Facing a Hobson's Choice
When planning for IRA and qualified plan distributions, clients sometimes have few real alternatives. It's a situation almost every CPA will find familiar. Harry and Betty have combined taxable estates of $1,350,000, including a jointly owned residence valued at $300,000, Harry's IRA valued at $675,000 (Betty is the designated beneficiary) and a jointly owned investment portfolio valued at $375,000. If Harry dies first, the IRA cannot be used to fund a bypass trust unless the trust--or Harry's estate--is named as beneficiary. Since the couple can't use a bypass trust, Betty's taxable estate would be valued at up to $1,350,000. The resulting estate taxes could be as much as $270,750 (based on the unified credit amount available in 2000). If Harry did name his estate or a trust as his IRA beneficiary, the result could be significant adverse income tax consequences. Clients like Harry and Betty face a classic dilemma inherent in many estate plans. Their combined estates are large enough to require them to pay estate taxes, but each spouse has insufficient separate assets--other than retirement benefits--to fund a bypass trust that could minimize or eliminate the tax bill. What's a client to do? By understanding the relevant income and estate tax rules that apply to qualified retirement benefits and IRAs, CPAs will be better able to see the apparent Hobson's choice their clients face and assess the available alternatives. INCOME TAX CONCERNS Under federal law, amounts accumulated in a qualified retirement plan or an IRA must be distributed according to the minimum distribution rules in IRC sections 401(a)(9) and 408(a)(6). Taxpayers who fail to make required distributions pay a 50% excise tax on the amount they should have distributed. The two sets of minimum distribution rules stipulate a required beginning date (RBD) for distributions. Under IRC section 401(a)(9)(C)(ii)(II), the RBD for non-Roth IRAs is April 1 of the calendar year following the year in which the participant reaches age 70 1/2. The RBD for qualified retirement plans depends upon whether the participant owns more than 5% of the employer. If the answer is yes, the RBD is April 1 of the calendar year following the year in which the participant reaches age 70 1/2. If a participant does not own more than 5%, the RBD is April 1 of the calendar year following the later of the year in which he or she reaches age 70 1/2 or the year in which he or she retires. No RBD applies to Roth IRAs. Death before reaching RBD. If a participant dies before reaching his or her RBD, the proceeds of a qualified plan or non-Roth IRA generally must be distributed by December 31 of the calendar year that contains the fifth anniversary of the participant's death (the five-year rule) unless the participant had named a designated beneficiary (DB). (Proposed regulations section 1.401(a) (9)-1 C-2A.) Since Roth IRAs do not have an RBD, all amounts must be distributed within the five-year period to avoid the excise tax--unless a DB was named. If a client had named a beneficiary, distributions instead can be made in annual installments over a period not exceeding the DB's life expectancy, but only if the distributions begin by December 31 of the year after the partcipant's death. (Section 401(a)(9)(B)(iii).) Since amounts received from a non-Roth IRA or a qualified retirement plan are subject to income tax, stretching the distribution period can result in significant income tax savings. CPAs should recognize that helping a client identify and name a DB is, therefore, very important. A participant should name one before reaching his or her RBD. After that date, it's too late to extend the payout period. Since the distribution of benefits is based upon a DB'S life expectancy, the named beneficiary generally must be an individual or a group of individuals, such as the participant's children. (As discussed later, under limited circumstances a trust can be named as DB and the trust beneficiary with the shortest life expectancy [usually the surviving spouse] is used as the measuring life. …