Summer 2007

Careful Consideration Is Needed in Selecting Your IRA Beneficiaries

Holland & Knight Newsletter
Andrew R. Gelman

With retirement plans becoming more prevalent and comprising a larger percentage of families’ net worth, beneficiary designation decisions have become more important. Although there are no restrictions on who may be named as the beneficiary of your IRA, the designation that you make may have profound income tax consequences. Whether your IRA is a traditional IRA, rollover IRA or inherited IRA, the original account owner received an income tax deduction when the funds were invested; consequently under federal law, when the proceeds are distributed, the distribution will be considered taxable income to the recipient.

When it comes to beneficiary designations, Congress has made a distinction between an owner’s death after his or her Required Beginning Date (RBD), which is April 1 of the year following the year the owner attains age 70-1/2, and death before the RBD.

In the case of someone dying after his or her RBD without naming a beneficiary, the beneficiaries under the account owner’s will (or by state heirship laws if there is no will) would be required to withdraw the funds in the account at least as fast as the account owner had been required to withdraw them if he or she had remained alive. However, if the account owner’s surviving spouse is named as the beneficiary, he or she can roll the funds into his or her own IRA and defer taxation of the benefits. If the beneficiary of the account is someone other than the owner’s spouse (such as a child), the beneficiary can receive benefits over his or her own life expectancy (or the IRA owner’s remaining life expectancy under IRS tables, if longer).

On the other hand, if the account owner dies before his or her RBD and the owner has not named a beneficiary, the entire IRA must be paid out by December 31 of the fifth year following the owner’s year of death. If the owner’s surviving spouse is named as the beneficiary, he or she may elect to withdraw the account over the remaining life expectancy of the account owner (as if he or she had remained alive) or may rollover the IRA to his or her own IRA to defer the taxation of the benefits. If the account owner’s spouse is not the beneficiary, payments may be made over the life of the designated beneficiary if the payments begin by December 31 of the year following the owner’s year of death.

Consider Naming a Designated Beneficiary or Creating a Credit Shelter

In order for the above income tax deferral benefits to apply, the beneficiary must be classified as a Designated Beneficiary (DB) under the Internal Revenue Code. An individual is always considered a DB but an estate or charity is not, which is one of the reasons that you should not name your estate as the beneficiary of your retirement accounts. If you do, and you die before your RBD, your IRA assets must be distributed within five years; if your spouse or another individual had been your beneficiary, he or she could have deferred the taxation of the benefits over a longer period of time

Although a charity is not a DB you do not have to avoid naming a charity as a beneficiary of all or a portion of your IRA. Because a charity pays no income tax relating to its charitable purposes, using an IRA is an ideal way to pass your hard earned money to charity. For instance, if you are contemplating making a gift to a public charity, a donor advised fund or a private foundation at your death, why not have that gift come from your IRA which otherwise will be subject to income tax (and possibly estate tax) when the assets are distributed to one or more members of your family?

A trust may also be a DB but only if certain requirements are met by October 31 in the year following the IRA owner’s year of death: (a) the trust must be valid under state law; (b) it needs to be irrevocable at the owner’s death; (c) the beneficiaries must be identifiable; and (d) the custodian must receive a copy of the trust or a list of all the present and contingent beneficiaries.

A common estate planning technique for married couples who have more than $2 million in assets is the creation of a credit shelter trust at the death of the first spouse. For many couples, the only asset available to fund the credit shelter trust is an IRA. In order to provide the surviving spouse with maximum flexibility, the account owner could name the surviving spouse as the primary beneficiary and designate the credit shelter trust as the contingent beneficiary of the IRA. This would provide the surviving spouse with the option to either roll the benefits into his or her own IRA and defer the income taxation, or to disclaim the IRA and use it to fund the credit shelter trust. The decision would require an analysis of the estate and income tax laws at the time of the death of the first spouse.

New Rules for Distribution

Distributions from qualified retirement plans follow many of the same requirements as distributions from IRAs. Under the Pension Protection Act of 2006 (PPA), effective for distributions after 2006, non-spouse beneficiaries have the option to transfer all or part of the deceased employee’s qualified plan account balance to an IRA where the benefits may be paid over the life of the designated beneficiary, instead of having to withdraw the plan proceeds within five years. The purpose of this provision of the PPA was to give non-spouse beneficiaries of qualified retirement plans the same distribution rights as non-spouse beneficiaries of IRAs.

However, in a recent notice, the IRS asserted that if a qualified plan offers only a lump sum form of payout, a non-spouse beneficiary must follow the plan requirements and may not rollover the benefits to an IRA for a payout over the non-spouse’s life expectancy. We expect that the IRS will be asked to re-examine its published notice in light of the contrary intent of the PPA.

In conclusion, there are many opportunities and many pitfalls in designating beneficiaries of an IRA. Unfortunately, these decisions are often not made carefully. Given that IRAs often grow to become a significant part of an individual’s wealth, such designations are a key element in estate and tax planning and deserve careful consideration.

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