Estate Planning Options for IRAs

By Philip J. Michaels

There are three taxes that may be payable on the death of an IRA owner that could take a significant part of the account balance. The author explains various alternatives that may be used to minimize their impact.

Estate planners and financial planners are having to deal with substantial IRA account balances as never before. Through the use of mutual funds and other investments, IRAs, Keogh plans, 401(k) plans, and other similar deferred income plans are increasing daily. While most taxpayers are aware of the benefits of deferring the income tax on these dollars currently and realize that they will have to pay income tax when these funds are drawn down, most are unaware of other tax implications, namely excise and estate taxes that will also be levied upon these funds.

Taxes at Death

There are three taxes that must be considered in dealing with an IRA account at death. First, there is, of course, the income tax and the fact the entire account, which has been growing free of current income tax, will be subject to income tax when the funds are drawn down. Secondly, because the IRA account is an asset of the decedent--a $100,000 exclusion was eliminated by TRA 84--the total IRA account is now includable in the estates of decedents dying after December 31, 1984.

The third and final tax is the 15% excise tax based on the individual's "excess retirement accumulation." At death, the 15% excise tax is considered an additional estate tax, but the unified credit is not allocable against it. In addition, neither the charitable nor marital estate tax deductions are available to shield against this additional tax. Finally, neither the beneficiaries nor the estate is permitted an income tax deduction for the payment of this excise tax. However, the payment of the excise tax is a legitimate deduction against the gross estate in calculating the estate tax that may be due.

To calculate the excise tax, the
"threshold amount" must first be calculated. The applicable threshold amount is the present value of a single life annuity contract that is to provide for equal annual payments of $150,000 (indexed for inflation) commencing on the date of the decedent's death. The aggregate value of the client's IRA over the threshold amount will be subject to the 15% excise tax.

Surviving Spouse

The simplest way to deal with a large IRA account is to have the client designate his or her surviving spouse as the beneficiary of the IRA. This means the surviving spouse will receive the benefits of the IRA outright and not in trust. In this case, with minimal planning the surviving spouse can defer literally all estate and income taxes with respect to the IRA account.

In most cases, the surviving spouse is entitled to collect and "rollover" the entire IRA account into a new spousal rollover account. Because, the asset is "passing" from the decedent to the surviving spouse, the IRA will qualify for the estate tax marital deduction and thus, no estate taxes will be due. Further, there will be no income tax payable until the surviving spouse actually draws down from the roll-over IRA account or is required to do so because of minimum distribution rules after age 70Aw .

Finally, the 15% excise tax may also be deferred in the discretion of the surviving spouse. In certain situations, it may be beneficial to have the surviving spouse pay the 15% excise tax due at the death of the first spouse. By factoring in the decedent's grandfather amount and calculating the amount of the excise tax due at the death of the first spouse, it may be more cost effective in the long run to actually pay the excise tax at the death of the first spouse. For example, in one case a 63-year-old surviving spouse was the beneficiary of her husband's $2.2 million IRA account. At the time of death, the excise tax was calculated to be approximately $85,000. Because, the widow had other sufficient assets to satisfy her cash requirements, she did not intend to draw down on the IRA account until she reached the mandatory age of 70 Qs. In this case, she elected to pay the excise tax when her husband's U.S. estate tax return was filed. In this fashion, the IRA account could continue to grow tax-deferred with the entire account now completely sheltered from any future excise tax.

Life Insurance

Life insurance products have a place in proper estate and financial planning. One solution is to incorporate life insurance with an IRA. The easiest way to do this is to advise the client who is possibly taking minimum distributions from his or her own IRA, to make withdrawals from the IRA in greater amounts. After putting aside amounts to pay the income tax and attempting to avoid the payment of the 15% excise tax, (in 1996 the maximum withdrawal to avoid the 15% excise tax is $155,000), the IRA owner should consider using those extra after-tax dollars to buy life insurance. The new life insurance policy, of course, could be owned by a life insurance trust to avoid estate taxation. However, when more sophisticated planning is called for, the life insurance trust could be drafted to take into account generation-skipping. Thus, the IRA account could be used to fund either a policy on the life of the IRA owner or a second-to-die policy on the lives of the IRA owner and his or her spouse. This is a way to "leverage" the IRA account and turn a "wasting asset" that would be subject to numerous taxes into a fund that would be free of estate tax and possibly generation-skipping consequences. The one caveat to remember is that if the IRA owner and his or her spouse are relying on or need the IRA account during their retirement years, this solution might not be the best. However, for those who have substantial assets outside of their IRA accounts, and can afford to invade the IRA and use "excess" funds to purchase life insurance, this is a viable solution that should be considered.

Unified Credit Trusts

In reviewing existing estate plans, it is disturbing to discover that even though there is a surviving spouse, IRAs are sometimes payable on the death of the IRA owner to either a nonspouse family member or, in other cases, used to fund the unified credit or bypass shelter trusts under the IRA owner's will. As the reader now realizes, by having a nonspouse individual as the beneficiary of the IRA account, the possibility of deferring the estate and income tax may be lost. In almost all situations, this approach should be rejected. Further, having the IRA payable to the unified credit or bypass shelter trust is also not desirable. To fully fund a $600,000 unified credit trust under an IRA's owner's will, you would need approximately $800,000 to $1,000,000 to fund the trust after netting out the income tax that would be due upon the death of the IRA owner. Of course, one alternative is to have the IRA account paid into the trust on an annualized basis. Upon the death of the surviving spouse, however, all remaining amounts in the IRA would be subject to immediate income tax.

Thus, in most situations where there is a surviving spouse, unless, as will be discussed later, the IRA owner wishes to fund a charitable bequest upon his or her death, the surviving spouse should be named as the primary beneficiary of the IRA.

Trust for Surviving Spouse

The previous discussion assumed the IRA passing to the surviving spouse would pass outright and the surviving spouse would be free to deal with the account or leave it to anyone or any organization he or she chose. However, if the IRA account owner wishes to "control" the account and dictate who the ultimate beneficiary will be, there are alternatives. The IRA owner will want to consider structuring the payments from the IRA so that they flow to the surviving spouse via a QTIP or marital deduction trust and not outright.

This area is still in flux but with appropriate planning, the benefits of an IRA can be paid into a QTIP trust for distribution to the surviving spouse without jeopardizing the estate tax marital deduction. While the decedent may retain control over the IRA, it appears that the ability to defer the 15% excise tax will be lost.

The QTIP trust should be designated as the direct beneficiary of the IRA. It is recommended that an irrevocable inter vivos trust serve as the designated beneficiary. The income tax on the IRA account will not be accelerated at the decedent's death. Rather, the distributions from the IRA account will first flow into the QTIP trust and then be distributed from the QTIP trust to the surviving spouse. The potential conflict is the amount of the withdrawal or distribution and how much income must be distributed to the surviving spouse each year from the marital deduction trust. For the marital deduction trust to qualify for the estate tax marital deduction, the IRC mandates that all of the income from the trust must be distributed at least annually to the surviving spouse. The problem is how much of the IRA account must be drawn into the QTIP trust each year and then distributed to the surviving spouse. At the moment, it appears the IRS's position is that the decedent must make an election before his or her death that provides the "greater" of all income earned in the IRA or the minimum distribution amount required under IRC Sec. 401(a)(9) must be paid from the IRA to the QTIP trust. Further, there must be no power in the trustee to accumulate income in the IRA or in the QTIP trust.

For example, assuming the IRA account is the only asset in the QTIP trust and the required distribution amount from the IRA for the particular year based on the surviving spouse's age, etc., is $1,000, and the income earned within the IRA for the year is $800, the required distributions would flow as follows: If the proper elections are made, $1,000 must be withdrawn from the IRA by the trustee of the QTIP. However, only $800 must be distributed from the QTIP to the surviving spouse to satisfy the "all income" requirement for the marital deduction trust. The difference, or $200, remains in the QTIP, and the trust pays an income tax on that amount. The $200 (less the income tax paid by the QTIP) remains in the trust for future accumulation and distribution to the ultimate remainder beneficiaries of the trust. (This, of course, assumes no principal distributions are either made or permitted by the terms of the QTIP trust.)

If, on the other hand, the minimum distribution amount from the IRA for the particular year is only $800 and the income earned within the IRA is $1,000, the full $1,000 is drawn down from the IRA and must be distributed to the surviving spouse from the QTIP trust to satisfy the income requirements of the QTIP. While the $800 must be drawn down from the IRA, the $200 may be paid from another source within the QTIP if there are additional assets available.

The purpose of using a QTIP arrangement with an IRA is to control the ultimate beneficiaries of the account. However, all elections and the trust must be in place before the date of death if this complex planning is to be effective.

Non-U.S. Citizen Spouse

If the surviving spouse is a non-U.S. citizen, a QDOT trust arrangement is required, or the assets passing to the surviving spouse will not qualify for the marital deduction. A QDOT trust is similar to a QTIP trust but has additional requirements: at least one trustee must be a U.S. citizen or a domestic corporation; if there is a principal distribution, the estate tax must be withheld by the U.S. trustee from the distribution; and, finally, if the assets in the trust exceed $2,000,000, one of the trustees must be a domestic corporation (bank) or a bond must be provided to guarantee future tax payments.

The same result can be achieved with a QDOT as with a QTIP regarding an IRA account. The IRS has issued a series of rulings that permit the estate tax marital deduction where a QDOT was designated the beneficiary of the IRA account.

Charitable Bequests

If the client wishes to make a bequest to a charity at his or her death, the tax professional should first examine what assets may be utilized to satisfy the bequest. Any bequest to charity will be deductible for estate tax purposes on a dollar for dollar basis with no limitations. An IRA account might be a suitable asset to use to fund the charitable bequest. However, it is poor planning to have the owner of the IRA account arrange for his or her IRA account to be first paid to his or her estate and then have the net amount, after the payment of income taxes, distributed to charity.

The best method is to have the charity named directly as the beneficiary of the IRA account. Thus, on the taxpayer's death, the account (or any portion thereof) will pass free of estate and income tax to the charitable organization (or family foundation).

This strategy, though, will not work during the IRA owner's lifetime. During his or her life, the IRA owner must first draw down on the IRA account and then after paying the income tax on the distribution, give the remaining net amount to the charity. In addition, all charitable gifts during lifetime are subject to certain limitations. Thus, the recommended method is to wait until death and have the IRA account paid to the charity or family foundation at that time. However, it should be noted that an IRA account payable directly to a charity will probably be subject to the 15% excise tax.

Charitable Remainder Trusts

Surviving Spouse. In those cases where the client wishes to provide for his or her surviving spouse and then have the net proceeds paid to charity, the IRA owner could elect to have the IRA paid to a QTIP trust for the benefit of the surviving spouse and then designate the charity as the ultimate beneficiary of the QTIP trust. In this case, the estate will receive a full estate tax marital deduction for the interest passing to the QTIP trust for the surviving spouse and a corresponding full estate tax charitable deduction when the remaining amounts in the IRA account pass to charity at the death of the surviving spouse. The only taxes will be the income taxes on the distributions from the IRA/QTIP to the surviving spouse and possibly the 15% excise tax. Another alternative is to have the IRA account paid into a charitable remainder trust for the benefit of the surviving spouse and then to charity. The same basic result is achieved in a far simpler fashion.

Children. Up to this point, we have dealt with those situations where the IRA owner had a surviving spouse or wished to have the IRA account payable directly to a charity. However, many IRA owners are faced with the situation of providing for one or more children and having their principal asset, namely their IRA account, be subject to a series of taxes before any benefits are received by the next
generation.

Assuming the IRA owner's sole asset is a $2,000,000 IRA account and his or her only beneficiary is an adult child, there is another alternative to consider. If the IRA account is left directly to the child, the account would be subject to estate taxes, income taxes as it is withdrawn by the child, and possibly the 15% excise tax. These taxes could leave the child with as little as $400,000 as his or her sole inheritance from the parent.

One technique that may be utilized to provide the child with a greater inheritance is the use of a charitable remainder trust ("CRT"). A typical CRT provides a stream of income to a noncharitable beneficiary or beneficiaries (i.e., individuals) either for their lifetime or for a set period of years. At the end of the trust term, the remaining assets in the CRT are then paid to one or more charitable organizations or possibly a family foundation. The most interesting aspect of a CRT is that it is totally exempt from income tax. Thus, if a client wishes, he or she could designate the CRT as the beneficiary of their IRA account at death for the benefit of the child. Since the CRT is exempt from income tax, the receipt of the IRA will not result in the payment of any income tax by the CRT. The benefit here is that the income beneficiary will receive an income stream from a much larger source rather than an IRA that has been subjected to various taxes. The negative aspect is that upon the death of the individual or individuals, the remaining assets in the CRT must pass to charity and are lost to the rest of the family.

Before the IRA owner client decides on using a CRT, the estate tax situation must first be dealt with. Assuming in our example that the child is 55 years of age when the parent dies, the CRT provides for an 8% annuity payout to the child, and the IRC Sec. 7520 rate is 8%, there will be a partial charitable deduction for the actuarial value of the remainder interest that will eventually pass to charity. In this case the estate tax charitable deduction will be approximately $400,000. Assuming the estate taxes can be paid from another source, the child will receive the sum of $160,000 each year from the trust (8% of $2,000,000) for the rest of his or her lifetime. At the child's death, the remaining assets in the CRT will be paid to one or more qualified charities. No portion of the CRT will be subject to either estate tax or income tax at the time of the child's death.

There are different ways to structure the CRT that may result in more income being paid to the child with a smaller charitable deduction. A charitable remainder annuity trust will pay a set amount to the chid each year and can never be varied. On the other hand, a charitable remainder unitrust will pay a percentage of the CRT's assets each year to the child. In this type of CRT the assets must be valued each year and if they appreciate, an additional amount will be distributed to the child in that particular year. If the assets in the unitrust should fall in value in a particular year, the child will be penalized by receiving a smaller distribution from the trust for that year.

Tax Appointment Clause. In those situations where the taxpayer has accumulated a large IRA account, the use of a CRT may be the only way to avoid losing a substantial portion of the asset to taxes. In planning for an IRA of any appreciable size, it is mandatory to review the tax appointment clause in either the will or trust. If the IRA is to be payable to a CRT, for example, the IRA owner should avoid having the estate taxes paid from the CRT. If the taxes are paid from the CRT, an "interrelated calculation" will result in higher estate taxes and leave the testamentary plan in ruins. *

References to code sections, regulations, etc., related to this article are available on request.