (2007).
32Treas. Reg. § 1.401(a)(9)-4, A-5(c) (2007).
33Treas. Reg. § 1.401(a)(9)-5, A-7(a) (2007).
34Treas. Reg. § 1.401(a)(9)-5, A-7(b) (2007).
36Treas. Reg. § 1.401(a)(9)-5, A-7(c)(3), ex. 2 (2007).
38Treas. Reg. § 1.402(c)-2, A-12(a) (2007).
39I.R.C. §§ 402(c)(9) (qualified plans), 408(d)(3)(C)(ii) (IRAs).
40An IRA is treated as “inherited” if the individual for whose benefit the account is maintained acquired the account by reason of the death of another individual, and such individual was not the surviving spouse of such other individual. I.R.C. § 408(d)(3)(C)(ii) (2007).
41I.R.C. §§ 408(a)(3)(C)(i) (2007).
42I.R.C. § 401(a)(9)(B)(iv) (2007).
43If the plan allows for a surviving spouse to elect between the 5 year payout or the life expectancy payout then the surviving spouse needs to be careful to make that election by the end of the year that contains the5th anniversary of the date of death. The election must be made by the earlier date of when the first distribution would be made to the spouse or by the end of the year which contains the 5th anniversary of the date of death. If the election is not made then the default option could be the 5 year rule and result in a lump sum distribution of the account. See Natalie Choate, Life and Death Planning for Retirement Benefits Sections 1.6.04 and 1.5.07 (6th Ed. 2006)
44Treas. Reg. § 1.401(a)(9)-5, A-5(c)(2) (2007).
45Treas. Reg. §1.401(a)(9)-3, A-5, A-6; §1.401(a)(9)-4, A-4(b).