From the November 2002 issue of Investment Advisor • Subscribe!

November 1, 2002

Part 2:Deferred Gratification

Annuities can be the key to a less-taxing inherita

The sale of annuities to people who don't need them has been the subject in the press and in the courts. It's old news. So here's a switch: a story about a new opportunity to sell annuities to people who really need them.

The opportunity has arisen thanks to a new IRS letter ruling obtained by Seymour Goldberg. Goldberg, a Garden City, New York attorney, who is one of the nation's foremost experts on IRA distributions, was frustrated by a case brought to him by Ed Slott, an accountant who often lectures on IRA rules to advisors. That led him to try to get the IRS letter ruling.

According to Goldberg, one of Slott's clients, a single individual, died owning a Keogh account. With a Keogh, which is a retirement plan for self-employed individuals, the self-employed person who owns the account is the account's sponsor. Thus, when the account owner dies, so does the account's sponsor.

If you're married and own a Keogh, then your spouse can roll the assets into an IRA upon your death and it is not a taxable event. The spouse preserves the tax deferral on the assets and can withdraw them based on the IRS required minimum distribution rules over his or her life expectancy.

In the case of a Keogh owner who dies and who has no spouse, however, the absence of a sponsor for the Keogh forces heirs to the account to take an immediate distribution. There is no way to preserve the tax deferral, and the heir will get stuck paying tax on the entire Keogh account they inherit in one lump.

"I made an argument to the government that this shouldn't happen," says Goldberg. "If you had an IRA that was inherited, a child could stretch out the inheritance over years and would not be subject to taking the taxable lump sum at once. Just because it's in a Keogh and the father dies, the child has to pay all this tax up front--it's not fair."

Goldberg submitted a plan to the IRS that would allow the heirs to a Keogh to take a long-term payout on the assets. "They'll allow an annuity that has special wording in it to be purchased by trustees of the Keogh plan," he says. "The annuity product can be transferred to the beneficiary without paying income tax and the beneficiary will then be able to draw down distributions from the annuity based on his or her life expectancy and get the stretched payout through this approach."

Goldberg says the ruling is the first to allow a variable annuity to be used to accomplish this. "The annuity contract needs to contain language to allow this approach to be used, and that now will be developed with insurance companies," he says. The "magic words" will include language stating that that once the beneficiary gets the annuity, it cannot be assigned; the contract will also contain other restrictions.

While Goldberg sought the ruling for a Keogh account owner, it may also be used in cases where a 401(k) is inherited. Heirs to a 401(k) have been treated a little better than Keogh heirs. If a single 401(k) owner dies, most 401(k)s have rules allowing heirs, usually the children of the account owner, to withdraw the money over five years--although a small number of 401(k)s have much shorter payout requirements of one year. Goldberg says the letter ruling will also give them relief and allow them to use the annuity to take stretched-out payouts from the inherited 401(k) assets.

Goldberg says his letter ruling is likely to be the first of several that will now be applied for and that will flesh out the IRS rules in this area over the next year or two. Advisors who want to avoid dealing with a messy situation can proactively check to see if they have clients with no spouse who own a Keogh or 401(k). If so, consider telling the client to shift those assets into an IRA before they die.

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