By Myron S. Blatt, CPA, affiliated with Lockwood Pension Services, Inc.

Preserving IRAs for children, grandchildren, and other heirs is a common goal of IRA owners. A common practice is to name the spouse of the IRA owner as the initial beneficiary of the IRA and then, upon the death of the IRA owner, “roll over” the decedent’s IRA into the spouse’s own IRA and name the children and grandchildren as the new beneficiaries. Upon the death of the spouse, the children and grandchildren inherit the IRA and receive distributions from the balance essentially over their lifetimes.

This strategy can generate huge distributions for decades after the deaths of both the IRA owner and the spouse. However, the funds needed to pay the applicable estate taxes, which are due upon death of the survivor spouse, must be available from other sources.

Exhibit 1 shows the total amount of distributions to heirs over 30-, 40-, 50-, and 60-year periods at different rates of appreciation of a $1 million inherited IRA. Using the 10% appreciation column in Exhibit 1, Exhibit 2 shows the actual distributions received by the heirs from this IRA over 60 years in 10-year periods. As the chart shows, the IRA balance continues to grow until the sixth and final decade of the projected life of the IRA beneficiaries, when the majority of the distributions take place. In effect, the IRA becomes a valuable long-term tax deferral vehicle for the heirs.

But a problem occurs when the non-IRA owner spouse dies first. Descendants can be named as the new beneficiaries, but upon the death of the IRA owner they can only complete the remaining original term that was elected at the required beginning date for distributions (assume the term certain method of distribution was selected for both the IRA owner and the spouse). The results shown in Exhibits 1 and 2 will never be accomplished if the spouses die in the “wrong” order.

To virtually guarantee that at least a part of an IRA is available for the ultimate desired nonspouse heirs, a separate IRA should be created by the IRA owner and the heirs should be named as beneficiaries of that IRA before the owner’s required distribution beginning date. The spouse can be named as contingent beneficiary. If the IRA owner dies first, the primary beneficiaries would be permitted to disclaim their inheritance and the surviving spouse could then inherit the entire IRA and roll it over to a new spousal IRA. This type of planning is not for everyone, as it could generate animosity within a family if the nonspouse IRA beneficiaries do not ultimately disclaim the right to inherit the IRA upon the IRA owner’s death. Therefore, if children and grandchildren are named as beneficiaries, in most cases it should be planned that they would eventually inherit at least that IRA of which they are the primary beneficiaries, and funds should be available to pay estate taxes due on the value of that portion of the IRA.

Naming children and grandchildren as the original primary beneficiaries, besides essentially guaranteeing that at least part of an IRA is passed down to future generations to be distributed over their remaining lifetimes, has other advantages.

The distributions from the IRA naming the children and grandchildren as beneficiaries will probably have lower annual distribution requirements. Exhibit 3 compares the distribution requirements for an IRA owner and children who are more than 10 years younger (IRA No. 1), with the requirements for an IRA owner and spouse who are the same age (IRA

No. 2). In the very first year, IRA No. 2 requires that over 27% more be distributed. By the sixth year, almost 40% more must be distributed and by the sixteenth year more than 146% must be distributed. In the twenty-first year, IRA

No. 2 has been completely distributed (with possibly both the IRA owner and the spouse still alive) while IRA No. 1 still has a life of at least 20 more years. Assuming an original IRA of $1 million and a rate of return of 10%, there would be approximately $2,255,000 remaining in IRA No. 1 after 21 years and the IRA owner would have to live past the age of 110 to see this IRA completely distributed.

The results shown in Exhibit 3 for IRA No. 1 are possible despite the required use of the Minimum Distribution Incidental Benefit (MDIB) Table (see IRS Publication 590). This table uses a maximum age difference of 10 years between the IRA owner and the nonspouse heir that produces a starting joint life expectancy of 26.2 years when the IRA owner is 70 years old. However, the MDIB table also uses a recalculating method to determine life expectancy (unless an actual calculation would generate a higher distribution) that generally produces a very long life expectancy and, therefore, low distribution requirements from an IRA. The odds are such that a substantial IRA will be passed down to the beneficiary.

The other advantage in naming children and grandchildren as the original primary beneficiaries is that the IRA is transferred to the heirs at the death of the IRA owner rather than after the death of both the IRA owner and the spouse. If the spouse lived a long time after the death of the IRA owner, the size of the IRA could be diminished, leaving an extremely small balance in the IRA for children and grandchildren to inherit.

If the IRA owner meets the requirements to convert part of a regular IRA to a Roth IRA, that may be the best way to guarantee an IRA is passed down to subsequent generations. A Roth IRA has no requirement for lifetime distributions, so it will be available to heirs whenever the death of the Roth IRA owner occurs. However, income taxes must be paid at the time of the conversion to a Roth IRA, and some commentators have observed that the Roth IRA may somehow be taxed in the future either directly or indirectly. Unfortunately, the history of tax law lends some support to this theory.

A trust may be appropriate as the beneficiary of an IRA when a minor is named as the beneficiary or when the IRA beneficiary is not considered able to manage the inherited IRA properly. Trusts can also be used if there are no other assets to fund a bequest that will be sheltered by the uniform gift and estate tax credit, and to protect assets in cases of failed marriages and against the claims of creditors. To properly set up a trust to be funded by an IRA requires thorough knowledge of the laws regulating both IRAs and trusts. An improperly set up trust can result in accelerated IRA distributions, leaving the heirs to lose a significant tax deferral opportunity.

Any grandchildren born after the required beginning date of the IRA owner may be added as beneficiaries to an existing IRA for other grandchildren or children. However, the distributions from that IRA will be based upon the age of the oldest beneficiary. If possible, the IRA owner should establish separate IRAs for each heir when there is a wide age difference among heirs in order to maximize available tax deferral for the younger heirs. A recent IRS ruling allows multiple heirs of a single IRA to use their own ages to compute required distributions, but only when the IRA owner dies before the required beginning date for distributions. After the required beginning date, distributions are based upon the age of the oldest heir, which could cause the loss of substantial tax deferral. Another advantage to multiple IRAs is that each owner can select the IRA’s investments. The only disadvantage is the paperwork involved.

All IRAs, including Roth IRAs, are subject to estate taxes. If the estate taxes must be paid from a withdrawal from an IRA, there will be a considerable income tax to be paid in addition to the estate tax and the combined taxes can equal more than 80% of the amount in the IRA. On the positive side, any federal estate tax paid on the value of an IRA will be a miscellaneous itemized deduction, not subject to the 2% of adjusted gross income limitation, on the tax return of the heir. Thus, a portion of the estate tax will be recovered over a period of years, as shown in Exhibit 4.