Naming IRA beneficiaries that cut taxes.

Alternative beneficiaries including charitable trusts should be considered.

In income and estate tax planning, sometimes insufficient consideration is given to naming a beneficiary for the capital that has accumulated in qualified retirement plans and individual retirement accounts. In many instances, wealthy clients accumulate substantial sums sometimes millions of dollars--in such plans. While qualified plans and IRAs are preferred vehicles to defer taxes while the owner is alive, without proper planning they are an inefficient way to pass wealth at death. The combined income, estate and in some instances excess accumulation excise taxes that typically apply to qualified plan and IRA accumulations distributed at death are staggering.

Because of the potential heavy tax burden, CPAs should consider advising some taxpayers to name alternative beneficiaries, such as a spouse, a charity or a charitable remainder trust. This article reviews the benefits of naming other beneficiaries--often to the benefit of both the taxpayer and the beneficiary.

ALTERNATIVE BENEFICIARIES

The scope of the tax problem--and the planning opportunities--presented by' substantial retirement plan accumulations can best be demonstrated by an example:

Dr. Smith is a wealthy physician who has assets that put her in the highest marginal estate tax bracket; $1 million of them are in an IRA. She is happily married and has adequately provided for her husband under her will. Wishing to similarly provide for her children, Dr. Smith names them as equal beneficiaries of her IRA, thinking each will receive a substantial sum.

Dr. Smith also is philanthropically inclined and is willing to make a meaningful charitable bequest if she is convinced the aftertax cost is low and that a donation will not otherwise disturb her estate plan.

If Dr. Smith makes no changes in her IRA beneficiary designation and leaves it to her children, the IRA will be subject to income, estate and possibly excess accumulation taxes. The total tax potentially associated with a $1 million IRA is approximately $770,000. Indeed, under certain circumstances, such as if Dr. Smith's children live in a state that has its own income tax or if Dr. Smith lives in a state, like New York, that has an estate tax greater than the maximum federal credit for state estate taxes, the tax burden could be even greater.

SPOUSAL DESIGNATION

Not surprisingly, designating a spouse as beneficiary can save on taxes. If the spouse has the right to withdraw the entire sum, the IRA qualifies for the estate tax marital deduction. Consequently, no estate tax is payable until the spouse's death. Similarly, if the owner had no other qualified plan or IRA benefits payable to a beneficiary other than the spouse, the excess accumulation excise tax could be delayed until the spouse's death under Internal Revenue Code section 4980A(d)(5).

Whether children or a spouse are designated as beneficiary, income taxes are delayed until money is withdrawn from the IRA. However, under the IRC rollover and minimum distribution rules, the timing of distributions can be delayed significantly if a spouse is the designated beneficiary. For example, if a spouse is the beneficiary when the IRA owner dies, he or she can roll over the IRA balance to his or her own IRA, delay distributions until age 70 1/2 and then receive distributions over his or her lifetime and the lifetime of another beneficiary.

A retirement plan owner who considers his or her spouse a spendthrift may still want to transfer the plan to the spouse, but not outright. The owner might make the plan payable to the spouse as an annuity, or in installments. The owner should, however, be alert to an estate tax issue: Under the terminable interest rule, installments payable to a spouse (with no right to accelerate payments) do not ordinarily qualify for the marital deduction.

To deal with this problem, owners can name as beneficiary a trust that qualifies for the marital deduction. If an owner is willing to give up control of whom the assets pass to at the surviving spouse's death, there are two alternative beneficiary designations:

* An estate trust, which provides for fixed installments to the surviving spouse, with the balance remaining at the survivor's death paid to his or her estate.

* A life income-general power of appointment trust, which gives the surviving spouse the right to receive all income at least annually and to designate the trust beneficiary at his or her death.

If the owner wants to limit the spouse's access to the plan and also wants to control disposition of the assets at the spouse's death, a qualified terminable interest property (QTIP) trust can be designated as beneficiary. To qualify as a QTIP, the trust must give the spouse the unqualified right to receive all trust income at least annually.

A QTIP does, however, have limitations. Because it is not a tax-exempt entity, the entire IRA balance cannot be distributed to the trust in a single lump sum at the owner's death. Instead, the funds must remain in the plan and gradually be distributed to the QTIP and in turn to the spouse. Alternatively, the IRA itself can be designated as a QTIP trust. In either case, distributions must be made according to both the qualified plan minimum distribution rules and the QTIP income distribution rules. This involves a degree of complexity and a lack of flexibility that will make it undesirable to some.

CHARITY DESIGNATION

Greater tax savings can be achieved if a charity is designated as beneficiary: The owner enjoys both an income and estate tax charitable deduction. The only federal tax that may apply is the excess accumulation excise tax which, under IRC section 2053(c) (1) (B), is fully deductible for estate tax purposes.

To demonstrate the significance of these rules, consider the $1 million IRA described above. If instead of naming her children as beneficiaries, Dr. Smith designates a charity, the net aftertax transfer will be about $983,000 ($1 million minus an approximate $17,000 excess accumulation tax). Thus, approximately $753,000 more of the $1 million would be transferred than if Dr. Smith had named her children as beneficiaries.

Significantly, if Dr. Smith instead bequeaths $1 million of her general estate assets to charity, she will not achieve the same tax efficiencies as donating her IRA. The reason: An IRA is income "in respect of a decedent" (IRD), which is subject to both income and estate tax. (While IRC section 691(c) reduces the double tax, it does not eliminate it; the IRD recipient gets an income tax deduction, not a credit, for the estate tax attributable to the IRD. Because of this, a charitable donation of IRA assets reduces both estate and income taxes. By contrast, a charitable bequest of other assets under a will results in an estate--but not income--tax deduction.

Notwithstanding its tax appeal, some may shy away from donating their IRAs to charity because they believe those assets are needed by loved ones. This concern should not prevent the use of an IRA-charitable donation strategy. Because an IRA is subject to both income and estate taxes, if a taxpayer wants to make any size bequest to charity, it should be made from an IRA (or qualified plan) instead of from other assets. This can easily be done by splitting an IRA into two separate accounts, one with a family member as beneficiary and the other with the charity as beneficiary.

CHARITABLE REMAINDER TRUST

Rather than creating two separate accounts, a "horizontal" split between the income interest--which is made payable to the spouse--and the remainderman-which is made payable to a charity--may be the best way to save taxes. The appropriate mechanism is a charitable remainder trust (CRT) with the spouse as income beneficiary. While a CRT also can be established for a child or other individual, it will not fully achieve the tax results and other benefits described below.

Under the suggested approach, a CRT is designated as the IRA beneficiary. On the IRA owner's death, the entire account balance is transferred to the trust in a single lump sum, with provision for regular payments to the spouse. At the spouse's death, the remaining trust assets are distributed to charity or held in further trust for charitable use.

Designating a (CRT as an IRA beneficiary achieves many estate planning objectives:

* Substantial reduction, although not total elimination, of applicable taxes.

* A stream of regular income payments to the owner's spouse.

* A substantial gift to charity. These objectives are accomplished with great flexibility but without excessive administrative complexity.

Taxes. The tax consequences of the IRA-CRT arrangement are

* Total elimination of estate taxes. Even though the spouse's income interest is a terminable interest, it qualifies for the estate tax marital deduction under IRC section 2056(b)(8). Similarly, the charitable remainderman qualifies for the estate tax charitable deduction. (See private letter rulings 9253038 and 9237020.)

* Partial deferral and elimination of income taxes. Unlike a QTIP and certain other trusts, a CRT is a tax-exempt entity. Consequently, the entire balance can be distributed directly to the CRT with no current income tax. Furthermore, highly appreciated, non-income-producing assets transferred to the CRT can later be sold and reinvested in income-producing assets without triggering capital gains taxes. As amounts are distributed from the CRT to the spouse, they generally are includable in his or her income. However, amounts not distributed to the spouse, whether attributable to the principal amount originally transferred from the IRA or to earnings on the transferred amount, totally escape income tax.

* The excess accumulation tax is not eliminated or deferred.

Income distributions to spouse. While certain limitations apply, there is substantial flexibility in the level of income distributions that may be made from a CRT to the spouse. Under section 664, regular distributions must be made from the trust at least annually for the spouse's life or for a term not in excess of 20 years. The trust can, however, provide that payments will terminate earlier on the occurrence of a stated contingency, such as the spouse's remarriage.

There are two kinds of CRTs--a charitable remainder annuity trust and a charitable remainder unitrust. With an annuit5, trust, the amount to be distributed annually is a fixed percentage of at least 5% of the trust's initial fair market value--the amount transferred from the IRA to the trust. With a unitrust, the amount to be distributed annually is a fixed percentage of at least 5% of the trust's then-existing fair market value. Because of this difference, if an IRA owner wants income distributions to be a fixed dollar amount, an annuity trust generally should be used; if the owner wants inflation and the trust's investment performance to affect the amount distributed, a unitrust is the better option.

Another important difference between a unitrust and an annuity trust is that a unitrust may, but need not, provide for payment of the lesser of the fixed percentage or actual trust income (a net-income-only unitrust). Such a provision may provide that any amount by which trust income falls short of the fixed percentage be paid out in subsequent years to the extent the trust's income exceeds the fixed percentage in those years.

Significantly, whether a unitrust or an annuity trust is used, the IRA owner generally can select a high- or low-interest rate for distributions. Subject to the 5% minimum rate and, for an annuity trust, a maximum rate determined under the charitable contribution 5% probability rule (see revenue ruling 77-374), the distribution rate of an IRA-funded CRT can be based solely on the spouse's needs, without concern for collateral tax implications. Unlike in a typical CRT transfer, where the reduced tax deduction that comes with a higher rate of income distribution has to be considered, in the IRA-CRT arrangement, a full estate tax deduction is available on the IRA owner's death, regardless of the distribution rate to the spouse.

CREATIVE IDEA

While a CRT is not the shoe for every foot, it frequently is an ideal fit. Because the alternative may be to give away 75% or more of an IRA or qualified plan accumulation to Uncle Sam, every CPA should have the CRT in his or her inventory of creative ideas. When it's appropriate to establish a CBT as the IRA or qualified plan beneficiary, CPAs should work with an attorney experienced in designing trusts.

  IRA Tax Drain

  $1,000,000         IRA balance
  (770,000)          Potential income, estate
                     and excise taxes

 $ 230,000 Net to heirs other than spouse

Family members may not be the best beneficiaries for individual retirement accounts.

EXECUTIVE SUMMARY

* WEALTHY CLIENTS OFTEN ACCUMULATE substantial sums in qualified retirement plans and individual retirement accounts. Without proper planning, these vehicles are an inefficient way to pass wealth at death; the combined income, estate and sometimes excise taxes can be staggering.

* NAMING CERTAIN BENEFICIARIES--A spouse, a charity or a charitable remainder trust--often can reduce the tax burden and help make more money available for a charitable or noncharitable beneficial.

* DESIGNATING A SPOUSE AS BENEFICIARY instead of other family members--such as children--results in obvious estate tax savings because of the unlimited marital deduction and also may result in a significant income tax deferral.

* IF A CHARITY IS THE BENEFICIARY OF a retirement plan distribution, even greater tax savings can be achieved. The owner enjoys both an income and estate tax charitable deduction. At death, only the excess accumulation excise tax may apply.

* REGULAR PAYMENTS CAN BE MADE TO A spouse and significant tax savings can be achieved if the beneficiary of a retirement plan or IRA is a charitable remainder trust.

JAY FENSTER, JD, LLM, is a tax attorney with Loeb and Loeb in New York City'.