An important aspect of estate planning centers around testamentary IRA distribution strategies, efficient planning designed to defer or mitigate taxation, and enhance the legacy for heirs.
IRAs, and IRA rollovers from qualified retirement plans can experience considerable erosion due to a combination of federal income, estate, generation-skipping transfer, and even state estate and income taxes. IRAs are considered “income in respect of a decedent” (or “IRD”) and are subject to taxation, as Exhibit I illustrates.
As Exhibit II indicates, how quickly an IRA must be distributed upon the owner’s death depends upon the chosen IRA beneficiary, and whether the IRA owner dies before or after reaching the “required beginning date” (“RBD”). The unlimited marital estate tax deduction also shields an IRA passing to a surviving spouse from federal estate tax.
However, the estate tax is merely deferred since the appreciated value of the IRA will ultimately be included in the spouse’s estate. An IRA passing to a child or grandchild is sheltered from estate tax, provided the IRA is not larger than the decedent’s remaining estate tax exemption. In addition, any value passing to a grandchild or a more remote descendant can be sheltered from the federal generation-skipping transfer tax with the decedent’s GST tax exemption.
Trusts are popular planning vehicles in estate and testamentary planning. They can incorporate dispositive freedom, flexibility, and protection. The “stretch” IRA planning technique allows deferral of post-death distributions over a “designated beneficiary’s” life expectancy, enabling the IRA to continue to grow and build a larger legacy.
Can a stretch IRA be incorporated into a trust? If applicable see-through requirements are met–the trust must be valid under state law; trust beneficiaries must be identifiable; and the trust must be irrevocable or become irrevocable at the death of the grantor–a trust can incorporate the stretch distribution option. However, if there are multiple trust beneficiaries, required distributions are based upon the life expectancy of the oldest beneficiary (shortest life expectancy), which means the IRA may be depleted by the time the oldest beneficiary dies.
As an alternative to the trust, separate IRAs can be considered for all beneficiaries, in which case separate accounts must be established by December 31 of the year following the owner’s death.
Effective estate planning typically incorporates optimal use of the federal estate tax exemption and the unlimited estate tax marital deduction. What are the practical considerations of funding a QTIP marital deduction trust with an IRA?
To ensure the marital deduction, QTIP language requires that all income generated by the trust be paid to the surviving spouse, and no one other than the spouse can receive income or principal during the spouse’s lifetime. Upon the spouse’s death, any remaining trust assets then passes to individuals directed by the decedent. However, required distributions from the IRA must be based upon the surviving spouse’s (oldest trust beneficiary’s) life expectancy, compromising the stretch IRA opportunity and amount ultimately passing to remainder beneficiaries.
Should an IRA be considered to fund the decedent’s credit shelter trust? Effective estate tax planning ensures a couple coordinating their tax planning receives the benefit of both spouses’ estate tax exemptions. However if everything, including the IRA, passes to the surviving spouse, the first spouse to die’s exemption is wasted.
If there are insufficient other assets to fully fund the exemption, it may be desirable to direct all or a portion of the IRA to individuals other than the surviving spouse, such as children, grandchildren, or a credit shelter trust for their benefit. The appreciated value of the decedent’s credit shelter trust will also “bypass” the surviving spouse’s estate (unlike the QTIP marital deduction trust). However, like the QTIP trust, distributions are based upon the oldest trust beneficiary’s life expectancy.
For the client with charitable intent or inclination, how should a charitable bequest of an IRA be structured? To ensure income tax (IRD) is eliminated, the charity (income tax exempt entity) should be named as the IRA beneficiary. The unlimited charitable estate tax deduction will also shelter the IRA from federal estate tax. Note however, that if both charity and individuals are named as beneficiaries, all the individuals will be subject to the 5-year rule for required distributions, unless the charity is “cashed out” by September 30 of the year following the decedent’s death.
An IRA can instead pass to a testamentary charitable remainder trust (CRT) for the benefit of both charitable and non-charitable beneficiaries.
How do the benefits of a testamentary charitable remainder trust (“CRT”) compare with a credit shelter trust and stretch? The stretch IRA through a credit shelter trust requires distributions to be made over a period not exceeding the life expectancy of the oldest trust beneficiary. However, a CRT term can last until the youngest of multiple beneficiaries dies, and can extend the payout period from one individual’s life expectancy to actual years lived by one or more individuals.
Distributions and income tax may be deferred considerably longer, particularly if there is a sequence of beneficiaries or significant age disparity among beneficiaries. The decedent’s estate also receives an unlimited charitable estate tax deduction for the value of the charity’s remainder interest in the CRT.
Under what circumstance might a beneficiary consider disclaiming an IRA? Disclaimers can be used by a spousal beneficiary in favor of non-spousal beneficiaries (children or grandchildren), in order to fully fund the decedent’s estate tax exemption or credit shelter trust. Disclaimers might also be considered to fund a charitable bequest.
The disclaiming beneficiary must execute and file a qualified disclaimer within 9 months of the IRA owner’s death, must not accept any IRA benefits prior to making the disclaimer, and must comply with all applicable federal and state requirements.
Finally, life insurance can enhance IRA distribution planning. Properly structured life insurance plays a vital role in IRA distribution and estate planning, providing a tax favored source of liquidity to pay income or estate taxes, a wealth replacement bequest in coordination with a charitable bequest, or a leveraged legacy for heirs.
Lifetime distributions, such as required minimum distributions which must begin at age 70 1/2 , can fund the premiums on a policy positioned outside the taxable estate, such as in an irrevocable life insurance trust or ILIT.