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Using a QTIP trust to extend the life of an IRA.

An Individual Retirement Account (IRA) is an excellent tool for deferring income tax and a great way to plan for those "golden years." IRAs are very simple investments, usually set up at a minimal cost by banks or brokerage houses, into which the owner may contribute up to $2,000 a year tax deferred. With regular annual contributions, by the time an individual reaches retirement age, he or she may have a large portion of his or her estate in an IRA. For example, if an individual begins making maximum contributions ($2,000) at the age of 23, by the time he or she reaches age 60, the account will be in excess of $615,000, assuming a 9% constant interest rate [see Appendix 1].

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Although the figures in Appendix 1 are based on an annual contribution directly to an IRA, many Individual Retirement Accounts are created as rollover accounts. A rollover IRA occurs when an individual who has been involved in an employer-provided qualified plan (i.e. 401 (k), etc.) transfers that account, tax deferred, into an Individual Retirement Account.

Many individuals who participate in qualified plans are not allowed to make deductible contributions to a separate IRA due to income limitations.(1) For these individuals, however, the accumulation of assets in the qualified plan can be substantial due to matching contributions made by the employer and a higher permissible annual tax deductible contribution than allowed for an Individual Retirement Account.(2) Therefore, the rollover IRA may contain a sizable sum of money.

It is obvious that clients and practitioners must assess how an IRA, including rollover IRAs, are to be treated for estate tax planning, including the best method for post-death transfer of the remaining IRA principal to the intended beneficiary. An excellent tool in achieving maximum tax benefits and control of final disposition of the IRA is the use of a QTIP trust. In order to determine how to best use a QTIP trust with an IRA, it is imperative that one first understand the IRA distribution rules.(3)

Distribution Rules

Owners of IRAs are allowed, without penalty, to begin withdrawals from their IRA when they reach the age of 59 1/2. If they have not yet begun withdrawing from an IRA by April 1st following the year in which they turn 70 1/2 (required beginning date) they are required to begin doing so.

Distributions During

the IRA Owner's Lifetime

Withdrawals from the IRA can be based upon the joint life expectancy of the owner and the designated beneficiary.(4)

* Spousal Beneficiary -- If the beneficiary is a spouse, the withdrawals must be based upon the couple's actual "joint and survivor life expectancy."(5) The IRS provides tables to determine how to calculate the combined life expectancy of two individuals.

* Non-Spouse Beneficiary -- Same as above; however, if the beneficiary is a non-Spouse and is more than 10 years younger than the owner of the IRA, the withdrawals must be made in accordance with the Minimum Distribution Incidental Benefit (MDIB) table found in IRS publication 590. The MDIB table is used to prevent excessive deferral by presuming that the beneficiary is exactly 10 years younger than the IRA owner.(6)

Distributions After the

IRA Owner's Death

Following the death of the IRA owner, several different methods are in place for distributing the remaining assets in the IRA. These post-death distributions are based upon who the beneficiary is and whether the decedent died prior to the required beginning date or after such date.

Death prior to required

beginning date

* If the surviving spouse is the beneficiary, there are two options:

First Option: The surviving spouse may wait until the decedent would have been 70 1/2 to begin withdrawals.(7) The amount of such withdrawals will be based upon the sole life expectancy of the surviving spouse or

Second Option: The surviving spouse may treat the decedent's IRA as his or her own and as such may "roll it over"(8) as well as designate a new beneficiary.(9) If the surviving spouse has not reached his or her own required beginning date, the withdrawals may be postponed until such date.

* If the beneficiary is an individual but not the surviving spouse, there are two options:

First Option: The entire IRA must be withdrawn by the beneficiary no later than December 31st of the 5th year following the IRA owner's death;(10) or

Second Option: By December 31st of the year following the owner's death, the beneficiary is required to begin annual withdrawals based upon the beneficiary's life expectancy.(11)

* If the beneficiary is not an individual (i.e. a charitable organization, non-qualifying trust, etc.):

The entire IRA must be withdrawn by December 31st of the 5th year following the IRA owner's death.(12)

Death after required beginning date

Withdrawals begun before the IRA owner's death must be continued by the beneficiary in the same amounts as by the decedent or, alternatively, they may be accelerated.(13) An exception to this rule applies if the withdrawals were earlier calculated using the MDIB table (referred to above), in which case the withdrawals of the remaining assets in the IRA may now be made over the actual life expectancy of the non-spouse beneficiary.(14)

The Use of a Trust as

a Designated Beneficiary

The option of using a trust as a beneficiary for an IRA can be very useful in estate tax planning. The client must be made aware that generally only an individual can be a designated beneficiary;(15) not all trusts qualify. If, however, the trust meets certain requirements (irrevocability), then the trust beneficiaries will be deemed the designated beneficiaries of the IRA and the general distribution rules may be followed.(16) If the trust is revocable (i.e. a grantor trust, etc.) then the payout after death will fall under the five-year rule described above.

Recalculating Life Expectancies

In extending the life of an IRA, it is imperative that the owner, along with the spousal beneficiary if applicable, determine if they will recalculate life expectancies for purposes of withdrawing funds from the IRA.(17) The effect of recalculating or not recalculating life expectancies can impact the timing of payouts, and the wrong decision can lead to less deferral of income and therefore more income tax.

Without recalculation, the owner of an IRA determines his or her life expectancy on the date he or she begins to receive distributions (as described above). The owner divides the valuation amount in the IRA by the number of years he or she -- and the spousal beneficiary if applicable -- is expected to live. The owner is required to withdraw an amount at least equal to the quotient of this calculation by the end of the year. Each successive year the owner decreases his or her life expectancy, or expectancies, by one and performs the process in the exact same manner.

The Process of Recalculating

Life Expectancies

Under the regulations proposed by the IRS, the distributions can be based on an annually recalculated life expectancy or expectancies.(18) Therefore, instead of decreasing the life expectancy by one each year, the owner -- and spousal beneficiary if applicable -- can use a new divisor prescribed by the IRS. This divisor decelerates the timing of payouts by reducing the life expectancy annually in an amount less than one. For example, if in year one a person's life expectancy was 20 years, then his or her life expectancy in year two, using the IRS tables, may be 19.5 not 19.

The owner of the IRA has four options regarding the recalculating of life expectancies. They are as follows:

* Option One: no recalculation of life expectancies.

* Option Two: the owner of the IRA recalculates his or her life expectancy, but not the beneficiary's.

* Option Three: recalculate only the spousal beneficiary's life expectancy.

* Option Four: recalculate life expectancies for the owner and the spousal beneficiary.

If the designated beneficiary is a nonspouse, only the first two options are available. The determination of which option to use is also based on the language within the IRA itself The IRA can specify an option (including allowing any of the four) or, if it makes no reference, then recalculation is mandatory. It is important to note that the election must be made by the required beginning date, and once chosen it is irrevocable.

The Use Of a QTIP Trust

IRC Sec. 2056(a) of the Internal Revenue Code allows a "marital deduction" from the taxable estate for property that passes from the decedent to the surviving spouse, thereby removing such property from taxation in the estate.(19) Qualified terminable interest property (QTIP) by definition qualifies for the marital deduction under this section.(20) QTIP is defined as property that passes from the decedent to the surviving spouse, who will have qualifying interest income for life but not actual title to the property.(21)

There are several reasons why a taxpayer would choose to use a QTIP trust as opposed to giving the assets outright to the surviving spouse. By setting up a QTIP trust, the taxpayer has a guarantee as to who will ultimately receive his or her property. This is controlled by the trust instrument itself. In other words, the trust is an insurance policy to guard against the chance of poor decisions caused by the lack of financial expertise or senility of the surviving spouse. In addition, a QTIP trust can alleviate estate tax through the use of the marital deduction.

Requirements of a QTIP Trust

The surviving spouse is deemed to have qualifying interest income for life if under the terms of the QTIP trust he or she is entitled to all the income from the property, payable at least annually, and no person has the power to appoint any part of the property to anyone other than the surviving spouse for his or her lifetime.(22)

The IRS has ruled that an individual will have qualifying interest income for life when at the decedent's death all income from the IRA passed to the surviving spouse in annual distributions which were the greater of (1) all the income earned by the IRA during the calendar year, or (2) the balance of the account payable over the surviving spouse's life expectancy.(23) The IRS has found that in cases where the surviving spouse is not unequivocally and undeniably provided with qualifying income interest for life, the instrument is ineligible for treatment as qualified terminable interest property.(24)

In regard to an IRA, the IRS has stated in Rev. Rul. 89-89 25, that an IRA interest will qualify as QTIP property if certain conditions and procedures are met. Annual withdrawals of the IRA principal balance (distributed over the surviving spouse's actual life expectancy) must be made by the QTIP trust. These annual withdrawals must follow the distribution rules discussed above.

In addition, the income earned on the undistributed portion of the IRA must be withdrawn by the QTIP trust no later than the end of each year, and such income must flow through to the QTIP trust and be distributed to the surviving spouse. In this sense the QTIP acts as a conduit for the income earned by the IRA. Any income that the IRA earned previously on the later withdrawn principal of the IRA shall also be withdrawn by the surviving spouse on an annual basis, and any income earned by the QTIP must be paid to the surviving spouse annually.

Upon the death of the surviving spouse, all remaining principal of the IRA, along with the other assets in the QTIP, will be included in the estate of such individual. The assets remaining in the IRA will pass to the QTIP trust where they, along with any balance in the trust, will flow through to the designated beneficiary [see Appendix 2].

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Consequences Without a QTIP Trust

The Individual Retirement Account itself may constitute qualified terminable interest property(26) which case a trust is unnecessary and all required payments flow from the IRA directly to the surviving spouse. This strategy is risky -- by failing to set up a trust, the taxpayer may lose some benefit. In establishing an irrevocable QTIP trust, two main objectives are achieved. First, such a trust will ensure that all distributions from the IRA will be made using the joint and survivor life expectancy of the owner and the beneficiary of the trust (the surviving spouse in the case of a QTIP).(27) Second, by setting up a trust, the trustee has discretion to distribute the proceeds of the IRA to the spouse rather than making an outright distribution.

In failing to establish a trust, the primary downfall is that the surviving spouse has an option to take a lump sum distribution from the IRA and, therefore, the tax advantage would be lost. Additionally, most IRA beneficiary designation forms do not allow for the specific designations necessary for beneficial estate tax planning. Attempting to amend the IRA agreement as a remedy to this flaw without approval from the Internal Revenue Service may jeopardize the tax-deferred status of the IRA.

In addition, the IRS has confirmed that assets placed in a qualified domestic trust, including an IRA, constitute qualified terminable interest property and therefore allow the marital deduction.(28) The IRS has also held that a Support trust(29) as well as a Decedent's trust(30) granted the surviving spouse income interest for life and therefore each were deemed qualified terminable interest property.

Conclusion

The rules for qualified terminable interest property (QTIP), found in IRC Sec. 2056(b)(7), can be used in conjunction with an Individual Retirement Account to provide a very beneficial estate tax planning tool. In combining these two tax planning devices, it is imperative that the distribution rules, including recalculation of life expectancies, are considered in order to maintain the IRA in the most favorable tax position.

The QTIP will allow the taxpayer estate tax savings through the use of the marital deduction. Furthermore, the QTIP allows the client to determine who will be the final recipient of his or her assets. Moreover, it is important that a practitioner become well aware of the client's changing needs. An annual reevaluation of the estate plan, including how the client's IRA should be used, is considered beneficial.

Ralph V. Switzer, Jr., JD, CPA, is professor of accounting and taxation in the College of Business at Colorado State University.

Daniel A. Pollock is a master's candidate in taxation at Colorado State University.

Footnotes (1) IRC Sec. 219(g). (2) IRC Secs. 415(c)(1)(A) & 415(b)(1)(A). (3) IRC Sec. 401(a)(9). (4) IRC Sec. 401(a)(9)(A)(ii). (5) Supra at 3. (6) Prop. Treas. Reg. Sec. 1.401(a)(9)-i, F-1 & Prop. Treas. Reg. Sec. 1.401(a)(9)-2. Q-1. (7) IRC Sec. 401(a)(9)(B)(iv)(II). (8) IRC Sec. 408(d)(3)(C)(ii)(II). (9) Prop. Treas. Reg. Sec. 1.408-8, A-4. (10) Prop. Treas. Reg. Sec. 1.409-1(a), C-2. (11) Prop. Treas. Reg. Sec. 1.401(a)(9)-1, C-3. (12) Supra at 10. (13) Prop. Treas. Reg. Sec. 1.401(a)(9)-1, B-4 & LTR 9119067. (14) Prop. Treas. Reg. Sec. 1.401(a)(9)-1, F-3A(b). (15) Prop. Treas. Reg. Sec. 1.401(a)(9)-1, D-3. (16) Prop. Treas. Reg. Sec. 1.401 (a)(9)-1, D-5(a). (17) Prop. Treas. Reg. Sec. 1.401(a)(9)-1, E-6, E-7, E-8. (18) Ibid. (19) IRC Sec. 2056(a). (20) IRC Sec. 2056(b)(7). (21) IRC Sec. 2057(b)(7)(B)(i). (22) IRC Sec. 2057(b)(7)(B)(ii). (23) LTR 9245033. (24) LTR 9220007. (25) Rev. Rul. 89-89, 1989-2 CB 231. (26) Ibid; see also LTR 9416016 & LTR 9418026. (27) Supra at 16. (28) LTR 9322005. (29) LTR 9416016. (30) LTR 9420034.
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Title Annotation:effect of qualified terminable interest property trusts on individual retirement accounts
Author:Switzer, Ralph, Jr.; Pollock, Daniel A.
Publication:The National Public Accountant
Date:Apr 1, 1996
Words:2658
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