IRAs consist of savings that have grown tax-deferred.  That means that when funds are withdrawn, they are subject to ordinary income tax rates.  The entire balance of the withdrawal is taxable, not just the earnings.

Most of us are familiar with the basic IRA/retirement account rules.  With limited exceptions, you cannot take money from your IRA prior to age 59 ½ without penalty.    You can continue to make contributions until age 70 ½.  You must start taking distributions no later than April 1 in the calendar year following the calendar year you reach age 70 ½.  This is referred to as your Required Beginning Date (“RBD”).

If all goes according to plan, at age 70 ½ you start taking Minimum Required Distributions “MRDs” in amounts determined by life expectancy tables published by the IRS.  If you live to your life expectancy, theoretically the money would be gone.  But what happens if there is money left in the IRA at the time of your death?

The Planning Process – An Example

Let’s look at an example:  Mr. Smith is the IRA owner.  He wants Mrs. Smith to be his primary beneficiary at his death, and his two children to receive the IRA if Mrs. Smith does not survive him.  Let’s review a few of the unique issues to consider in IRA planning.

Estate Tax Planning

One option available to married couples is for each spouse to name the other as the beneficiary of the owner’s IRA.  This is commonly referred to as the All to Spouse option.  When the owner spouse dies, the surviving spouse will own the IRA and there will be no estate taxes imposed because bequests to a spouse are protected by the Unlimited Marital Deduction.  This is a simple plan that protects the surviving spouse from estate taxes or income tax uncertainty.  However, this method may cause Mr. and Mrs. Smith’s children to bear the burden of paying avoidable estate taxes out of their inheritance.  How would that happen?

Let’s assume, for a moment, Mr. Smith has an IRA with a balance of $5.49 million and Mrs. Smith also has property with a value of $5.49 million.  If Mr. Smith names Mrs. Smith as the primary beneficiary of his IRA, and she survives him, Mrs. Smith will own her own property plus Mr. Smith’s IRA. If Mrs. Smith dies shortly thereafter, she will have a taxable estate of $10.98 million.  As you may know, each person dying in 2017 can leave up to $5.49 million without any federal estate taxes imposed.

Unfortunately, the $5.49 million exemption is a “use it, or lose it” proposition.  Thus, with proper planning – the “use it” option – Mr. and Mrs. Smith could have left their children a combined value of $10.49 million, consisting of $5.49 million from each parent.  However, the “simple” plan of naming Mrs. Smith as the beneficiary without electing portability or additional planning has erased the ability to use Mr. Smith’s $5.49 million exemption because his assets were combined with hers and she subsequently died with a $10.98 million taxable estate. The Smith children will have to pay federal estate taxes of $2.2 million at their mother’s death. This is a “simple,” but expensive estate plan for the IRA.

Is there a way to avoid the $2.2 million estate tax bill?  Yes!  Mr. and Mrs. Smith could have used a specially prepared trust to preserve Mr. Smith’s estate tax exemption and receive the rights to Mr. Smith’s IRA by naming this trust as the primary beneficiary of his IRA.  Mrs. Smith would still have been the beneficiary of this trust and received its benefits.  The trust pays all of its income to Mrs. Smith and principal for her health, education, maintenance or support.  However, when Mrs. Smith dies, the balance of Mr. Smith’s IRA will be owned by the trust and not taxable in Mrs. Smith’s estate as when she, individually, was his primary beneficiary.  Mrs. Smith is economically protected and the children inherit the entire $4,000,000 free of federal estate tax.  Of course, there remains the income tax due on the undistributed portion of the IRA.  More on that shortly.

Some argue this complicates the planning process.  It does to some extent, but saving over $2.2 million as we did in this example is worth a little complexity.  How might that impact your plan?  When we name the trust as the current IRA beneficiary, the $5.49 million IRA is subject not only to IRS rules but the potentially stricter rules of the IRA Administrator.  Let’s review the IRA distribution rules.

When Must Withdrawals Be Made?

If Mr. Smith turns 70½ in 2015, there is an MRD due for 2016 which he must withdraw by April 1 of 2017, his RBD.  If Mr. Smith waits until April 1, 2017 to take his first MRD, then he must take two distributions in 2017, one for 2016 and the 2017 MRD no later than December 31, 2017.

If Mr. Smith’s IRA had a balance of $1,000,000 in the first year the IRS life expectancy tables show he is expected to live 27.4 years.  We then divide $1,000,000 by 27.4 and determine he must withdraw $37,736 in the first year. He will continue to take annual minimum distributions (or more, if he desires) by December 31^st of each calendar year for the balance of his lifetime, or until the IRA funds are dissipated.

Let’s assume the Smiths decide none of the reasons to use a trust in their IRA are compelling, so he names Mrs. Smith as his primary beneficiary.  What are the rules governing what happens when Mr. Smith dies leaving Mrs. Smith as his primary beneficiary of the IRA? This is where we learn about IRA Rollovers.

The IRA Rollover

Only a spouse may rollover an inherited IRA. By “rollover” we mean that the beneficiary of an IRA may elect to treat the IRA as his or her own by putting the IRA in her name, or transferring the IRA proceeds to a newly created IRA of her own.  Once the rollover has been completed the spouse need not take distributions until she reaches age 70 ½.  The minimum distributions will be based on her life expectancy at that time.

Then the question is, “Who will be the beneficiary of Mrs. Smith’s IRA?”  To understand this even better let’s review what happens when Mrs. Smith dies.  She wants to leave the IRA to her children.  This is where the options and the rules governing them get very complicated.

Inherited IRAs

The rules are different if a child or trust inherits an IRA.  The key question is over what period must the children take distributions from the IRA they inherited?  Again, great caution is urged.

If Children Are Named as Beneficiaries of an IRA

Of course, children – or any individual, for that matter – can inherit an IRA as direct, named beneficiaries.  The first step is to review the IRA Custodial Agreement to determine your options.

By naming her children as beneficiaries Mrs. Smith is able to create a “stretch” IRA. If Mrs. Smith dies the next year and had named a 42 year old daughter as a beneficiary, the IRA payment period can be “stretched out” to the daughter’s then-life expectancy of 39.6 years. The ability of the daughter to stretch out payments over 39.6 years is a considerable benefit.

Assuming the IRA Custodial Agreement does not require otherwise, if more than one person is named as a beneficiary, the beneficiaries may use the “separate account rule” to split the IRA into shares for each of them and take their RMD’s over their individual life expectancy.  This is especially beneficial if there is a significant difference in the ages of the beneficiaries.  By doing this, the youngest beneficiary is not stuck with the shorter life expectancy of the oldest.

If a Trust Is Named as the IRA Beneficiary

There are occasions when a trust will be used as the beneficiary of an IRA.  The potential reasons to use a trust include the estate tax issue previously discussed, as well as numerous non-tax reasons – protecting beneficiaries from creditors, protecting assets from marital dissolution, protecting beneficiaries from squandering their inheritance, controlling the amount of distributions to them, or preventing them from mishandling their inheritance, to name a few.  Again, there are many trade-offs in this decision and experienced counsel is recommended.

Generally, a trust is not an individual and would therefore not appear to qualify for the beneficial “stretch” distributions.  Normally, IRA proceeds not paid to an individual must be paid out within five years.

However, there is some relief if the trust meets certain requirements.  These requirements are precise and should be considered only with professional advice.  If met, the IRS will “look through” the trust and, for purposes of calculating MRDs, treat the trust beneficiaries as if they were named as individual beneficiaries by the IRA owner.

If all the trust beneficiaries are individuals and the trust meets other specific requirements, the IRA benefits can be paid out over the life expectancy of the oldest trust beneficiary.  In our case, if the Smiths had three children, ages 45, 42, and 29, the MRDs would be calculated based on the life expectancy of the 45 year old child.  The separate account rule would not apply. Recent IRS rulings continue to clarify the planning options when using a trust as an IRA beneficiary.

If There Is No Beneficiary To Your IRA

You’ll remember that if you name an individual on your IRA beneficiary form, and that person survives you, you have what is referred to as a “designated beneficiary” and that beneficiary gets to “stretch” required distributions over his life expectancy (again, from the Single Life Expectancy table) based on his age in the year after the IRA owner dies.

If there is no beneficiary named on the beneficiary form, you may still have options if the Custodial Agreement provides a safety net by stating that if there is no named beneficiary on the form then a presumption is made that the spouse is the beneficiary, if living; if not, then the children are beneficiaries; and, if there are no children the “estate” of the IRA owner is the ultimate beneficiary.

Most often we don’t get that lucky and the estate is the default beneficiary if there is no named beneficiary.  In that case, there is no “designated beneficiary”; therefore, the option to “stretch” distributions is lost.  The rules further reveal that if the IRA owner died before his RBD the entire balance must be taken before the end of five years following the owner’s death.  There is some relief if the owner was past his RBD.  In that case the IRA can be paid out over the owner’s remaining life expectancy (assuming he had lived) based on his age in the year of death.

Planning Under Uncertainty

The point of this chapter is to give you an overview of basic IRA planning principles and to alert you to seek professional expertise when making decisions with this important asset.  Do not let assumptions, or what you may read in the paper, provide false comfort.  If your IRA is a significant part of your retirement plan you must get professional advice.