Annuities and Your Spouse as Beneficiary of Your IRA
Most married couples choose the surviving spouse as each other's IRA beneficiaries. Both income and estate tax laws favor this designation. When including others, such as children, in the estate, assets other than your IRA(s) should be used to fund bequests to non-spouse beneficiaries, and the IRA benefits should be paid to the spouse. Of course, naming the spouse as outright IRA beneficiary is not always feasible. Some circumstances make it more appropriate to name a trust for the spouse's benefit (typically, a QTIP trust) or, if the IRA benefits are the only assets available, to fund a credit shelter trust in full. This article highlights the tax advantages of designating the spouse as IRA beneficiary.
Spousal Exceptions to Minimum Distribution Rules
The purpose of the minimum distributions rules (MDRs) is to require an IRA owner to begin to withdraw the funds at some point, called the "required beginning date for distributions" or "required beginning date," and set at April 1 of the year following the year in which the IRA owner reaches age 70½. Withdrawing less than the minimum annual amount can subject the IRA owner (or his beneficiary) to a 50% penalty. Whether or not an IRA owner designates a beneficiary as of his required beginning date and whether or not the name beneficiary qualifies as a "designated beneficiary" determine not only how the benefits pass at the IRA owner's death but also what he must withdraw before death. If an IRA owner has named a beneficiary as of his required beginning date, the identity of the beneficiary fixes the maximum payout period. The IRA owner can change the beneficiary after the required beginning date, but this change can't extend the maximum payout period.
Under the minimum distribution incidental benefit (MDIB) rule, when determining the life expectancy of a non-spouse beneficiary who is more than ten years younger than the IRA owner, the beneficiary is treated as if he were only ten years younger than the IRA owner. The effect of this rule, which is applicable only during the IRA owner's life, is to accelerate payments. But if the IRA owner names his spouse as beneficiary as of his required beginning date, then withdrawals from the IRA can be taken over the joint life and last survivor expectancy of the IRA owner and his spouse, with one or both life expectancies recalculated annually (see below) – regardless of how much younger the spouse is. And if the IRA owner dies before his required beginning date, having named his spouse as beneficiary, distribution can extend over the spouse's life or life expectancy (depending upon whether or not her life expectancy is recalculated annually). The distributions to the spouse must begin before the later of (i) December 31 of the calendar year immediately after the year in which the IRA owner died, or (ii) December 31 of the calendar year in which the deceased IRA owner would have reached age 70½.
Spouse Is Only Beneficiary Whose Life Expectancy Can be Recalculated
The spouse is the only beneficiary whose life expectancy can be recalculated. The IRA owner must make an irrevocable election as of the required beginning date whether or not to recalculate his own and/or his spouse's life expectancy. If the IRA owner dies before his required beginning date, his spouse as beneficiary can elect to have her life expectancy recalculated. Recalculation produces lower minimum distributions during the lifetime of the IRA owner and his beneficiary. Where life expectancy is recalculated, a smaller percentage of the IRA balance must be distributed in each year after the first distribution year. This is because a person's remaining life expectancy is reduced by less than a full year for each year he ages. Thus, more income tax deferral is available when life expectancy is recalculated. But minimum distributions accelerate after the death of the individual whose life expectancy is being recalculated because a deceased persons' life expectancy is reduced to zero.
Spouse Has Most Opportunities for Financial, Estate, and Income Tax Planning
Naming the spouse as IRA beneficiary and allowing her to choose the method of distributions from standard options affords the most flexibility for income tax, estate tax, and financial planning purposes. If the spouse chooses an installment form of payment, she is able to tap the IRA for living expenses after the IRA owner's death and to spread the payment of income taxes over a period of years. Choosing this alternative doesn't necessarily produce optimal tax results, but it may be the only practical solution for a spouse in need of funds. A spouse who wants complete control over the IRA (whether or not she currently needs the funds) would prefer to withdraw the entire account balance in a single sum, rather than in installments. Because income taxes on the entire taxable portion must be paid at one time, there's no income tax advantage to doing so, unless income tax rates increase significantly after the year of withdrawal. (Note that forward income averaging isn't available for single-sum distributions from an IRA.) But taking a single sum can make sense from an estate planning perspective: the payment of income taxes depletes the amount subject to estate tax in the surviving spouse's estate; and the spouse may choose to reduce her taxable estate further by making gifts with the funds withdrawn from the IRA.
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If the spouse has other funds available for her support after the IRA owner's death and if she is willing to forego immediate use of the funds in the IRA, she can elect to treat the decedent's IRA as her own IRA. This can be accomplished by the spouse's adding contributions to the IRA or, more commonly, by the spouse's withdrawing the entire account balance and "rolling it over" into an IRA in her own name. The spouse is the only beneficiary who can make this election. A surviving spouse's election to treat the deceased spouse's IRA as the survivor's own IRA may be made at any age; there is no requirement that the surviving spouse cannot have reached her required beginning date.
Where the spouse elects to treat the IRA as her own, she is treated as the IRA owner for purposes of applying the MDRs, and she can designate the beneficiaries of the IRA. The greater the age difference between the IRA owner and a younger spouse, the more opportunity there is to defer income taxes with a spousal rollover. This is because the surviving spouse can wait until April 1 in the year following the year in which she reaches age 70½ before making any withdrawals form the rollover IRA. And she can determine required distributions on the basis of her own life expectancy and that of the beneficiary (or beneficiaries) designated by her.
Where the spouse "rolls over" her deceased spouse's IRA into her own IRA (to which no other contributions are made), the income tax, the regular estate tax (see marital deduction below), and the increased estate tax under Code Sec. 4980A (described below) are all postponed with respect to the IRA.
To take advantage of the rollover option, the spouse must generally be named as the direct beneficiary. If a decedent's IRA proceeds pass through a third party, such as an estate or a trust, before they are distributed to the spouse as the estate or trust beneficiary, the spouse is generally treated as acquiring the funds from the third party and not from the decedent. This means that the spouse can't roll over the IRA proceeds into her own IRA. But in a number of private letter rulings, the IRS has permitted, under certain circumstances, a spousal rollover to an IRA even thought the spouse received the IRA proceeds indirectly through an estate or a trust.
Ensuring that the estate of the deceased IRA owner receives the benefit of the marital deduction for an IRA can be done in several ways. The simplest and safest way to accomplish this is to name the spouse as the beneficiary of the IRA.
Where the spouse is the beneficiary of all but a de minimis amount of her spouse's retirement benefits, another tax-favored election is available to her: she can elect to have the retirement benefits treated as her own for purposes of determining the tax on excess retirement distributions during life and on excess retirement accumulations at death under Code Sec. 4980A. This election is available only to the spouse. By making the election, the spouse is able to defer the Code Sec. 4980A increased estate tax on excess accumulations of her deceased spouse, and she may be able to avoid the tax entirely–depending upon her age, health, etc. and whether she has any retirement benefits of her own.
Spousal Disclaimer in Post-Mortem Planning
Any beneficiary can make a qualified disclaimer of his interest in property, but the spouse is the only beneficiary who may disclaim property in favor of herself. For example, the disclaimed property can pass to a so-called "contingent" or "disclaimer" trust in which the surviving spouse has an income interest.
Moreover, the IRS has privately ruled that distributions from an IRA to an IRA owner's children made after the spouse disclaimed her right to receive the benefits from the IRA could be made over the spouse's remaining life expectancy even though her life expectancy was being recalculated. Thus, the IRS treated the disclaiming spouse as the beneficiary during the IRA owner's life for purposes of establishing the minimum required distribution period, and the IRS treated the children as the new beneficiaries as of the spouse's disclaimer (though the children's longer life expectancies couldn't extend the maximum payout period). This has important planning implications for situations where the secondary beneficiary–such as a trust–would not have qualified as a designated beneficiary as of the IRA owner's required beginning date.