PENSION DISTRIBUTIONS TO
ESTATES AS BENEFICIARIES

by Lawrence M. Lipoff, CEBS, CPA, Lipoff and Company, CPA, PC

Pensions have become one of the most significant assets that Americans own. Beneficiary forms rather than wills will be directing an increasingly larger proportion of decedents' distributions. It is imperative for estate planners to focus clearly on pension designations to ensure that they are coordinated with the rest of the estate plan.

To divide assets equitable among heirs, the most feasible way to coordinate pension assets with the rest of the estate plan is to simply designate the client's estate as the postmortem beneficiary. Unfortunately, such planning has potentially adverse consequences. Some individuals have been accumulating large pension assets and, at the same time, other substantial assets with which to retire. Many of these people would typically prefer to keep money in their pension to ensure tax-deferred growth for the longest possible period and perhaps to pass their pension assets on to subsequent
generations.

In analyzing pension distribution planning, two important considerations are 1) whether the participant has reached the required beginning date (i.e., April 1 of the calendar year following the calendar year that he or she became 70wQ ) for application of IRC Sec. 401(a)(9) minimum distributions and, 2) if this required beginning date has been reached, whether the distributions are subject to term certain or age recalculation rules. (Note that if a spouse is the designated beneficiary, distributions can be based upon recalculation for either or both of lives. Otherwise, only the participant's life may be recalculated.)

If a pension participant dies before the required beginning date, distributions must be made based on the five-year rule under IRC Sec. 401(a)(9)(B)(ii) or the exception to the five-year rule under IRC Sec. 401(a)(9)(B)(iii). However, if the estate is the postmortem beneficiary, the exception to the five-year rule is not
available.

The five-year rule as set forth in Treasury Prop. Reg. 1.401(a)(9)-1, Q & A C-2, mandates that the participant's entire plan balance must be distributed as of December 31 of the calendar year that contains the fifth anniversary of the date of the employee's death. The exception to the five-year rule requires that the plan balance be distributed over the life of the nonspouse designated beneficiary or within the life expectancy of the nonspouse designated beneficiary.

The default rule (i.e., should the five-year rules not have been chosen) for a surviving spouse as the designated beneficiary is the exception to the five-year rule. While the exception to the five-year rule generally requires distributions to commence by December 31 of the calendar year immediately following the calendar year in which the employee dies, a surviving spouse [as 1.401(a)(9)-1, Q & A C-3 (b) indicates], may wait until December 31 of the calendar year in which the participant would have attained age 70 wQ to commence distributions. For a nonspouse designated beneficiary, the default rule (should the exception to the five-year rule have been chosen) is the five-year rule. The default rules are reviewed in Q & A C-4 of the same regulation section.

Simply stated, the exception to the five-year rule is not available to an estate as a designated beneficiary because it does not have a life expectancy.

Upon reaching the required beginning date, minimum distributions must be made under the recalculation or term certain method. Under Prop. Reg. 1.401(a)(9), minimum distribution incidental benefit (MDIB) requirements for nonspouse joint-life beneficiaries, the required minimum distribution is the participant's account balance divided by the lesser of 1) the "applicable life expectancy" or 2) "the applicable divisor." Determination of life expectancy is made using Treasury Regulation 1.72-9, Table V for single life and Table VI for joint life expectancy.

For years after the first minimum distribution under the term certain method, the applicable life expectancy is the life expectancy for the first minimum distribution less one year for each year elapsed. For example, if a person in his or her first distribution calendar year has a life expectancy under Table V of 16 years, then the following year the minimum distribution will be calculated with a 16 ­ 1 = 15 applicable life expectancy. However, if life expectancy is being recalculated, the applicable life expectancy, again using Table V, for the next distribution year as found in the table is 15.3 years. The recalculation method requires reference to the table for every distribution year.

If the participant's account balance is $1,000,000, the first-year required distribution under either method will be $1,000,000/16 = $62,500. The second- year required distribution under the term certain method would be $1,000,000/15 = $66,667. If the recalculation method is applicable, the second minimum distribution will be $1,000,000/15.3 = $65,359.

If the participant has reached his or her required beginning date prior to death and if the term certain method is in effect, then the plan must [under Prop. Reg. 1.401(a)(9)-1, Q & A F-3A] distribute the plan proceeds at least as fast as the plan had been distributing (or as the plan was required to distribute) the proceeds to the participant. In this case, a participant choosing his or her estate as contingent beneficiary does not suffer a disadvantage.

If the plan document is silent, the IRC's default choice is the recalculation method, not the term certain method.

If the participant had reached his/her required beginning date prior to death and the life expectancy recalculation rules are in effect, having the estate as contingent beneficiary will cause an "acceleration distribution" (i.e., distribution of remaining pension proceeds must be made by December 30 of the calendar year following death). As Prop. Reg. Sec. 1.401(a)(9)-1, Q & A E-8 indicates, the recalculated life expectancy is reduced to zero in the year following death, and the pension balance must be distributed prior to the last day of such year.

The "acceleration distribution" requirement under the recalculation method is why many advisors believe that the more conservative approach is the term-certain method. Should there be an overriding need for slower distributions, a hybrid method (using two lives where one life is recalculated and the other uses the term certain method) is often considered.

In conclusion, unless the participant had reached his or her required beginning date and has elected the term-certain method for distributions, tax deferral pension distribution planning will be adversely affected when an estate is the contingent beneficiary of the client's pension account. *

Editors:

Marco Svagna, CPA

Lopez Edwards Frank & Company

Edward A. Slott, CPA

E. Slott & Company

Contributing Editors:

Richard H. Sonet, CPA

Zeitlin Sonet Hoff & Company

Lawrence M. Lipoff, CEBS, CPA

Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA

Own Account

Jerome Landau, JD, CPA

Eric Kramer, JD, CPA

Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

James McEvoy, CPA

Chemical Bank Corporation