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Getting the most tax deferral from the traditional IRA.

The traditional IRA (individual retirement account) provides opportunities for tax-deferred investment growth, which benefits the holder and ultimate beneficiaries of the account. This article focuses on maximizing tax deferral from IRAs by illustrating how that tax deferral can continue after the death of the IRA holder.

Required Beginning Date

The tax deferral consequences depend in part on a concept called the required beginning date (RBD). The RBD is April 1 of the year after the IRA holder turns age 70 [degrees].[1] After the IRA holder's RBD, he must take certain minimum required distributions from his IRA. This is important because the tax deferral opportunities change after the IRA holder's RBD.

Naming a Beneficiary

The tax deferral opportunities offered by an IRA depend not only on the RBD of the IRA holder, but also on whom the IRA holder names as beneficiary. The least favorable tax deferral opportunities usually occur where the IRA holder names no beneficiary. It should be noted that the default beneficiary under most IRA agreements is the IRA holder's estate. Therefore, if the IRA holder names no beneficiary and the default beneficiary is the IRA holder's estate, then on the RBD, distributions will be based on the IRA holder's single life expectancy.[2] Also, if the IRA holder dies prior to his RBD, the IRA must distribute all its assets to the IRA holder's estate by the December 31 of the fifth year after the year of the IRA holder's death.[3]

Naming a beneficiary provides longer tax deferral only if the IRA holder names the beneficiary before his RBD. The naming of a beneficiary may result in distributions made over the joint life expectancy of the IRA holder and his beneficiary.[4] In this case, the minimum required distributions may be smaller. As a result, the tax deferral is greater than where distributions are made over the single life expectancy of the IRA holder. Although naming a younger nonspouse beneficiary allows for greater tax deferral, naming a younger spouse as beneficiary provides the greatest possible tax deferral.

IRA Holder Dies Before His RBD

If the IRA holder dies before his RBD and names a beneficiary, he may provide that the assets of the IRA will be distributed over the single life expectancy of the beneficiary.[5] The tax deferral is greater than under the default rule requiring that the IRA distribute all its assets by December 31 of the fifth year after the IRA holder's death.

If the IRA holder names a nonspouse beneficiary, the IRA must begin distributions by December 31 of the year after the IRA holder's death.[6] But if the IRA holder names a spouse beneficiary, distributions may begin as late as December 31 of the year in which the IRA holder would have attained age 70 [degrees].[7] Therefore, by naming a spouse beneficiary, the IRA holder can maximize the tax deferral offered by the IRA.

If the IRA holder dies before his RBD and names a spouse beneficiary, the spouse beneficiary may treat the IRA as her own IRA and roll it over into an IRA in her own name.[8] This rollover option is available only to spouse beneficiaries. This is because an "inherited" IRA, which is not eligible for such a rollover, is defined as an IRA acquired as a result of the death of the IRA holder by anyone other than the spouse of the IRA holder.[9] Therefore, the spouse beneficiary has the rollover option available to her because the decedent's IRA is not treated as an "inherited" IRA for federal income tax purposes.

IRA Holder Dies After His RBD

If the IRA holder dies after his RBD and names a spouse beneficiary, the tax deferral is the greatest. If the IRA holder dies after his RBD and names a nonspouse beneficiary, the IRA must distribute its assets at least as rapidly as under the method being used at the time of the IRA holder's death.[10] In other words, if the IRA was making distributions based on the joint life expectancy of the IRA holder and the non-spouse beneficiary before the death of the IRA holder, then the IRA would continue to make such distributions after the death of the IRA holder.

In contrast, if the IRA holder dies after his RBD and names a spouse beneficiary, the spouse may treat the IRA as her own IRA and roll it over into an IRA in her own name.[11] In this case, the spouse beneficiary must receive distributions only after her RBD. Once again, the IRA holder can maximize the tax deferral offered by the IRA by naming a spouse beneficiary.

Spouse Can Name a Beneficiary Too

A spouse beneficiary who rolls over the decedent's IRA into an IRA in her own name may also name beneficiaries with respect to the new IRA, so long as she does so before her RBD.[12] Therefore, a beneficiary spouse can name her children as beneficiaries provided that she does so before her RBD.

An example best illustrates this rule. Let us suppose that an IRA holder named Harold has a spouse named Samantha and a young daughter named Debbie. When Harold dies after his RBD, Samantha rolls over his IRA into an IRA in her own name.

Samantha can name Debbie as the nonspouse beneficiary of her IRA. As a result, Samantha would receive distributions over the joint life expectancy of herself and Debbie. Because of the resulting slower rate of the distributions from her IRA, the tax deferral achieved in this case is greater.

There is one complication, but only in the short term. So long as Samantha is alive, Debbie is deemed to be no more than 10 years younger than Samantha.[13] After the death of Samantha, this rule would no longer apply and the distributions made to Debbie would be based on the actual joint life expectancy of Samantha and Debbie, as determined at Samantha's RBD and as adjusted for the years that have elapsed since then. The net effect of this complication may be that even greater tax deferral occurs after the death of Samantha, the initial spouse beneficiary.

A Word About Roth IRAs

Unlike a holder of a traditional IRA, a Roth IRA holder does not have an RBD. This is because the Roth IRA holder is not required to receive any distributions from his Roth IRA during his lifetime.[14] As a result, the opportunities for tax-free investment growth offered by a Roth IRA are similar to the tax deferral opportunities offered by a traditional IRA in which the holder of the traditional IRA dies before his RBD.[15]

For example, if the Roth IRA holder dies and names a beneficiary, the beneficiary may elect distribution of the Roth IRA assets over her own single life expectancy.[16] If the beneficiary makes this election, then the tax-free investment growth is much greater than under the default rule requiring that the Roth IRA distribute all its assets by December 31 of the fifth year after the Roth IRA holder's death.

If the Roth IRA holder names a nonspouse beneficiary, the Roth IRA must begin distributions by December 31 of the year after the Roth IRA holder's death.[17] Just as with traditional IRAs, the Roth IRA holder can maximize tax-free investment growth by naming a spouse beneficiary. If the Roth IRA holder names a spouse beneficiary, then the spouse beneficiary may either receive distributions beginning as late as December 31 of the year in which the Roth IRA holder would have attained age 70 [degrees], or treat the Roth IRA as her own Roth IRA and roll it over into an Roth IRA in her own name.[18] If the spouse beneficiary elects the second option, she may name younger beneficiaries with respect to his new Roth IRA.

Conclusion

The greatest tax deferral under an IRA is available where the IRA holder names a spouse beneficiary, who then rolls over the IRA and names a younger beneficiary, such as a child. Also, where the spouse is a beneficiary of the IRA, the potential tax deferral is greater than where a nonspouse is the beneficiary and is much greater than where the IRA holder named no beneficiary at all.

Maximizing the tax deferral offered by IRAs is becoming an increasingly important and widespread objective. Moreover, this trend is very likely to continue as the number of retiring baby boomers increases over the next two decades, as the value of assets held in IRAs appreciates because of the bullish stock market, and as rollovers of qualified retirement plan assets into IRAs become more common as people change jobs with greater frequency.
 Timing of Distributions
Death of
IRA Holder Spouse Beneficiary Nonspouse Beneficiary

Before RBD Begin at decedent's Begin one year
 RBD or at spouse's after death of IRA
 RBD after a holder over
 rollover beneficiary's single
 life expectance

After RBD Begin at spouse's Continue at least
 RBD after a as rapidly as
 rollover under the method
 being used at
 IRA holder's death

 Timing of
 Distributions
Death of
IRA Holder No Beneficiary

Before RBD All IRA assets
 must be
 distributed within
 five years of death
 of IRA holder

After RBD Continue at least
 as rapidly as
 under the method
 being used at
 IRA holder's death


[1] See I.R.C. [sections] 401(a)(9)(C)(i).

[2] See I.R.C. [sections] 401(a)(9)(A)(ii)); Prop. Treas. Reg. [sections] 1.401(a)(9)-1, Q&A D-3(a).

[3] See I.R.C. [sections] 401(a)(9)(B)(ii)); Prop. Treas. Reg. [sections] 1.401(a)(9)-1, Q&A C-2.

[4] See I.R.C. [sections] 401(a)(9)(A)(ii).

[5] See I.R.C. [sections] 401(a)(9)(B)(iii).

[6] See Prop. Treas. Reg. [sections] 1.401(a)(9)-1, Q&A C-3(a).

[7] See Prop. Treas. Reg. [sections] 1.401(a)(9)-1, Q&A C-3(b).

[8] See Prop. Treas. Reg. [sections] 1.408-8, Q&A A-4.

[9] See I.R.C. [sections] 408(d)(3)(C)(ii).

[10] See I.R.C. [sections] 401(a)(9)(B)(i).

[11] See Prop. Treas. Reg. [sections] 1.408-8, Q&A A-4.

[12] See PLR 95-34-027 (June 1, 1995); PLR 93-11-037 (Dec. 22, 1992).

[13] See Prop. Treas. Reg. [sections] 1.401(a)(9)-2.

[14] See I.R.C. [sections] 408A(c)(5).

[15] See Prop. Treas. Reg. [sections] 1.408A-6, Q&A 14.

[16] See I.R.C. [sections] 401(a)(9)(B)(iii).

[17] See Prop. Treas. Reg. [sections] 1.401(a)(9)-1, C-3(a).

[18] See Prop. Treas. Reg. [subsections] 1.401(a)(9)-1, Q&A C-3(b), 1.408-8, Q&A A-4.

Raimond N. Tullius practices in the fields of employee benefits and executive compensation in the Miami office of Greenberg Traurig, P.A. Mr. Tullius received his A.B., magna cum laude, in history from Harvard University and his J.D. from Georgetown University Law Center.

This column is submitted on behalf of the Tax Section, David E. Bowers, chair, and Michael D. Miller and Lester B. Law, editors.
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Author:Tullius, Raimond N.
Publication:Florida Bar Journal
Geographic Code:1USA
Date:Jun 1, 2000
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