Distributing Large IRAs and Purchasing Annuities
Because large IRAs funded by large plan rollovers are quite commonplace today, it has become more important than ever to correctly structure their beneficiary designation as part of the annuitant's overall estate planning strategy. Tax and non-tax considerations must both be reviewed when determining a married IRA owner's best course of action for designating a large IRA beneficiary.
In this article we present two approaches to the question of how to plan for the death of the IRA owner; specifically, is it better to leave the IRA proceeds payable to a spouse or to a trust?
Naming the Spouse as the IRA Designated Beneficiary
As a general rule, naming a spouse as the IRA Designated Beneficiary is good practice. In this case, upon the death of the IRA owner, the surviving spouse has the following options, all of which provide certain advantages and flexibility.
A spouse retains great control over how the IRA proceeds will be distributed.
Taxes may be postponed upon the death of the IRA owner.
A spouse can treat the IRA as his or her own.
A spouse can roll the proceeds into another IRA.
A spouse retains ultimate control over how the IRA moneys are invested.
Marginal tax rates for a spouse will be lower than for the QTIP trust as concerns Income in Respect of the Decedent (IRD).
Depending on the type of IRA, any number of distribution options are available. Payment could be taken by the surviving spouse as an annuity, in installments based on life expectancy, or all at once in a single sum. The spouse can retain the IRA and treat it as his or her own, or roll it over to his or her own personal IRA. The only requirement under these options is that the spouse follows the Required Minimum Distribution (RMD) rules. Flexibility in choosing settlement options is an important advantage for a spouse in need of money. Also, the income needs of a spouse can change over time especially after the death of the IRA owner. Who's in a better position to judge those needs than the surviving spouse?
The IRA automatically qualifies for the marital deduction. In total, estate, income and potential excess accumulation penalty taxes can be postponed until the death of the surviving spouse. Unless there are compelling reasons otherwise, there is no need to incur the administrative expenses associated with creating trusts to handle the proceeds. Controlling the taxation of the proceeds is a major goal of the spouse in maintaining the IRA proceeds for his or her benefit. Down the road, the tax situation of the surviving spouse may change because of the manner the spouse utilized the IRA to his or her advantage.
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If the spouse is under age 70 ½, additional deposits could flow into the IRA from a number of sources which include contributions, rollovers and transfers. When the spouse is the Designated Beneficiary of all but a de minimus amount of the owner's IRA, the spouse can make an election to defer the 15% excess penalty taxes. These penalty taxes come off the top and include a 15% penalty for excess distributions made during the life of the recipient and a 15% penalty for excess accumulations upon death. This type of election is made on Schedule S of IRS Form 706. The election also applies when the spouse rolls over the proceeds into his or her IRA as outlined in item 4 below. Depending on the spouse's age and health and whether he or she has qualified money of their own, the surviving spouse may be able to structure distributions to escape these penalties down the road. For example, the younger and healthier a surviving spouse, the more likely that amounts can be drawn over time to reduce exposure to penalty taxes.
By rolling the money into his or her own IRA, the spouse will now be able to designate new beneficiaries under the IRA. This might not be the case if the spouse retained the original IRA. The spouse would also be able to calculate RMDs in a different manner than what might otherwise be allowed in the original IRA. A surviving spouse who is much younger than the IRA owner will be able to postpone RMDs for more years than what might have been allowed under the original IRA.
This allows the spouse to combine various IRAs to take advantage of investment opportunities as they develop through the use of transfers and rollovers. The ability to combine IRAs may later prove useful in disposing of the IRA proceeds upon the second death. On the other hand, if a planning need develops down the road, the spouse retains the ability to split an IRA into several IRAs.
Distributions received by an estate or beneficiary from a deceased owner's IRA are treated as Income in Respect of a Decedent. The estate or beneficiary receiving the payments reports the entire taxable amount (unless non-deductible contributions are excluded) as ordinary income in the year received. There is no step-up basis. Any direct distributions from the IRA to the spouse are taxed at the spouse's income tax rates. Under current law, trust income tax rates reach the maximum rate of 39.6 % at just $7,500 of income while individual income tax rates don't reach this level until $250,000. Payments which go directly to the spouse instead of the QTIP trust allow the spouse to minimize the income taxes paid on the distributions from the IRA.
Naming a QTIP Trust as the Beneficiary
As an IRA owner wants to retain limited control of the IRA assets after death, a QTIP trust can provide an excellent mean to accomplish this. In essence, the QTIP trust forces limitations upon the spouse that would otherwise be non-existent if he or she were named the beneficiary of the IRA. Situations in which an IRA owner may want to maintain control occur when the IRA owner seeks to provide for the spouse after death and also wants to provide an inheritance to the children of this marriage. A variation would be if the IRA owner also has children from a previous marriage or marriages. The IRA owner's concern is that upon death, if the spouse later re-marries, IRA assets may end up in the hands of the new spouse and not the children the IRA owner seeks to benefit. Assets could end up in the hands of the children of the new marriage or even the children from a previous marriage of the new spouse.
IRS Revenue Ruling 89-89 provides a basic outline for how IRA distributions and a QTIP trust should be coordinated. This Revenue Ruling applied to a testamentary QTIP trust in which the IRA owner dies before his or her Required Beginning Date (RBD). After the RBD, an irrevocable trust must be used.
An IRA can be treated as Qualified Terminable Interest Property (QTIP) if: (a) the decedent elected an IRA distribution option requiring the principal balance to be distributed in annual installments to a testamentary QTIP trust and the income earned on the undistributed IRA balance is paid annually to the trust, and (b) the trust requires that both the income earned on the undistributed portion of the IRA, and the income earned by the trust on the distributed portion of the IRA, be paid currently to the decedent's spouse for life. The above arrangement appears easy enough. However, any number of fine details can ruin the whole affair. Outlined below is a list of details or actions that must be accounted for, and followed through on, in order to reach the desired goals.
A QTIP election must be made for both the IRA and the trust to which the IRA is payable.
If the arrangement is not carefully structured, the marital deduction is lost.
The election is made using IRS Form 706, Schedule M. This is to ensure that whatever is left in the IRA and the trust is included in the estate upon the second death.
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In order to qualify as QTIP property, the spouse must be entitled to all of the income from the property. That means annual payments from the IRA to the trust must be sufficient to cover any RMDs plus all the interest associated with the IRA accrued for the year. RMDs and interest-only payments do not coincide. A "greater than" amount should be distributed from the IRA holding the assets to the QTIP trust. The estate can claim a marital deduction for the IRA payable in installments to the QTIP trust if the QTIP distributes all income from the IRA to the spouse. In this manner the IRA serves as a conduit.
Using the "greater than" approach provides more income tax deferral than the distribution option originally outlined in Rev. Rul. 89-89. A typical "greater than" formula would provide that the IRA election call for a distribution equal to the greater of: (a) the amount distributable under the payout method otherwise in effect (at a bare minimum–the RMD), or (b) all the net income of the IRA to be paid each year to an irrevocable QTIP trust created and nominally funded during the IRA owner's life.
Another area of concern is integrating (a) the need of the trustee to increase distributions above RMDs in order to take all income with (b) the spouse's ability to turn unproductive property into productive property. In 1992, the IRS issued two Letter Rulings that provide a mechanism for coordinating these two issues. There should be no problems with the IRS if the IRA owner expressly extends the right of withdrawal to the QTIP trustee, either in the IRA beneficiary designation form or in the QTIP trust's governing instrument, and if the IRA owner also provides in the instruments that the spouse, as beneficiary of the QTIP trust, has the right to direct the QTIP trustee to make the IRA productive.
To ensure that the spouse receives all income, the QTIP trust's instrument should also provide that all trust expenses normally chargeable to corpus, including taxes payable on the IRA distributions, be charged to corpus. One additional consideration is to have the QTIP trustee authorized to elect out of withholding for any IRA distribution.
The IRA Required Minimum Distribution (RMD) rules must be followed.
Single or joint life expectancies are critical in RMD calculations. So is the decision to recalculate or not to recalculate life expectancies. Keep in mind that the choosing of a Designated Beneficiary as of the RBD affects not only how the benefits pass on at the IRA's death, but also affects the amount to be withdrawn before death. The decision whether or not to recalculate, annually, the life expectancy of the IRA owner and/or his spouse affects the amount of required distributions for years both before and after the IRA owner's death.
In general, recalculating life expectancies produces lower RMDs during the lifetime of the IRA owner and any beneficiary. However, minimum distributions accelerate after the death of the individual whose life expectancy is being recalculated. This is where the lifetime needs and health of the spouse play a critical role in the decision making process.
The QTIP trust must meet four requirements.
In order for the QTIP trust to be the Designated Beneficiary of the IRA proceeds (and thus meet the RMD rules and continued income tax deferral), four requirements must be satisfied in the following time intervals: (a) as of the IRA owner's death when death occurs before the RBD, and (b) as of the RBD if the IRA owner dies after the RBD, and (c) at all times thereafter.
The four requirements necessary for the QTIP to be considered the IRA Designated Beneficiary are as follows.
The QTIP trust must be valid.
The QTIP trust must be irrevocable.
The QTIP trust's beneficiaries must be identified in the trust instruments.
QTIP trust documentation must be provided to the IRA trustee, custodian or annuity administrator.
The trust must be valid under state law. Subject to state law, this requirement is satisfied if the trust is un-funded.
Revocable and testamentary trusts meet this requirement if the IRA owner dies before the RBD since these types of trusts become irrevocable upon death. However, the QTIP trust must be irrevocable as of the IRA owner's RBD if the IRA owner hasn't died by the RBD. A point to bear in mind is that, as of the RBD, a beneficiary designation (or the lack of one) fixes the maximum payout period for IRA distributions.
All of the beneficiaries who are living as of the IRA owner's death or the RBD (whichever date is applicable) must be identified for purposes of determining the maximum period based on the shortest life expectancy. The life expectancy of any contingent beneficiary is disregarded in making the RMD calculation.
A copy of the QTIP trust's instruments must be provided to the financial institution serving as the IRA trustee, custodian or annuity administrator. This requirement must be completed as of the IRA owner's death or the RBD, depending on whether the IRA owner dies before his RBD.5. Review the IRA documents for any distribution restrictions.
The IRA documents (generally IRS Form 5305, or 5305-A, or an annuity endorsement) should be reviewed so that any restrictions regarding installment payments to the QTIP trust are considered. In addition, clear language should be provided that while the QTIP trustee will receive the IRA payments, the spouse's life expectancy will be used as the measuring life for RMD calculations. If the IRA trustee doesn't want to change the IRA governing instruments or accept beneficiary designations, find someone who will. Usually, customized beneficiary designations must be acceptable to the financial institution.
Used in the proper situation, a QTIP trust may provide the following advantages. Estate taxes are deferred until the spouse's death. The QTIP trust arrangement qualifies for the unlimited marital deduction. An inheritance for the children designated by the IRA owner is protected and preserved. Upon the spouse's subsequent death, the IRA owner controls the ultimate disposition of the remaining assets based upon the governing trust instrument. A limited amount of income tax deferral is maintained under the arrangement. If distributions are made in installments (instead of a single lump-sum payment) from the IRA to the QTIP trust, the undistributed portion of the IRA is income tax-deferred until the time subsequent distributions are mandated because of the RMD rules or the spouse's death. Controls are placed upon the spouse preventing the haphazard spending (for whatever reasons) of assets which would ultimately harm both the spouse and any children designated by the IRA owner to benefit under the arrangement.
There are some disadvantages to keep in mind when reviewing the need for a QTIP election. The arrangement must be carefully structured or the marital deduction is lost. The spouse as beneficiary of the QTIP trust cannot defer the 15% excess accumulation tax. If the IRA RMD rules are not followed, the IRA must be withdrawn over a period not to exceed the IRA owner's life expectancy. When compared to naming the spouse instead of the QTIP trust as the Designated Beneficiary, the mandatory income payout requirements for the QTIP trust results in less income tax deferral when the IRA payments are made in installments. IRA principal distributions retained in the trust are taxed at trust rates which will probably be higher (depending on the fact pattern) than individual rates.
Leaving the spouse as the Designated Beneficiary of IRA proceeds is usually the choice which provides the greatest flexibility for planning purposes. In certain situations, a QTIP trust election for IRA distributions may serve a dual purpose in providing for the spouse's remaining lifetime needs as well as ensure an inheritance for designated children.