IRA's and Pensions - Generally

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Estate planning for IRA's and pension plans is complicated because there are two taxes which must be considered:  estate and income taxes. 

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Estate Tax

Your estate consists of all property, real or personal, tangible or intangible, wherever situated in which you had an interest at the time of your death.  This includes assets held in IRA's (for brevity, IRA's will be discussed, but the rules apply to qualified pension plans as well).  Therefore, IRA's are subject to estate taxation in the same manner as all of your other assets.

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Important:  The ultimate disposition of your IRA is controlled by the beneficiary you designate.

Disposition of an IRA is not controlled by your Will, living trust, other other estate planning document unless you designated your estate or trust as the beneficiary.  Many clients fall into this trap, thinking that by executing a Will or trust they have provided for the ultimate disposition of their IRA as well.

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Income Tax

Since assets in a typical IRA have not been subject to income tax, these taxes must be paid when distributions are made - either to you or to your beneficiaries.  In order to properly plan for the income taxes due upon distribution, it is important to understand the rules governing IRA distributions. 

The key to estate planning for IRA's is being able to "marry" your estate planning goals with the income tax aspects of IRA's.  This is often a difficult proposition, since the estate tax rules and income tax rules often clash.

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Income Taxation - The Minimum Distribution Rules

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The income taxation of IRA's is driven by the general concept that the federal government will eventually collect income tax on IRA assets.  The question is:  When will the tax be paid?  An IRA, by its very nature, is designed to defer the account owner's payment of income taxes.  In order to prevent a perpetual deferment of the tax, "minimum distribution rules" have been established that require withdrawals from an IRA upon the occurrence of certain events -- the death of the IRA owner, or the IRA owner reaching age 70 1/2.  By requiring withdrawal, these rules ensure the collection of income tax, since the tax is paid by the individual receiving the distribution.  To further ensure collection, failure to follow these rule results in severe tax penalties.

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Remember that the following rules are minimum distribution rules.  Withdrawals in excess of these minimums are permitted without penalty once you reach age 59 1/2.

The minimum distribution rules that apply when the holder of an IRA dies are geared to the identity of the designated beneficiary. The designated beneficiary is the persons (or charities) that you designate in writing with the IRA custodian. This is typically accomplished when the account is opened, but generally the designation is revocable and can be changed in writing at any time.

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Here is a brief summary of the minimum distribution rules that apply after an IRA owner's death:.

 

Spouse as designated beneficiary:  If you designated your spouse, he or she has the following options which can help further defer the income taxation of the IRA:

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   (1) Your spouse can rollover the IRA and treat it as his or her own.  This means the spouse can continue to defer income taxation by basing distributions on his/her age using a more liberal life expectancy table and can change the ultimate beneficiary of the assets. Despite this deferral, this may not be the best choice for a surviving spouse who is under age 59 1/2 (because of the early (10%) withdrawal penalty). 

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  (2) Second, your spouse can transfer the assets to an inherited IRA. Minimum distributions for an inherited IRA are based on the spouse's using a less liberal life expectancy table. Timing of distributions is based on the deceased spouse's age at the time of death (if over 70 1/2, then distributions must begin by December 31 of the year following the decedents death; if under 70 1/2, then the surviving spouse can delay distributions until the decedent would have reached age 70 1/2).

This flexibility offered by these two options makes your spouse an obvious choice as the designated beneficiary of your IRA; however, there are other non-income tax related issues that may make your spouse a poor choice (see Estate and Income Tax Planning).

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Non-spouse as designated beneficiary:  If you designated someone other than your spouse (such as a child), the IRS requires that individual to begin taking withdrawals in the year following your death.  The rate of withdrawal depends on the individual's age. While an individual does not have the same flexibility afforded to a spouse, remember that the chosen individual is likely to be much younger than your spouse, and therefore will be able to withdraw funds from the IRA at a much lower rate.  In certain circumstances, naming a child (or children) as a beneficiary can greatly enhance the benefits of an IRA by deferring the payment of tax.

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No beneficiary designation:  If the owner had no designated beneficiary, all assets remaining in the IRA must be withdrawn within five years after the owner's death (actually, by December 31st of the year in which the fifth anniversary of the owner's death falls).  Obviously, for an IRA with significant assets, the five year rule could create enormous income tax problems for the recipient(s).

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Estate and Income Tax Planning

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As mentioned above, the key to estate planning for IRA's is being able to "marry" your estate planning goals with the income tax aspects of such plans.  Many estate plans involve the use of marital (QTIP) trusts, family (bypass) trusts, and other sophisticated planning devices (click here for an explanation of QTIP trusts).  Often, a large percentage of an married couple's wealth is comprised of assets held in an IRA or qualified pension.  If these assets are left directly to a surviving spouse, the estate plan which looks so good on paper may not be effective in sheltering assets from estate tax.  If the assets are not left to the surviving spouse, the survivor might not be adequately protected and there may be adverse income tax consequences.  Moreover, if the spouse who owns the IRA desires to control the ultimate disposition of the IRA, naming the surviving spouse as the beneficiary will not work since the survivor can rollover the IRA and treat it as his or her own.  As you can see, these are many estate planning considerations which may conflict with the income tax aspects of IRA's.

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In order to better understand the planning issues in this area, two examples are helpful:

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The First Marriage

John is age 68 and his wife Ann is 62; they have one child who is 40.  Their goals are to protect the surviving spouse on the death of the first spouse, minimize estate taxes, and minimize income taxes.  They own assets of $4,000,000, as follows:
 

John: 

Mutual Funds - $125,000

​IRA - $1,875,000

Total:  $2,000,000

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Ann:

Mutual Funds - $1,575,000

Residence - $425,000

Total:  $2,000,000

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Their respective estates are perfectly balanced, and they each have sufficient assets to fully utilize their Vermont estate tax credits (in 2019, the credit is equivalent to $2,750,000 -- it rises to $5.0 million by 2021).  With proper planning, their estates should pay no estate tax, and their child should inherit the entire $4,000,000.

 

Here's the problem:  If John designates Ann as his IRA beneficiary, and he dies first, Ann's estate will balloon to $3,875,000.  At her death, her current Vermont credit (in 2019) is insufficient to shelter her estate.  The couple's child would face unnecessary estate taxes in excess of $250,000.  Although this is a good choice for income tax purposes (Ann would have a number of options regarding the IRA), it is a poor choice for estate tax purposes.

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In contrast, if John names his child as the beneficiary, the estate tax issues are solved, but this selection would leave Ann unprotected since the single largest asset of their combined estate would be payable to their adult child.

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What can John do?  If he creates a trust, and names the trust as the beneficiary, he can achieve a positive estate tax result and a good, but not perfect, income tax result.  The entire IRA would be sheltered from Vermont estate tax at his death by use of his Vermont credit, and at Ann's death would pass to their child free of estate tax.  For income tax purposes, if the trust is drafted properly, Ann will be considered the designated beneficiary, and her life would be used as the measuring life for setting the minimum distribution.  This is not perfect, since Ann loses the options of a surviving spouse (such as the ability to rollover the IRA).  However, this is a small price to pay in order to avoid estate taxes of over $250,000.

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John has another option.  He can create a trust, and name Ann as the primary designated beneficiary of the IRA, with the trust as the secondary beneficiary.  If John should die, Ann could accept the IRA and exercise favorable income tax options (i.e. rollover) or disclaim some or all of the IRA and allow it to drop into the trust to achieve favorable estate tax treatment.  (A disclaimer is simply a rejection of some or all of the IRA asset.  The disclaiming party is treated as having predeceased the IRA owner).

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This plan has some risk, since John and Ann could die simultaneously (or Ann might not implement the plan); however, the representatives of Ann's estate should be able to exercise any disclaimer needed to ensure the correct estate tax result.  This is a complicated area of estate planning -- if you decide to incorporate disclaimers as part of your plan, you should consult a professional advisor.

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The Second Marriage

Bob is age 72 and his wife Mary is 69; they were married five years ago.  They each have adult children from prior marriages.  Their goals are to: protect the surviving spouse on the death of the first spouse, ensure that the assets they brought into their marriage eventually pass to their respective children, minimize estate taxes, and minimize income taxes.  They own assets of $11,200,000, which they brought into the marriage, as follows:

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Bob: 

Stocks & Bonds - $150,000

IRA - $10,100,000

Life Insurance - $250,000

Total:  $10,500,000

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Mary:

Stocks & Bonds - $350,000

Residence - $350,000

Total:  700,000

 

Here's the problem:  If Bob designates Mary as his IRA beneficiary, he will not achieve his goal of ensuring that his assets eventually pass to his children since Mary could change the designation after his death.  If he designates his children, he will not achieve his goal of protecting Mary. 

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What can Bob do?  He should create a trust which divides his assets into two subtrusts: a credit shelter trust (also known as a bypass or family trust) and a QTIP marital trust (click here for an explanation of QTIP trusts).  He should then name the trust as the beneficiary of the IRA.  The entire IRA would be sheltered from estate tax at his death by use of the marital deduction and Bob's unified credit.  Both the QTIP marital trust and credit shelter trusts would provide income to Mary for life.  The trustee would have the discretion to distribute principal.  At Bob's death, the remaining assets in the IRA would pass to his children.

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What about income taxes?  Since Bob already reached his RBD, he was withdrawing assets at a rate which was calculated using his life expectancy (under the new regulations).  At his death, the trust would continue withdrawing, using the rate of the oldest beneficiary (Mary).  Likewise, at Mary's subsequent death, Bob's children would be required to withdraw from the IRA at the same rate.  While this is not the most advantageous income tax result, it is the best blend which achieves all of Bob's planning goals.

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The key to planning in this area is to ensure that the trust document complies with all of the rules governing QTIP trusts, credit shelter trusts and minimum distributions from IRA's.  The trust should require the trustee to withdraw the greater of the income generated by the IRA and the amount required under minimum distribution rules.  To comply with the QTIP rules, the trustee should be required to distribute the IRA income to the surviving spouse.  Without these provisions, the trust might fail to give the trustee the adequate authority and direction necessary to comply with both the QTIP and minimum distribution rules.

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Charitable Giving

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As the foregoing discussion illustrates, an IRA is subject to both estate and income taxation.  For larger estates, the combined tax bite can be as high as 70% or more.  This means that for every dollar in an IRA, the beneficiaries might ultimately receive as little as 30¢.

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Designating a charity as a beneficiary of an IRA can be extremely cost-effective.  With proper planning, the designation of a charity can result in the charity receiving all of the IRA assets free of both income and estate tax.  In essence, by making a charitable gift of your IRA, the government is contributing a majority share.

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What about your heirs?  Obviously, if you leave IRA assets to charity, your heirs will receive less.  One way to soften the blow is to replace the IRA with life insurance.  Using common estate planning devices, such as an irrevocable life insurance trust, you can pass assets to your heirs free of estate and income tax.  Since you only have to replace a fraction of the IRA to make your heirs whole, this can be a very cost-effective way to dispose of your IRA, benefit your favorite charity, and ensure that your heirs receive the entirety of your estate.  Under this type of plan, the government receives nothing.

 

What if you cannot, or do not desire to, obtain life insurance?  You may not want to leave your entire IRA to charity, and yet do not want to see a large fraction of it paid in taxes.  One option is to use a charitable remainder trust as the beneficiary of the IRA.  This type of trust is designed to pay an income stream to the beneficiary of your choice (usually for life), with the remainder passing to charity.  A charitable remainder trust effectively splits the IRA between the charity and your heirs.  Your estate receives a charitable estate tax deduction, but no income taxes are paid until your heirs receive payments from the trust.

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For more information on charitable trusts, visit the Charitable Trusts (CRATS & CRUTS) webpage.

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If you have any questions regarding estate planing for IRA's or pensions, or any aspect of the estate planning process, please contact Richard W. Kozlowski, Esq. at (802) 343-7419 or by e-mail.