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.

Pre-death options

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.

Separate IRAs. If the IRA owner does not wish to employ a separate trust for each beneficiary or a master trust strategy, separate life expectancy treatment may be available where the account is split into separate IRAs prior to death, with one individual beneficiary named for each account. However, if the IRAs grow at different rates and are not rebalanced regularly, the owner’s objectives of leaving a certain amount or portion to each beneficiary may not be met. This strategy also creates additional paperwork and account management fees. Furthermore, some custodians do not permit multiple accounts of the same type with different beneficiaries.

Post-death options

Separate Accounts. Generally, multiple individual beneficiaries who are not taking their shares through a trust may ask that an IRA be segregated into separate accounts post-death. If the separate accounts are created by December 31 of the year after the year of death, this technique can allow them to use their own life expectancies to calculate minimum distributions.

If the December 31 deadline is not met or the individuals are taking their shares through a trust, creating separate accounts generally will not allow them to use their own life expectancies. However, there are still other reasons for separating each individual’s funds. For example, the beneficiaries may desire different investments or they may want to avoid responsibility for one another’s RMDs. They may simply want to avoid having to interact with one another.

If separate accounts are created, all post-death investment gains, losses, contributions and forfeitures must be allocated pro rata between the accounts in a reasonable and consistent manner. If any distributions have been made after death to one of the beneficiaries, it must be allocated to his or her account.

Qualified disclaimer. Another technique that can be employed after death is a qualified disclaimer. If John’s mother in the example above executes a valid disclaimer of her interest in the IRA within 9 months after the date of death, she will be removed as a beneficiary for purposes of the calculation of life expectancies. Note that the disclaimer deadline will likely be earlier than the September 30 beneficiary determination date.

Payout. Similar to a disclaimer, if the executor of the estate pays Ida her $1 million share prior to September 30 of the year after death, she will be removed as a beneficiary. It is important to note that in the event of Ida’s death, even prior to September 30, she would not be removed as a beneficiary for purposes of the life expectancy calculation.

Don’t fail to plan

The income tax costs of failing to plan for multiple beneficiaries with disparate ages are considerable. Whether the client has a large estate that justifies highly sophisticated techniques or a more modest approach, several strategies are available for helping the client’ s beneficiaries enjoy tax-deferred compounding for as long as possible.

April K. Caudill, JD, CLU, ChFC, is an advanced marketing director at Prudential Insurance Company of America, Newark, N.J. You can e-mail her at .