Estate Planning For IRAs

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, GST 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 (GST) 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 pass 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 exemption of the first spouse to die is wasted.