A rude awakening that awaits many IRA owners, after the satisfaction of watching their accounts grow tax-deferred for many years, is the huge tax bite that income and estate taxes can take if their heirs receive the funds without proper estate planning steps in place. The combined effect can consume more than two-thirds of the account.
While many individuals have documents in place that take basic steps, such as funding the exemption amount of the first spouse to die and establishing a testamentary trust for their minor children, sometimes those documents do not effectively use the longer measuring life expectancies of younger beneficiaries of IRA or qualified plan interests.
Impact of life expectancy
Anytime an IRA or qualified plan interest has multiple beneficiaries, RMDs required after death generally must be calculated using the shortest of their life expectancies. (This article assumes the IRA or plan interest is not payable to a charity, estate or non-qualifying trust, but only to “designated beneficiaries,” including individual beneficiaries of “see-through” trusts.)
When the age difference between beneficiaries is small, as with close siblings, the consequences of this rule are minimal. However, if an IRA owner is ill-informed enough to choose a young beneficiary and a much older co-beneficiary, such as his own sibling or spouse, the lost tax deferral for the younger beneficiary can be significant.
Example: William, age 16, and his sister Grace, 14, are the beneficiaries of their deceased father John’s IRA. When John was widowed 7 years earlier, he named his mother Ida, 72, as a co-beneficiary to allow her access to the funds in the event of his death. The value of the IRA is $3 million.
Beginning in the year after John’s death, required distributions will be $64,516 per beneficiary each year if based on Ida’s life expectancy. However, as shown in Figure 2, distributions to William and Grace would be much lower if they could use their own life expectancies. The reduced payouts offer income tax savings and the ability to prolong tax-deferred growth.
The example assumes the family desires income tax deferral and that sufficient liquidity is established to allow the family to pay any estate taxes due on the IRA funds. Given these facts, one objective should be to allow the younger beneficiaries to use their own life expectancies as the measuring period for required distributions. With appropriate tax and legal assistance, there are several ways to do this, whether in planning mode before death or in a remedial situation after death.
Master Trust. Since most trusts have multiple beneficiaries, dozens of private letter rulings have sought approval of language splitting a single trust into multiple trusts after death for the purpose of gaining separate life expectancy treatment. Most have failed. However, in 2005, the IRS issued a favorable ruling on this issue in a master trust that governed a number of subtrusts, each for the benefit of one of the IRA owner’s beneficiaries. (See Letter Ruling 200537044.) The distinguishing feature of the trust in this ruling was that the subtrusts, not the master trust, were the named beneficiaries of the owner’s IRAs.