By Howell Branson, LLM, McCarthy, Fingar, Donovan, Drezen & Smith

Qualified pension plans are often rolled over into individual retirement accounts (IRAs), and therefore these accounts often constitute a substantial portion of an individual's estate. Accordingly, IRAs should be carefully considered as part of the overall estate plan.

The matter for discussion is how IRAs can be bequeathed to a trust, generally to either a qualified terminable interest trust (QTIP), in which the testator wants it to qualify for the marital deduction, or to a unified credit trust, which would be most common, where the testator does not have sufficient other assets in his or her own name to fully utilize the unified credit. It should be noted that IRAs, unlike qualified pension plans, are not subject to the spousal consent rule which requires the spouse to be named as the beneficiary of the plan unless the spouse consents otherwise. However, if the IRA resulted from a rollover of a qualified pension plan, spousal consent was required for the rollover.

Minimum Distribution Requirements

In planning for the disposition of IRA funds, it is important to consider the minimum distribution requirements of IRC Sec. 408(a)(6), as amended, which provides that rules "similar" to the distribution rules of Sec. 401(a)(9) (relating to required distributions from qualified plans) should apply. Proposed regulations have been issued under Sec. 401(a)(9), and are applicable to IRA distributions except where the Sec. 408(a)(6) proposed regulations are in conflict.

Generally, distributions from IRAs must commence no later than April 1 of the calendar year following the calendar year in which the individual reaches age 70 1/2 (the "required beginning date"). The interest of the individual can be paid in periodic installments over alternative periods based on the life (or expected life) of the individual, or the joint lives (or expected joint lives) of the individual and a "designated beneficiary."

If an employee dies before the distribution of his or her interest has begun, the entire interest generally must be distributed within five years after death. There are two exceptions to the foregoing rule, one that applies when the beneficiary is not the surviving spouse, and one that applies when the beneficiary is the surviving spouse. When the beneficiary is not the surviving spouse, the five-year rule does not apply if: 1) any portion of the employee's interest is payable to (or for the benefit of) a designated beneficiary; 2) such portion will be distributed over the life of such designated beneficiary (or over a period not extending beyond the life expectancy of such designated beneficiary); and 3) such distributions begin no later than one year after the date of the employee's death. Where the beneficiary is the surviving spouse, the same rules apply, except that distributions need not begin until the date on which the employee would have attained age 70 1/2.

If an employee dies after distributions from an IRA have commenced, the portion of his or her interest remaining at death must be distributed at least as rapidly as under the method of distribution being used as of date of death.

Is a Trust a "Designated Beneficiary"?

As mentioned, the interest of an IRA owner can be paid over alternative periods based on the life of the owner or the joint lives of the owner and a "designated beneficiary." Where a trust is the beneficiary of an IRA, there is an issue regarding whether the trust is a "designated beneficiary." The same issue arises in connection with the exceptions to the five-year rule that require that the interest of a deceased owner of an IRA be payable to a "designated beneficiary." The proposed regulations under Sec. 401(a)(9) provide that all of the beneficiaries of a trust are treated as having been designated as beneficiaries if certain conditions are met. First, the designated trust must be a valid, irrevocable trust under state law (or a trust that would be valid but for the fact that there is no corpus). Second, the beneficiaries of the trust who are beneficiaries with respect to the trust's interest in the qualified plan or IRA must be identifiable from the trust instrument. Third, a copy of the trust instrument must be provided to the qualified plan. In the case where distributions commence while the owner is alive, these conditions must be met as of the later of the date on which the trust is named as beneficiary or the owner's "required beginning date." In the case where the owner dies before distributions have commenced, these requirements must be met as of the date of the owner's death. Accordingly, a testamentary trust, which does not come into existence until the testator's death, presumably would not qualify as a designated beneficiary in the case where distributions commence while the owner is alive. If the owner of an IRA dies before distributions have commenced, or before the required beginning date, a testamentary trust presumably would qualify as a designated beneficiary, because the trust will come into existence as of the owner's death.

The proposed regulations also provide that when there are more than one designated beneficiary as of the applicable date for determining the designated beneficiary, the designated beneficiary with the shortest life expectancy will be the designated beneficiary for purposes of determining the distribution period. This rule would be applicable where a trust with more than one beneficiary is named as the beneficiary, because in such a case each beneficiary of the trust is treated as a "designated beneficiary."

QTIP as the Beneficiary

When a QTIP is the beneficiary of an IRA, and the benefits are paid to the QTIP in installments, there is an additional issue of concern, i.e., can the decedent's executor elect to treat the decedent's IRA as qualified terminable interest property, and thus have it qualify for the marital deduction? The issue arises because to qualify as terminable interest property, the surviving spouse must be entitled to all income from the property, payable at least annually. Rev. Rul. 89-99 addressed this issue and held that an IRA can qualify as terminable interest property if: 1) the decedent elected an IRA distribution option requiring the principal balance to be distributed in annual installments to a testamentary QTIP trust and the income earned on the undistributed balance of the IRA to be paid annually to the trust; and 2) the trust requires that both the income earned on the undistributed portion of the IRA which it receives from the IRA and the income earned by the trust on the undistributed portion of the IRA be paid currently to the decedent's spouse for life.

These rules permit a bequest of the remaining principal of an IRA to a beneficiary other than a spouse, often a useful tool in financial planning.

Editor: Milton Miller, CPA Miller & Company, CPA, PC Contributing Editors: Raymond G. Russolillo, CPA Coopers & Lybrand Irving Baumwald, CPA Borek, Stockel & Co.