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The Ever Ready IRA

By Marvin R. Rotenberg

A number of onerous taxes are just waiting to jump on the distributions from an IRA. Many of these can be avoided or postponed, and benefits of tax-free accumulations continued through careful planning. The author provides a few techniques focusing on nonspousal beneficiaries.

Individuals who have accumulated sizable retirement nest eggs may find an unpleasant surprise awaiting them. The IRS stands ready to levy a remarkably wide array of income, estate, excise, and penalty taxes on retirement plan distributions. The combination of these taxes can consume more than 80% of the value of the remaining account balance leaving children or heirs with only a minor portion of the balance that remains at death.

It is incumbent in planning for retirement to make tax-wise provisions for the disposition of IRA or plan assets so that the value that has built up over the years for the benefit of the family can be

Possible Taxes

The wide array of taxes and penalties referred to above include the following:

* Taking distributions from qualified plans and IRAs prior to age 59 Qs may incur a 10% penalty in addition to the ordinary income tax on the amount withdrawn.

* When an owner of a qualified plan or IRA attains age 70 Qs (April 1st of the following year), he or she must commence required minimum distributions. If the required minimum distributions rules are not met, there could be a 50% penalty on the shortfall of the required minimum

* Upon the death of the account owner, the IRS imposes an estate excise tax equal to 15% of an individual's excess retirement accumulation, sometimes referred to as a "success tax." The term "excess retirement accumulation" is the excess (if any) of the value of the decedent's interest in qualified plans and IRAs as of the date of his or her death that exceeds the present value of a single life annuity based on owner's attained age.

* Annual distributions that exceed $155,000 (inflation adjusted) could also be subject to a 15% excise tax on the excess amount over $155,000 in addition to ordinary income tax. The $155,000 threshold amount will be increased annually based on the cost of living index published by the Commerce Department.

The Small Business Job Protection Act (commonly known as the minimum wage bill) and the Health Portability and Accounting Act signed into law on August 20, 1996, have liberalized some of these penalties. Beginning in 1997, IRA owners can take penalty-free early distributions from their IRAs if the funds are used to pay for medical expenses exceeding 7Qs% of adjusted gross income or for the purchase of health insurance if an individual has been receiving unemployment compensation for more than 12 weeks. Effective January 1, 1997, required minimum distributions from qualified plans can be delayed until an employee retires, as long as he or she does not own 5% or more of the company. The 15% excise tax an annual distributions that exceed $155,000 is suspended for three years: 1997, 1998, and 1999.

For the most part, money in a qualified plan or IRA has never been taxed. Therefore, when a distribution occurs, whether taking the minimum required distribution or a distribution to beneficiaries at death, it will be subject to income tax. At the death of the account owner, if the surviving spouse is not the primary beneficiary, the total amount in his or her qualified plans will be included in the taxable estate.

While it may be virtually impossible to avoid or negate all of these taxes and penalties, knowledge of distribution planning can achieve substantial savings. An IRA can be preserved after the owner's death for the surviving spouse, children, grandchildren, or other heirs. IRAs can extend for many years, in some instances 50 or more years, after the owner's death while continuing to defer current income tax on a substantial portion of the assets.

Inherited IRA--
Nonspouse Beneficiaries

A properly structured IRA could allow the beneficiaries of IRAs to extend the tax deferral and avoid several of the penalties by having the designated beneficiary inherit the decedent's IRA. An inherited IRA is defined as an IRA that is acquired by reason of the death of another individual, and such individual is not the surviving spouse of such individual.

At the death of the IRA owner, the nonspouse beneficiary, the inheritee, must continue to maintain the IRA account in the name of the decedent. The title of the account must not be changed to the inheritee's name. If the account name is changed to the inheritee's, the IRS would consider the change as a total distribution and the entire amount would be income taxable at once. The inheritee, while maintaining the account in the decedent's name, must meet the minimum distribution rules by continuing to receive payments from the IRA over his/her life expectancy. The annual minimum distribution is based on the IRA value the previous December 31, divided by a factor that represents life expectancy.

If the account owner dies before the required beginning date (not in pay status), there are two methods that can be used for distributions to nonspouse beneficiaries. The first method requires the entire amount be distributed no later than December 31 of the fifth year anniversary of death (the five-year rule). The second method allows the designated beneficiary to take distributions not to exceed his or her life expectancy based on his or her attained age at the death of the IRA owner. The required minimum distribution rules would apply, and distribution must commence within one year of the owner's death. For example, if the individual inheriting the IRA was 50 years of age, distributions cannot exceed 33.1 years. The first year required minimum distribution would be Z\cc.z of the previous December 31 balance. To preserve the life expectancy of each inheritee, if there are multiple inheritees, separate shares must be established prior to the owner's death.

If the IRA owner of the account being inherited was in pay status, over age
70 Qs, at death, a different formula must be used
to determine the life expectancy of the individual inheriting the IRA. At the IRA owner's death, reference is made to the year the owner attained age 70 Qs and the inheritee's attained age at that time. Using the age of the owner (70Qs), or age when account was established, and the attained age of the inheritee, a joint life expectancy is determined. Life expectancy tables can be found in IRS publication 590. Using the joint life expectancy factor, the number of years that elapsed since the owner was 70 Qs to the date of death is subtracted. The remainder indicates the maximum number of years the inheritee can take withdrawals. For example, if the IRA owner was age
70 Qs and the attained age of the inheritee was 35, the joint life expectancy would be 47 Qs years. If the IRA owner dies at age 75, five years would be subtracted from 47 Qs and the inheritee would have a maximum of 42Qs years to take distribution. This example assumes the IRA owner was not recalculating his or her life and the life of the beneficiary. If recalculation was being used, the formula would be based on the single life expectancy of the inheritee based on his or her age when the account owner was 70 Qs subtracting the number of years elapsed since the owner's age 70 Qs.

If the IRA owner had only one account and several nonspouse beneficiaries were joint beneficiaries, the age of the oldest beneficiary must be used for all the beneficiaries.

Establishing separate IRAs, with separate named beneficiaries prior to April 1st of the following year the IRA owner attained age 70 Qs, would allow the beneficiaries to use their attained age, rather than having to use the age of the oldest beneficiary, when comparing it to the IRA owner's age 70 Qs and computing the joint expectancy. IRA owners are permitted to establish as many separate IRA's as they wish. However, it is important to maintain the IRA owner's name and Social Security number on each account. All the IRAs would have the same title (name of owner) and Social Security number, but could have separate designated beneficiaries.

Whether separate shares were established prior to death, upon the death of the IRA owner the account should be divided into shares. Although the age of the oldest child will be used for life expectancy of all the beneficieries, the separate shares enable each child to withdraw as much or all of his or her inherited balance without an accounting nightmare.

Naming a Trust as

If the IRA owner doesn't completely trust his or her heirs with the money outright, or if they are minors, it is possible to name a trust as beneficiary. Except in certain circumstances, a trust is not considered a designated beneficiary and does not allow the account owner to use a joint life expectancy based upon the age of oldest beneficiary of the trust to calculate the required minimum distribution. However, if cer-tain complex rules are met, it would be permissible to look through the trust to the age of the oldest beneficiary and use a joint life expectancy. The trust must be irrevocable, the trust must be valid under state law, the beneficiaries must be named individually or by class, and a copy of the trust agreement must be on file with the IRA trustee. In naming a trust, taxpayers should consider naming tiers of contingent beneficiaries so the IRA won't revert to the beneficiary's estate if he or she dies. For example, if the taxpayer named his or her son as beneficiary and the son subsequently died, he or she might want the grandchildren to be the beneficiary and not the son's estate. Taxpayers with very large estates--more than $3 million--should consider skipping their spouse as heir in favor of the children or grandchildren. Even if he or she has less than $3 million, the account owner should consider splitting the IRA into two or more pieces and leaving one to his or her spouse and others to children or grandchildren. Assets less than $1 million that go directly to grandchildren will not be subject to the generation skipping tax, and these assets will get maximum income tax deferral over a longer period of time (based on the life expectancy of the grandchildren). Naming a trust as beneficiary does not generally provide the longest payout. An inherited IRA would provide a longer payout period. However, the reason for naming a trust may outweigh this disadvantage.

The Effect of Heirs Inheriting the IRA

Premature Withdrawal Penalty. If the nonspouse designated beneficiary is under age 59 Qs and distributions from the inherited IRA must commence, he or she would be exempt from the premature withdrawal penalty of 10%. The 10% penalty only applies to the account owner: the inheritee is not the owner.

Estate Excise Tax. If, at the death of the IRA owner there was an excise estate tax due (balance of the IRA was in excess of the threshold), it would be paid at the time of death. The inheritee would not be subject to the tax again at his or her death. If there was no excise estate tax due at the death of the IRA owner, the inheritee would never be subject to the tax even if the IRA continued to grow.

Excise Payment Tax. The excise distribution tax of 15% is applied to the account owner who withdraws more than $155,000 (inflation adjusted after 1995). This tax is only applied to the account owner and not the inheritees. Therefore, the inheritees can withdraw as much as they would like without penalty even if the amount exceeds the threshold of $155,000.

The Required Minimum Distribution Rules. These rules apply to the heirs and distributions must commence one year after date of death of the IRA owner. The 50% penalty on the shortfall of the required minimum distribution, if any, would apply to the inheritee.

Example--One Child

Exhibit 1 illustrates the establishment of an IRA rollover from the proceeds of a 401(k) plan in the amount of $400,000. The IRA owner, George Smith, is age 65, and his spouse beneficiary, Mary, is age 64. The assumed annual rate of return on the IRA is seven percent. At age 70 Qs:, required minimum distributions must commence and continue each year based on the joint life expectancy of George and Mary. There are two methods that can be used to calculate the required minimum distributions at age 70 Qs: the "recalculation" method and nonrecalculation, sometimes referred to as the "term certain method." A combination of the two is also permitted based upon a calculation of one life and not the other. The recalculation method refigures life expectancy every year and the term certain method is a one-time calculation for withdrawals over a fixed term, at age 70Qs. In this illustration, George chose the term certain method based on the joint life expectancy of him and Mary. George commences his required minimum distribution and continues until he dies at age 80. Over the 11-year period, minimum distributions total $429,229. At his death, the balance remaining in his IRA rollover is $594,116.

Assuming Mary survives, she can establish her own spousal rollover at George's death and defer any income tax that would be due if she received the entire balance outright. There would be no estate tax in light of the unlimited marital deduction, and there would be no excess accumulation excise tax based on the amount. Upon establishing her spousal rollover, Mary names her one child, Suzy, as her primary beneficiary. One year after date of death of her husband, she would be 80 years of age. Suzy's age is 45; however, the actual joint life expectancy of ages 80 and 45 cannot be used due to the minimum distribution incidental rule, which states that any nonspouse beneficiary at least 10 years younger or more is required to use a maximum 10-year spread for purposes of required minimum distributions. Thus, based on the minimum distribution incidental benefit tables, the life expectancy is 17.6 years. Mary's spousal rollover is also providing a seven percent annual return. If she dies at age 84, the remaining balance in her spousal rollover would be $616,296 after a total of $190,115 would have been withdrawn as required minimum distributions.

Normally, at Mary's death, Suzy would take out the remaining balance and pay current income tax on the entire balance of $616,296, assuming there is no estate tax or excess accumulation tax. However, Suzy can choose to inherit her mother's spousal rollover, take distributions over her life expectancy, and pay income tax only on the amount being withdrawn annually.

The result is the original $400,000 IRA rollover would have lasted for 53 years and produced a total of $3,070,705 in distributions. The original IRA owner, George, would have taken out $429,229 in payments; his spouse Mary $190,115; and his child Suzy $2,451,361.

Example-Four Children

Exhibit 2 illustrates the same scenario as Exhibit 1 except now we assume Mary had four children as the primary beneficiaries of her spousal rollover. The exhibit assumes Mary divided her spousal rollover in equal shares and named each one of the children separately as primary beneficiary. The use of separate accounts in this example would allow each of the children to use his or her actuarial age in the formula after the death of their mother. Thus, the oldest child, Child I, must take out a minimum of $5,417 the first year and the youngest child, Child IV, would be required to take out only $4,681. The children must use a single life expectancy and use the term certain method of distribution each year.

Given Congress' penchant for tax complexity, the rules on inherited IRAs are probably the most complex that taxpayers will ever encounter. IRS Publication 590 provides many of the answers. An inherited IRA provides taxpayers with substantial income tax deferral and insures financial security for their progeny. *

Marvin R. Rotenberg is national director of retirement services at The Private Bank at the Bank of Boston.

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