IRAs and the Estate Tax
To learn more about Estate Tax Planning, or if you would like a consultation to begin Estate Tax Planning, please do not hesitate to contact us at (805) 482-2282, or e-mail us.
Estate Tax Planning and IRAs:
I. Introduction – Distribute as little as the law requires and allow for tax free compounding.
1. Goal: Maximize the amount of dollars after taxes arising out of your retirement plans and going to your children or other beneficiaries.
2. Assumptions: You will not need to take out more than the minimum distributions for your support. The estate tax exemption is $1,000,000 (the year 2011 and beyond).
3. Key Principle: Otherwise taxable investments compound tax-free in a retirement plan, and so we want to delay distribution as long as the IRS allows.
Bottom Line: How much child has from $300,000 IRA after income taxes when child passes away | |
Old Rules | $1,610,766 |
New Rules | $2,157,299 |
4. Importance:
a. Minimum Distributions: The IRS will make you begin taking distributions from your IRA in the year you reach age 70 ½ or at the latest by April 1st of the following year. In general, if you do not need the money, you want to delay distributions as long as possible to allow the tax-free build-up inside the IRA of otherwise taxable investments.
b. Beneficiary: After you die, the IRS will force the distribution of your IRA. The question is over what period of time? Again, we want to delay distribution as long as is possible to allow the tax-free buildup.
c. Significant Asset: Increasingly more significant in overall net worth of individuals.
d. Complex Issues: Best way to distribute during life and after death, complex mix of income tax, estate tax, and non-tax issues.
5. Most Important and Frequently Forgotten – What Does the Plan Say?: Terms of the plan agreement control benefits. May be inflexible or may be supplemented.
6. Other Factors:
a. >Financial Needs.
b. Health of You and Your Spouse/Child.
II. Minimum Distribution Requirements – Definitions:
1. Required Beginning Date (”RBD”):
a. IRA’s and Qualified Plan Where More than 5% Owner of Business: April 1st of the calendar year following the calendar year in which owner attains age 70 1/2. Example: John Single turns age 70 on October 8, 2010. He turns age 70 ½ on April 8, 2011. His Required Beginning Date is April 1, 2012.
b. Qualified Plan Where Less than 5% Owner: Later of above or the year of retirement from the company.
2. Designated Beneficiary: A person (or a beneficiary of an irrevocable trust) who is the beneficiary of the IRA and then can be used as a “measuring life” in determining a joint life expectancy. For example, the life expectancy of a 70 year old is 16 years. On the other hand, the joint life expectancy of a 70 year old and a 60 year old (in other words, how many years until we expect both to be deceased) is 26.2 years.
3. Required Minimum Distribution: When you reach your RBD (remember that means “required beginning date”), your IRA must be:
a. Entirely distributed to you (and you get hammered with income taxes); or
b. Distributed to you in annual installments paid over a period no greater than:
i. Your life expectancy;
ii. The joint life expectancy of you and a “designated beneficiary.”
4. Distribution Year: A year in which you must take an RMD, a Required Minimum Distribution. The year in which you turn age 70 ½ is the first Distribution Year. However, you can defer taking the first RMD until the RBD, April 1st of the second distribution year. Normally it is good to defer income taxes. Nevertheless, you then get taxed on both the first and second year distributions in the second year. Example, John Single must take two distributions in 2012, and the second distribution may be taxed in a higher income tax bracket. However, the benefit of tax-free compounding in the IRA may offset the extra income tax cost of waiting.
5. Excise Tax: Failure to take the RMD in any year results in an excise tax equal to 50 percent of the shortfall between the amount, if any, distributed and the RMD. (IRS may waive penalty if a reasonable error.) For example, if John Single’s RMD for the first Distribution Year is $10,000 but he fails to take a distribution, the Excise Tax would be $5,000.
6. Repeal of 15% Additional Estate Tax on Excess Accumulations and Excess Distributions Excise Tax: In the 1997 Kevin Staker Full Employment Act, I mean, excuse me, the 1997 Taxpayer Relief Act, Congress repealed the 15 percent additional estate tax on “excess retirement accumulations” and the 15 percent Excess Distributions Excise Tax.
7. New Distribution Rules– 2001: In January 2001, one of the last acts of President Clinton was to liberalize the minimum distritbution rules. In the past, we had to worry extensively about who the beneficiary of the IRA was. Now, during life we use the life expectancy of the participant and an imaginary person 10 years younger This is called the “MDIB” rule. However, if you are so fortunate as to have a spouse more than 10 years younger than you, you use that longer joint life expectancy.
III. Optimizing Distributions:
The Bottom Line: Designated Beneficiary and Calculation Method | ||
Type of Participant | Designated Beneficiary (”DB”) | Calculation Method |
Single Person | Individual(s) or Irrevocable Trust | MDIB Rule |
Single Person | Estate (no beneficiary, do not do this! name a beneficiary) | MDIB Rule |
Single Person | Charity | MDIB Rule |
Married with all children with this spouse – no need to use IRA to use estate tax exemption | Spouse | MDIB Rule |
Same but IRA needs to use estate tax exemption | Irrevocable Trust for benefit of spouse – not a QTIP trust | Same |
Married with children of prior marriage – IRA not needed to use estate tax exemption | Irrevocable Trust for benefit of Spouse – a QTIP Trust | Same |
Same but IRA needed to use estate tax exemption | Irrevocable Trust for benefit of spouse – not a QTIP Trust | Same |
1. Calculating the RMD is mathematically simple: divide the IRA balance by a life expectancy factor. That is the question: which life expectancy factor results from the method used.
2. Death of Participant Prior to Required Beginning Date:
a. Not a qualified “designated beneficiary”: None, estate, charity,living trust – All IRA must be distributed by December 31st of fifth anniversary of participant’s death.
b. Qualified “designated beneficiary” (not spouse): Child, Other Individual, or Irrevocable Trust: Distributed over life expectancy of (oldest) beneficiary.
c. Spouse as Beneficiary: Spouse may rollover into IRA or may receive distributions over life expectancy. Almost always will rollover.
3. Death of Participant After Required Beginning Date:
a. Same as above. However, if using joint life expectancy with Designated Beneficiary, distributed over joint life expectancy (unless using recalculation method as to life of participant or DB).
4. Trust as Beneficiary – Underlying Beneficiaries as “Designated Beneficiaries”: On January 26, 1999, the IRS issued REG-209463-82, 1999-4 I.R.B., which amends the Proposed Regulations under IRC section 401(a)(9). For a trust now to qualify as a Designated Beneficiary:
a. Valid under state law (or would be but for the fact it has no corpus);
b. is or becomes irrevocable upon the death of the participant;
c. trust beneficiaries identifiable from the trust instrument; and
d. the IRA custodian/issuer or plan administrator is provided with either of the following and the participant must agree to provide a copy of any future amendment:
i. a copy of the trust; or
ii. a certified list of trust beneficiaries, including all contingent beneficiaries, with a description of the portion to which they are entitled and any conditions on their entitlement.
Therefore, a living trust or a sub-trust formed under it at death, may qualify as a Designated Beneficiary. Thus, a bypass, “B,” exemption, decedent’s, or whatever it is called trust, that receives the first assets of a deceased spouse up to his or her estate tax exemption (2009=$3,500,000), may receive the retirement benefits.
Note: either (1) the final updated trust instrument or (2) a final certification of trust beneficiaries must be provided to the plan administrator within nine months of death of the participant.
IV: Generation-Skipping
You have a living trust. Your trust avoids a probate or a conservatorship. If you are a couple, it also eliminates all capital gain on community property and can double your estate tax exemptions to $10,500,000 in 2013 and beyond adjusted for inflation.
However, if you over $5,250,000 in assets if you are single or over $10,500,000 if you are married, your living trust is really a plan to make your grandchildren pay unnecessary estate taxes at the death of your children. Please consider the following:
With its 40 percent rate, after 2012 the estate tax is one of the most expensive taxes. However, the government imposes it on each generation. When you pass away and leave everything to your children, your estate must pay estate taxes. However, when your children pass away, the estate tax is imposed again before anything goes to your grandchildren, even though the property was already taxed when you died.
Let us assume the following: Your child has a net worth of $1,000,000. He or she inherits $500,000 outright from you, and his or her net worth increases to $1,500,000. If he or she had died without the inheritance, his or her estate would have had zero estate tax to pay on $1,000,000 because we will assume the estate tax exemption will have gone down to $1,000,000.
However, the following results at the death of your child with the inheritance from you, assuming the exemption is only $1,000,000:
| Outright Trust Distribution to Child | |
| Item | Amount |
| Child’s Own Assets | $1,000,000 |
| Inheritance from You | $500,000 |
| Total Taxable Estate of Child | $1,500,000 |
| Estate Taxes Paid by Your Grandchildren | $210,000 |
The key reason why your grandchildren had to pay such estate taxes on your child’s death is because your child had absolute theoretical control over the $500,000 inheritance from you.
On the other hand, please consider the following:
Instead of having the $500,000 go outright to your child you would change your trust to say the $500,000 goes to a trust controlled by your child. Your child would be the trustee of the trust and so control its investments as if he or she owned it outright. Your child as trustee would decide when and how much to distribute out of the trust to himself or herself. Your child would have the power at his or her death to decide how his or her trust would be distributed among his or her children, outright or still in trust.
The only powers your child would lack would be the powers to wildly speculate, waste, or give away to non-family members the assets. However, these are things you would not want your child to do anyway.
Your child’s trust would be irrevocable. Hence, it would have the added advantages of being free from his or her creditors, his or her spouse in a divorce, or anyone else trying to seize it.
Consequently when your child passes away, the following would result:
| Child Holds Inheritance in Generation Skipping Trust | |
| Item | Amount |
| Child’s Own Assets | $1,000,000 |
| $500,000 Inheritance from You Held in Trust. Amount Taxable by Child’s Estate Tax | $0 |
| Total Taxable Estate of Child | $1,000,000 |
| Estate Taxes Paid by Your Grandchildren | $0 |
Therefore, through merely adding this additional provision in your living trust you will have saved your child’s children $210,000.
Notwithstanding, this trust for your child has tremendous potential for estate tax avoidance. With proper planning the wealthy could avoid estate tax for many generations. Therefore, Congress placed a limit on the use of generation-skipping trusts by imposing a generation-skipping transfer tax (”GST tax”). The GST tax is imposed on the trust when each generation dies, just as if each generation had received their inheritance outright and paid estate taxes on it. Unfortunately, the GST tax is a very expensive tax–a flat rate of 55 percent. Furthermore, the GST tax is in addition to estate taxes, which can also be as high as 55 percent.
Nevertheless, Congress has given everyone an exemption from the GST tax.($5,250,000 in 2013) Hence, a couple can presently shelter up to $10,500,000 in generation-skipping trusts free of the GST tax. If properly drafted, the generation-skipping tax exemptions can enable you to create a family “dynasty” trust to last for up to 100 years or more estate tax free! Depending on the size of your children’s estates, the generation-skipping trust can often save your descendants hundreds of thousands, and maybe millions, of dollars in estate taxes.
We typically only charge only an additional $300 to add this provision to your new living trust or to the restatement of your existing living trust we otherwise are preparing for you..
V. IRA’s and the Estate Tax:
1. Typical Estate Plan for Husband and Wife with over $1,000,000 in Assets: They have a living trust, commonly called an “A-B Trust.” Upon the death of the first spouse, an amount of his or her assets up to the estate exemption (unlimited in 2010 but then back down to $1,000,000 in 2011) is placed into the “B” trust (we call it the “Exemption” trust it is also commonly called the “decedent’s” or “bypass” trust). For our examples below, we will assume a $1,000,000 estate tax exemption.The balance of the assets typically go into the “A” trust (we call it the “Survivor’s” Trust). No estate tax is paid at the death of the first spouse. The Exemption “B” trust is never subject to estate tax. If the Survivor’s “A” trust exceeds the estate tax exemption at the death of the surviving spouse, only the amount in excess of the exemption is subject to estate tax. Thus, the A-B Trust effectively doubles the estate tax exemption to $2.0 million and can save up to $435,000 or even more in estate taxes at the death of the surviving spouse.
2. The Problem: Retirement plan benefits, such as an IRA, cannot be owned by a living trust (being the beneficiary, however, we will discuss in a moment). If such benefits were distributed out to the living trust, they would be taxed by the income tax and possibly even penalty excise taxes. On the other hand, retirement benefits are included in your estate subject to estate taxes. Therefore, an IRA may be subject to estate tax upon the passing of the surviving spouse.
3. Example: For example, suppose Husband and Wife have $1,000,000 in assets in their living trust and another $1,000,000 in the IRA of Husband. Assume Husband dies before Wife and Wife is the sole beneficiary of Husband’s IRA, as is the common plan, and so rolls over Husband’s IRA into her own spousal rollover IRA. Wife, therefore, may only put Husband’s half of the living trust assets in the B trust (see paragraph 1 above); Wife cannot include Husband’s share of the IRA because it is not part of the living trust. Therefore, when Wife passes away the unspent IRA is entirely and absolutely controlled by her in her spousal rollover IRA, thus will be included in her taxable estate, and so will be subject to estate taxes. The following diagram illustrates this problem of IRA’s and other retirement plans:
Living Trust – $1,000,000 Home, Savings, and Other Assets | Husband’s IRA’s – $>1,000,000 | |||||
Husband’s Community Property Half – $500>,000 | Wife’s Community Property Half – $500,000 | Husband’s Community Property Half – $500,000 | Wife’s Community Property Half – $500,000 | |||
$500,000 | $500,000 | Husband Passes Away | $1,000,000 | |||
Exemption (”B”) Trust – $500,000 Wife is Beneficiary | $500,000Survivor’s (”A”) Trust and the $1,000,000 IRA = $1,500,000 Wife Controls Both | |||||
$500,000 Passes Free of Estate Taxes | Wife Passes Away | $1,500,000 minus Estate Taxes of $210,000 = $1,290,000 | ||||
Total to Trust Beneficiaries $1,790,000 | ||||||
4. Solution: The solution is to position as much as possible of the Husband’s half of the IRA so it is not included in the Wife’s taxable estate when she passes away. We do this by designating the Exemption “B” Trust as the beneficiary of enough of the Husband’s community property half of the IRA so as to use up the balance of the Husband’s estate tax exemption left over after the Husband’s living trust assets go into the Exemption “B” trust.
Until late January, 1998, the IRS required us to set up a separate irrevocable trust now as the beneficiary. However, in late January, 1998, the IRS changed its rules and now allows us to name the Exemption “B” trust as a beneficiary of part of the Husband’s IRA or other retirement plan. (Prop. Reg. § 1.401(a)(9)-1, Q&A D-5, D-6 and D-7; Reg-209463-82.)The IRS further liberalized the rules in January 2001.
The following illustrates the solution:
Living Trust – $1,000,000 Home, Savings, and Other Assets | Husband’s IRA’s – $1,000,000 | ||||||||
Husband’s Community Property Half – $500,000 | Wife’s Community Property Half – $500,000 | Wife’s Community Property Half – $500,000 | Husband’s Community Property Half – $500,000 | ||||||
$500,000 | $500,000 | Husband Passes Away | $500,000 | $500,000 | |||||
Exemption (”B”) Trust – $500,000 Irrevocable Trust – Wife is Beneficiary | $500,000 Survivor’s (”A”) Trust and Wife’s $500,000 Rollover IRA = $1,000,000 – Wife Controls | $500,000 Also Added to Exemption “B” Trust formed at death of Husband – Beneficiary of Husband’s Half of IRA’s – Wife is Beneficiary | |||||||
$500,000 Escapes Estate Taxes | $1,000,000 Escapes Estate Taxes | $500,000 Escapes Estate Taxes | |||||||
Total to Trust Beneficiaries $2,000,000 | |||||||||
The Exemption “B” trust escapes estate tax when the Wife dies because she did not create it and cannot change who ends up with its assets when she is gone. The Wife should not want to do any of those things. On the other hand, the Wife can be, and usually is, the trustee and sole beneficiary of the Exemption “B” trust, and so she gives up no real control or enjoyment of the IRA or other retirement benefit.
5. Why is Keeping the Funds in the IRA or Other Retirement Plan so Powerful? The IRA or other retirement plan benefit has a feature of astounding power that we want to preserve. The longer assets remain in the plan, the longer they can continue to grow tax-free. Investments that are otherwise taxable, such as stocks, corporate or U. S. government bonds, and mutual funds of the same, increase with dividends, interest, and capital gains tax-free.
That is why traditionally the Wife is the beneficiary of the IRA or other retirement plan. She can do a tax-free rollover into her own spousal rollover IRA. However, after age 70 ½ she must begin taking minimum distributions of the rollover IRA, but they are taken out over many years. That period of time typically can stretch out over 26.2 years if she names her child(ren) as the IRA beneficiary.
On the other hand, the Exemption “B” trust as IRA beneficiary may take out its part of the IRA over an average of 19.8 years. This occurs because it is treated as if it were the Wife for purposes of avoiding the 50 percent IRS penalty. Hence, we can avoid estate taxes on the IRA going into the irrevocable trust, and the distributions stretch out over a period to time almost as long as with the Wife as beneficiary (19.8 versus 26.2 years).
6. Downside: The only real downside is our fee to advise you and handle the paperwork on properly making the Exemption “B” trust a beneficiary of the retirement plan. However, saving up to at least $435,000 in estate taxes makes the fee look pretty insignificant.
7. Other Details: The IRS requires that certain requirements be met, such as informing the IRA custodian or retirement plan administrator regarding the Exemption “B” trust beneficiaries. We will assist you with such details.
8. Additional Use of Exemption Trust: Another use of the Exemption “B” trust as retirement plan beneficiary is if the Husband has children from a prior marriage or other beneficiaries he would like to receive the retirement benefits after the Wife is gone. Under the traditional planning, if the Husband dies first, the Wife rolls over the entire retirement plan benefit into her rollover IRA. When she dies, her children or her family members usually get the IRA, and the Husband’s family gets nothing. The Exemption “B” trust allows us to achieve two normally disparate goals: first, have the IRA available to support the Wife for her lifetime, and second, get whatever is left over to the Husband’s children or family.
9. Conclusion: The Exemption “B” trust as the IRA or other retirement plan beneficiary can be a great tool. It can reduce or eliminate estate taxes in the case of large ($200,000+) retirement plan benefits. At the same time, it can preserve the powerful tax-free compounding of such benefits.
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Staker|Johnson Law Corporation is a tax and estate planning attorney firm providing services for living trusts, probate and trust administration.
