Let's Keep It in the Family with Intergenerational Minimum Distribution Planning^SM

By Andrew J. Fair and Melvin L. Maisel

In Brief

The Time Value of Money

Authors Fair and Maisel think like the little pink bunny. They demonstrate the ability to make qualified plan money keep going and going. Specifically, through a series of examples they show how to grow amounts in a qualified plan to make available to the planholder, his or her spouse, the children, and grandchildren a substantial nest egg, before estate and income taxes. It's all a matter of making the right elections, investing wisely and providing another source of funds to pay for the estate taxes.

During the last few years, distribution planning, the process of programming the distribution of benefits from qualified retirement plans, individual retirement accounts, and tax sheltered 403(b) annuities has developed into one of the most complex areas of financial and estate planning. Complexity breeds confusion, and the confusion which surrounds distribution planning impairs, to a significant degree, the ability of many financial and estate planners to properly guide their clients.

The importance of proper distribution planning, known as Intergenerational Minimum Distribution Planning^SM, cannot be overemphasized. Failure to plan, or planning improperly, can result in significantly reduced security for the individual and his or her family, substantially higher tax costs, and, in many cases, inadvertent selection of the wrong alternative.

The high-net-worth individual who has accumulated substantial amounts in tax-favored retirement accumulations is especially vulnerable to improper planning for those assets because the tax brackets and therefore the tax liabilities are more significant. Because the timing of distributions from tax-favored accumulations is an income tax rule, yet is affected by both estate tax and excise tax concerns, many planners are not aware of the special benefits Intergenerational Minimum Distribution Planning^SM can provide.

IRC section 401(a)(9) provides that benefits must begin on a "required beginning date," which for most people is April 1 of the calendar year following their attainment of age 701Ž2. An individual participating in a qualified retirement plan who is not a five percent owner, directly or by attribution, can defer receiving benefits until April 1 of the calendar year following actual retirement. IRC section 401(a)(9) also defines the period over which benefits can be distributed, which is in most instances the joint life expectancy of the participant and his or her designated beneficiary. The law permits the individual and, after the individual's death, the beneficiary, to withdraw any amount desired in excess of the required minimum. Thisprovides significant additional flexibility and can make these assets the most valuable assets the individual and beneficiaries possess.

The value of these assets is enhanced if the funds are protected from creditors of the individual and his or her beneficiary. Under Federal law, with certain exceptions, benefits held in qualified plans are exempt from creditors of the participant and his or her beneficiary. The protection is not available against tax liabilities due the Federal government and against the plan if the plan has obtained a judgment against the participant.

Although Federal law does not provide protection against creditors for individual retirement accounts, that protection is available to account holders and their beneficiaries under some state laws. New York law, for example, protects individual retirement accounts from creditors, as do the laws of Connecticut, New Jersey, and Florida. Other states also provide similar protection.

There are penalties imposed if an individual withdraws too soon, too late, or in too small an amount. Distributions prior to age 591Ž2 are subject to a 10% penalty, but that penalty can be avoided if the benefits are withdrawn over the participant and spouse's life expectancy. If distributions commence before age 591Ž2 pursuant to the exception, the annuity payments must continue until the later of the date the participant reaches age 591Ž2 or five years after the payments commenced.

Distributions must commence by the required beginning date, and to the extent the required amount is not withdrawn, a 50% penalty is imposed.

When benefits commence at the required beginning date, two decisions are made. The first is the measuring period over which amounts can be withdrawn, which is based on the ages of the participant and the beneficiary, and the second is whether the life expectancy of the participant and if the spouse is the beneficiary, the spouse will be recalculated. Exhibit 1 presents an example of the results if the annual recalculation method (the default method) is selected.

Recalculation involves recomputing the life expectancy each year. Although the identity of the beneficiary fixes the measuring period, in most cases the recalculation method will apply if no specific election is made. If the recalculation method is used, the measuring period on the first death becomes the survivor's life expectancy, and on the survivor's death the measuring period drops to zero. The shorter measuring periods resulting from recalculating life expectancy accelerate the income tax liability, with the entire amount taxed on the second death.

If a spouse is designated as the beneficiary and survives the participant, the spouse can roll the benefits to his or her own individual retirement account and begin a new measuring period for distribution. When the spouse dies, the ultimate beneficiaries, who are usually children or grandchildren, or trusts for their benefit, have a period approximating their own life expectancies over which to withdraw the funds.

When the beneficiary is not the spouse, and is more than ten years younger than the participant, the measuring period is calculated each year based on a table developed from the minimum distribution incidental benefit (MDIB) rule. The MDIB rule requires the participant to withdraw funds over an annually recalculated life expectancy of the participant and someone ten years younger, but allows the beneficiary when the participant dies to withdraw over the balance of the actual joint life expectancy of the participant and beneficiary measured as of the date benefits commenced.

If more than one beneficiary is selected, and a separate IRA is maintained by the participant, or by the spouse after the participant dies, the period over which the beneficiary can withdraw funds is separately calculated for each beneficiary. And, if a trust is used as the beneficiary, the period over which the trustee can withdraw funds is the life expectancy of the trust beneficiary with the shortest life expectancy. However, special rules apply when the beneficiary is a trust. Those rules include a requirement that the trust be irrevocable, be valid under state law except for funding requirements, have an identifiable class of beneficiaries, and be delivered to the custodian or plan administrator. If those rules are not satisfied, the minimum required distribution is substantially increased.

In many qualified retirement plans and individual retirement accounts, a default beneficiary is the estate. Estates have no life expectancy, and the minimum distribution is then determined by the life expectancy of the participant alone. This is also a problem if a charity is included in the class of beneficiaries, or a revocable trust is selected, since a charity and a revocable trust are treated under the income tax regulations as having no life expectancy.

The following exhibits show the benefits a high-net-worth individual can structure for his or her family with funds held in tax-favored retirement accumulations using Intergenerational Minimum Distribution Planning^SM.

Facts:

Brian Jones, age 63, is a participant in the Jones Corporation Profit Sharing Plan, and currently has an account valued at $5,000,000. Brian and his wife, Ginny, who is 61, have three daughters, Ellen, who is 35, Marie, 32, and Julie, 28. Brian and Ginny have six grandchildren, who are ages 6, 4, 4, 3, 2, and 1.

Brian continues to share in the profit-sharing plan contributions, which are made at the maximum amount permitted by law. That amount is currently $30,000, but will increase over time through cost of living adjustments. He is currently earning in excess of 10% on his profit sharing plan investments.

Exhibit 1 shows the benefits to Brian and his family if he designates Ginny as his primary beneficiary and his children as contingent beneficiaries. The recalculation method was elected by default, and Ginny dies before Brian at age 70. Brian dies at age 75, and the children are the beneficiaries. Because the recalculation method was used, the distribution period is reduced to Brian's recalculated life expectancy when Ginny dies, and to zero on Brian's death. As a result, at Brian's death the entire amount, $12,035,508, is subject to income and estate taxes.

Exhibit 2 shows the difference if Brian elected not to recalculate either his or Ginny's life expectancy. In that case, distributions continue after Ginny's death to Brian based on their nonrecalculated joint life expectancy, known as the term certain method, and continue to the children on the same basis after Brian dies. As in Exhibit 1, the account balance at Brian's death is included in Brian's taxable estate--$12,938,110.

Exhibit 3 shows the benefits to Brian and his family if Brian predeceases Ginny, Ginny rolls her benefits to a spousal IRA, and designates the children as her beneficiaries. Brian's withdrawals are over his joint life expectancy with Ginny determined as of the date distributions begin using the term certain method. After Brian's death in the year 2008, Ginny rolls the funds to her own IRA and withdraws over the period required by the MDIB rule. When Ginny dies, her children are permitted to withdraw the balance over the remaining joint life expectancy of Ginny and Ellen, measured as of the date Ginny began to receive benefits.

Exhibit 4 shows the benefits to Brian and his family if Brian transfers $1,818,000 to a rollover IRA and designates a trust for his children as the beneficiary. Brian's estate is prepared to pay an estate tax on the funds held in the trust even if Ginny survives him because the estate-tax rate is substantially lower than would be the case at Ginny's death. In order to limit the amount in this IRA so that it does not exceed $2,000,000 including earnings for the year (annual 10% return), each year Brian transfers to an IRA with Ginny as the beneficiary, any excess over $1,818,000. Ginny's IRA is shown in Exhibit 5. All references to children's or grandchildren's IRAs in this discussion refer to trusts on their behalf that are beneficiaries of the IRAs. The amount transferred to the children's IRA of less than $2,000,000, is in anticipation that an IRA for the grandchildren will also be set up at just under $1,000,000 to avoid the generation skipping tax (see Exhibit 6). The total of $3,000,000 is the point at which estate taxes reach a point of concern, since the the children's and grandchildren's IRAs will be included in Brian's estate. Brian withdraws from the IRA with the children's trust as beneficiary the amount required under the MDIB rule. Because the distributions under the MDIB rule are lower than the distributions required from the IRA for Ginny, the amount subject to income tax while Brian is alive is lower.

On Brian's death, the amounts payable to the children's trust can be withdrawn over the balance of the joint life expectancy of Brian and Ellen, who is the child with the shortest life expectancy, measured as of the required beginning date.

Exhibit 5 is the remainder account value after reducing the $5,000,000 for the amount allocated to the IRA where the children's trust is designated as the beneficiary. Each year, Brian transfers from the IRA illustrated in Exhibit 4 to the IRA illustrated in Exhibit 5 the excess of $1,818,000.

Exhibit 6 is similar to Exhibit 4 except that Brian transfers $909,000 to an IRA using the MDIB Rule and designates a trust for his grandchildren as the beneficiary. Brian's estate is prepared to pay an estate tax on the funds held in trust even if Ginny survives him because the estate tax rate is substantially lower than would be the case at Ginny's death. In order to limit the amount in the IRA so that it does not exceed $1,000,000, the generation skipping exemption is used, and because Brian is realizing a 10% return on the money, each year Brian transfers to an IRA in Exhibit 7, with Ginny as the beneficiary, any excess over $909,000. The Taxpayer Relief Act of 1997 provides for an inflation index for the $1,000,000 Generation Skip Transfer Tax in multiples of $10,000 with 1997 being the base year. Brian withdraws from the IRA with the grandchildren's trust as beneficiary, the amount required under the MDIB rule. Because the distributions under the MDIB rule are lower than the distributions required from the IRA for Ginny, the amount subject to income taxes while Brian is alive is lower. On Brian's death, the amount payable to the grandchildren's trust can be withdrawn over the balance of the joint life expectancy of Brian and the oldest grandchild, who is the grandchild with the shortest life expectancy, measured as of the required beginning date.

Exhibit 7 is the remainder account value using the term certain method after reducing the $5,000,000 by the amount allocated to the IRA where the children's and grandchildren's trusts are designated as the beneficiaries. Each year Brian transfers the excess over $1,818,000 and $909,000 from the IRA for the children and the grandchildren.

Exhibit 8 is similar to Exhibit 7 except that Ginny transfers $909,000 to a separate IRA in the year 2009 that designates the grandchildren as primary beneficiaries. When the assets exceed $909,000, Ginny transfers the excess to Exhibit 9, where the children are the primary beneficiaries. $909,000 is indexed in multiples of $10,000.

Exhibit 9 is similar to Exhibit 7 except that it reflects the transfer of $909,000 to a separate IRA in the year 2009 that designates the grandchildren as primary beneficiaries. When the assets exceed $909,000, Ginny transfers the excess to Exhibit 9, where the children are the primary beneficiaries.

The accompanying Summary of Distributions presents the total amounts available under the various scenarios.

In order to obtain the results of the various exhibits, it is necessary to coordinate the profit-sharing plan and the IRAs with comprehensive estate planning coordinated with survivorship life insurance and various legal documents. These documents include a beneficiary designation describing how the assets in the account, including the life insurance policy, are to be distributed; a distribution election, which includes a selection of the term certain method; and a spousal waiver, which permits the benefits to be paid without reference to the preretirement survivor annuity right otherwise mandated to a surviving spouse.

The exhibits demonstrate the range of planning opportunities available to a high-net-worth individual with substantial amounts held in qualified retirement plans or IRAs. The worst case would be no designated beneficiary, which would apply if the estate, a charity or a trust didn't meet the special rules that apply when a trust is to be recognized as a beneficiary. Exhibit 1 shows the next worst case, which is the result when no election is made and the default is recalculation. Exhibits 2 and 3 reflect the most common planning which preserves the marital deduction while allowing Intergenerational Minimum Distribution Planning^SM to enhance the value of the benefits for the children, the grandchildren, and other heirs.

Exhibits 4 and 6 show how a willingness to pay some first death tax increases the value of Intergenerational Minimum Distribution Planning^SM, and Exhibit 6 demonstrates that the use of generation skipping planning in conjunction with Intergenerational Minimum Distribution Planning^SM can further magnify the value of retirement accumulations.

Exhibit 7, Exhibit 8, and Exhibit 9 illustrate the remainder benefits to Ginny and the family.

Intergenerational Minimum Distribution Planning^SM allows an individual entitled to benefits from a qualified retirement plan or IRA to organize those amounts in a manner permitting long-term deferral of income taxes while the individual and his or her heirs retain the ability to withdraw whatever amounts they wish at any time. Proper planning makes these assets the most valuable assets an individual can possess both for the individual, the spouse, the children, the grandchildren, and possibly other heirs.

However, Intergenerational Minimum Distribution Planning^SM is not just an income tax deferral technique. The income tax deferral will not be possible if the retirement accumulations must be used to pay estate taxes and administration expenses, since any withdrawal to make such payments will be subject to income tax and will remove the funds from the tax sheltered vehicle. Intergenerational Minimum
Distribution Planning^SM is effective only if other assets are available to pay the estate taxes and administration expenses.

The benefits of Intergenerational Minimum Distribution Planning^SM will, in many cases, therefore require the purchase of life insurance to provide the necessary liquidity. With proper planning, that life insurance can be purchased with amounts held in a qualified plan of the profit sharing or defined benefit type, or with amounts held in a qualified plan rollover account. The last possibility was discussed in "Using a Profit Sharing Plan as an Estate Planning Tool" by Andrew J. Fair and Melvin L. Maisel, The CPA Journal, August, 1991. A qualified plan rollover account can be funded through amounts rolled back to the plan from a rollover IRA if the amounts in the rollover IRA have not been commingled with IRA amounts not rolled over from a qualified plan.

While the use of some of the qualified plan funds to purchase life insurance reduces the amount available for Intergenerational Minimum Distribution Planning^SM, payment of premiums from these amounts is often the most efficient use of tax-sheltered benefits since the funds will be subject to estate and income taxes at some point. Using plan benefits to provide life insurance will, in almost all cases, produce a greater return on the investment than would otherwise be available, especially if the planning keeps the insurance proceeds from inclusion in the estates of the insured and his or her spouse.

With proper liquidity planning as part of the process, Intergenerational Minimum Distribution Planning^SM will permit an individual to "keep it in the family." *

Andrew J. Fair, Esq. is a partner
in Fair, Aufsesser & FitzGerald,
P.C., White Plains, NY, Melvin L.
Maisel is chairman, Cornerstone
Bank, Stamford, CT and President/
CEO of Stabilization Plans for
Business, Inc., White Plains, NY and Greenwich, CT.

Copyright December, 1997 Andrew J. Fair and Melvin L. Maisel.

Intergenerational Minimum Distribution
Planning^SM is a service mark of Melvin L. Maisel.