IRAs - estate planning alternatives.

Individual retirement accounts (IRAs) are, by design, supposed to be simple, uncomplicated vehicles by which to make tax-deferred contributions (and obtain tax-deferred income growth) into a retirement nest egg. They were originally designed to give individuals in low-income brackets who did not participate in employer-sponsored plans an incentive to save for their retirement.

Individuals who are participants in an employer plan and who earn more than the income limit are not allowed to make a deductible contribution. IRAs are usually not considered in the estate planning scenario, because the typical textbook IRA is held by a low net worth individual. There are, however, many rollover IRAs that hold large investments. These IRAs deserve special consideration when providing estate planning services to clients, because the beneficiary designation and payout provisions greatly affect the tax implications.

The entire amount in an IRA is included in a decedent's gross estate under Sec. 2039. Additionally, an estate may be subject to an additional estate tax equal to 15% of the deceased participant's excess retirement accumulation. The unified credit and state death tax credit are not allowable as an offset to this additional "penalty" tax. Further, neither the marital deduction nor the charitable deduction is available. This provision can mean an effective estate tax rate of 70% (for estates in the 55% bracket) on the fair market value of the account. Distributions from an IRA are subsequently taxed to the beneficiary.

A surviving spouse who inherits an IRA from a deceased spouse can elect to treat the IRA as that of the surviving spouse. Minimum distributions are determined based on the surviving spouse's age. Alternatively, the surviving spouse may roll the IRA distribution, tax free, into the surviving spouse's own IRA. This is important to note if the estate is the beneficiary of the IRA, and the surviving spouse is a beneficiary of the estate. A beneficiary who is not a surviving spouse cannot roll the distribution into an IRA, and will be taxed on any distribution. IRAs qualify for the marital deduction.

An IRA becomes an "inherited IRA" after the death of the IRA owner, unless the beneficiary is the IRA owner's surviving spouse. Distributions from an inherited IRA do not qualify for rollover treatment and are taxed on distribution. If a trust is named as beneficiary of an IRA, the IRA is an inherited IRA even if the surviving spouse is the sole trust beneficiary. Therefore, the rollover treatment for surviving spouses may be lost, and distributions may be currently taxed to a surviving spouse.

If an IRA names a designated beneficiary who is not the surviving spouse, the IRA may be distributed in one of two ways (if distributions have not yet begun). If distributions have begun, but are before the required beginning date, the following options are still available:

1. The entire IRA must be distributed by December 31 of the year that includes the fifth anniversary of the decedent's death; or

2. Distributions may be made over a period not extending beyond the life expectancy of the designated beneficiary, if distributions begin by December 31 of the year that includes the first anniversary of the decedent's death (Sec. 401(a)(9)(B)(ii)). (In the case of multiple designated beneficiaries, the designated beneficiary with the shortest life expectancy is considered for purposes of determining the distribution period.)

Only an individual may be a designated beneficiary; a trust may not be the designated beneficiary. If a trust meets certain requirements (including irrevocability), the trust beneficiaries will be considered to be the IRA's designated beneficiaries. An IRA that does not have a designated beneficiary (e.g., a grantor trust beneficiary) must make distributions in accordance with the five-year rule.

If a decedent died after the required beginning date, post-death distributions must be made at least as rapidly as under the lifetime distribution method (Sec. 401(a)(9)(B)(i); IRS Letter Ruling 9119067).

It is important to consider IRAs in estate planning engagements. The designation of beneficiaries can have significant effects on the timing of the distributions (and tax) from the IRA on the owner's death. It is generally not recommended to name a decedent's trust as the beneficiary of an IRA, since the deferred distribution elections are unavailable.

A surviving spouse beneficiary has the most advantageous treatment with respect to distribution deferral. A beneficiary other than a surviving spouse can defer the tax on full distributions by electing to take distributions over his own life expectancy.

From Sharon E. Picolo, CPA, Ft. Lauderdale, Fla.