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IRA distributions on death.

The income tax consequences of individual retirement account (IRA) distributions on death depend on who is designated as the beneficiary. Unlike most property that passes at death, an IRA distribution is taxable as ordinary income to the beneficiary. While this treatment may seem harsh, it is consistent with the intent behind the creation of IRAs--simply to provide a tax deferral for retirement assets. Income deferred by the decedent during his lifetime accrues to the beneficiary and must be recognized. The 10% penalty on early distributions does not apply.

The timing of the income recognition depends on the decedent's relationship to the designated beneficiary. Under the Sec. 408 and 401 proposed regulations, a beneficiary generally must distribute and recognize IRA income within five years, with the entire inherited interest distributed by December 31 of the fifth year following death. Exceptions are included in the proposed regulations and vary, depending on whether the recipient is a surviving spouse, minor child, the decedent's estate, a trust or other designated beneficiary. Failure to make minimum distributions will result in a 50% penalty under Sec.4974.

The intent of the regulations is to limit the time of deferral allowed the beneficiary. The beneficiary is free to accelerate income recognition by receiving a lumpsum distribution or receiving the total amount more quickly than provided as a minimum by the law. The maximum deferral is first dependent on whether or not distributions have "commenced."

If distributions have "commenced," the beneficiary's distributions must continue "at least as rapidly as under the method of distribution being used . . . as of the date of his death" (Sec. 401(a)(9)(B)(i)). "Commencement" of distributions has no relation to actual distributions but rather refers to the "required beginning date." The required beginning date is the latest date an IRA owner can begin distribution without a penalty: April 1 of the year following the year the owner reached the age of 70 1/2. A decedent who elected to begin receiving annual distributions at age 67 and died two years later would not have commenced distributions for the purposes of this test. The provision only applies if the decedent dies after April 1 of the year after he attains the age of 701/2.

Distributions that are at least as rapid as the decedent's method of deferral, but provide the maximum deferral of income, become the distribution method in effect at death. The method is extended as if the decedent had completed the distribution. A decedent who elected to distribute based on an annually recalculated single annuity factor at age 70 1/2 and died five years later would have a divisor of 11.9 at death (from the IRS life expectancy table). The ficiary's minimum distribution permitted is the account balance at the prior year-end, divided by the adjusted life expectancy. The life expectancy for each subsequent year is reduced by one (Prop. Regs. Sec. 1.401(a)(9)-1, F-1, Q&A (d)). The minimum distribution requirement for plans that have "commenced" applies to all beneficiaries, estates and trusts.

If distributions have not commenced (or are not deemed to have commenced), spouses, minor children, estates, trusts and other designated beneficiaries are each treated differently. While, generally, distributions must be completed, exceptions apply depending on the beneficiary.

A nonspousal beneficiary has one available exception to the five-year rule. The beneficiary may choose to distribute the account based on the beneficiary's life expectancy, providing the first payment is made no later than one year after the date of death. Distributions must begin by the end of the calendar year following the IRA owner's death. The life expectancy may not be annually recalculated (as original owners of IRAs are allowed to do). A 35-year-old child who receives $10,000 from his parent's IRA could choose to defer the income until the fifth year after death or take the distributions over the next 48 years (assuming a single life expectancy) (Prop. Regs. Sec. 1.401(a)(9)-1, C-3, Q&A)). Again, any shorter recognition period is permitted. Nonspouse recipients are unable to treat the i IRA as their own and may not make additional contributions roll over the account tax free.

If a spouse is the designated beneficiary, there are three options. First, the spouse may elect to use the same deferral the nonspouse beneficiary was allowed: distribute over the recipient's life expectancy. Second, spouses are permitted to treat the inherited IRA as their own. Thus, the surviving spouse must defer distributions to their "required beginning date," or April 1 of the year after the survivor attains the age of 70 1/2. The surviving spouse may then choose any distribution method available to original IRA owners. This method provides the maximum deferral if the surviving spouse is younger than the decedent.

The third exclusion from the five-year distribution rule for surviving spouses is to begin distributions on the beginning date that would have applied to the decedent. An IRA owner who died in 1990 but would have reached age 70 1/2 in 1995 would have a required beginning date of Apr. 1, 1996. The distributions would be based on the surviving spouse's life expectancy and could be recalculated annually.

The effects of subsequent transfers should be considered since they are treated in a slightly different manner. If the surviving spouse should die before distributions begin, the five-year rule will again apply. Should the surviving spouse remarry, the second surviving spouse is treated as a nonspouse for purposes of that particular IRA.

IRA owners occasionally designate minor children as beneficiaries. The exceptions available to spouses will extend to minor children if certain conditions are met. These conditions, to be outlined in future regulations, are included in language set forth by the IRS in its prototype plan. Spousal exceptions "tack on" to the minor as long as the surviving spouse has a remainder interest in the IRA. The remainder interest must become payable to the surviving spouse when the child reaches the age of majority. Such provisions may be of limited use if the intent is to defer recognition of income. As a nonspouse beneficiary, the child is entitled to the life expectancy exception to the five-year rule. The distribution, based on the child's life expectancy, would be very small: between 1% and 2% of the account balance.

The definition of "designated beneficiary" comes into play if the IRA owner chooses to name his estate, rather than a person, as beneficiary. Only individuals are considered "designated beneficiaries" for Sec. 409(a)(9) purposes. An estate, therefore, is not entitled to any of the exceptions and must distribute the IRA within five years.

There are special "look-through" rules for trusts. Trust beneficiaries may be designated beneficiaries if three conditions are met. 1. The trust is valid under state law. 2. Trust beneficiaries are individuals. 3. The trust is irrevocable.

Further, a copy of the trust should be included with the IRA plan. If the conditions are met, trust beneficiaries are considered eligible for the appropriate distribution exceptions.

Another aspect of IRA distributions is the conflict with the Sec. 1014 step-up in basis to fair market value (FMV). The IRA provisions clearly indicate specific IRA assets have carryover basis to the new owner. Since a taxable estate will include the IRA at its date of death FMV, the question arises whether the subsequent income can use the offsetting deduction allowed income in respect of a decedent (IRD) under Sec. 691. Since there is no statutory definition as to whether such IRA transfers are IRD, one could assume they should be treated in a similar manner to other income deferral vehicles, such as deferred compensation and Series E bonds, both of which are IRD items.

While the burden of income tax from IRA distributions may fall to beneficiaries, there are a number of options to ease the pain. The options are flexible enough to either accelerate distributions if funds are needed or provide a satisfactory deferral if tax saving is the goal.
COPYRIGHT 1992 American Institute of CPA's
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Article Details
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Author:Riegger, Don
Publication:The Tax Adviser
Date:Apr 1, 1992
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