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Charitable remainder trusts as IRA beneficiaries.

Individual retirement accounts (IRAs) in large estates are subject to very onerous tax rates. It is not uncommon for taxes to deplete 85% or more of an IRA on the death of its owner if the assets are required to be distributed quickly (e.g., if the assets are needed to pay estate taxes or beneficiary designations or other IRA distribution planning has gone awry). The IRA may be subject to Federal and state income taxes, Federal and state estate taxes and the excise tax on excess accumulations.

As a result of this high effective tax rate, individuals receiving IRA distributions who have elected to recalculated life expectancy with their spouses as beneficiaries face a difficult problem if the nonparticipant spouse predeceases the participant. The new IRA recipient, who may be a newly designated beneficiary, will be forced to pay tax on the entire IRA balance within one year of the surviving spouse's death. A similar problem exists for nonspouse IRA beneficiaries when the IRA is not in pay status at death. These beneficiaries are required to liquidate their ERAs within five years of the participant's dead.

The impact of these taxes in situations in which the beneficiary cannot continue to defer income taxes is illustrated in the following example.

Example 1: J, a single individual residing in California, died during December 1995 with a $2,000,000 IRA. The IRA is part of her $5,000,000 taxable estate. J left her entire estate to her only child, B. B is required to withdraw all of the IRA funds immediately. B receives only $295,251 of the $2,000,000 IRA:
IRA balance $2,000,000
Less:
Federal and state
 income taxes (571,677)
Estate taxes
 (at 55% rate) (1,015,578)
Excise tax on
 excess accumulation (153,494)
Net to B $ 259,251




One alternative available to individuals who wish to continue the tax deferral is to name a remainder trust (CRT) as the IRA beneficiary. A CRT is a trust that provides income to a beneficiary or beneficiaries for life or a term of years not exceeding 20 years, with the remainder going to a qualified charity. The CRT is exempt from income tax and the donor receives a charitable deduction for the value of the remainder interest. The use of a CRT as an IRA beneficiary can be illustrated in the following example:

Example 2: J, from Example 1, named a charitable remainder unitrust (CRUT) as the beneficiary of her IRA. The CRUT provided that it would pay 9% of its value to B (age 45) for life. On J's death, the CRUT will receive $1,846,506, as follows:
IRA balance $2,000,000
Excise tax* (153,404)
 $1,846,506

*Note: Use of a CRUT does not eliminate excise
tax.

Other estate assets will need to make up the
$899,569 estate taxes on the IRA.

Value of IRA $2,000,000
Deductions:
 Excise tax (153,454)
 Charitable deduction (210,966)
Taxable value 1,635,580
Estate tax (at 55%) $ 899,569

 Assuming B invests the proceeds at 10%
and is subject to a 40% income tax rate,
compare the two alternatives.

 No CRUT
Proceeds $ 259,251
Additional assets from estate
 not used to pay estate tax 899,569
Total funds invested 1,158,820
After-tax income 6%
 (10% X 60%) $ 69,529

 CRUT
Value $1,846,506
After-tax income 5.4%
 90/. X 60%) $ 99,711

 If B can wait 20 years (until he is 65)
before withdrawing die funds, he can make
die CRUT a net income make-up
charitable remainder trust (NIMCRUT) and
allow the assets to accumulate inside the
CRUT. If he does this, the difference is
even more dramatic.

 No CRUT CRUT
Value of
 funds at
 age 65 $3,716,493 $12,422,369
Annual
 after-tax
 income $ 222,989 $670,808




The dramatic difference is the result of the CRUT compounding at 10% versus the after-tax money compounding at 6%. (The details and variations available through the use of NIMCRUTs and recent IRS attacks on these vehicles are beyond the scope of this article.)

Surviving spouses in pay status with beneficiaries who face immediate payout of their IRA balances on the spouse's death should consider the use of a CRUT or NIMCRUT to allow the beneficiary to continue the income tax deferral. Also, individuals with a nonspouse beneficiary may consider the use of a CRUT beneficiary prior to age 70 1/2, particularly if they are in poor health. Prior to receiving payments, they may switch their beneficiary from the CRUT to their nonspouse beneficiary. This strategy will help mitigate the five-year payout requirement to nonspouse beneficiaries.

Individuals contemplating the use of CRUTs must consider the possibility of the beneficiary's early death. Proper planning can help mitigate this problem and allow for a greater transfer of wealth. From Philip J. Baptiste, CPA, MT, Cohen & Company, Avon, Ohio
COPYRIGHT 1997 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Article Details
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Author:Baptise, Philip J.
Publication:The Tax Adviser
Date:Aug 1, 1997
Words:817
Previous Article:GSTT exemption planning related to life insurance trusts.
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