The biggest consideration in estate planning for qualified plans and individual retirement accounts (IRAs) is determining the “right” beneficiary.
Different rules apply between qualified retirement plans and IRAs that impact an account holder’s right to name a beneficiary other than a spouse.
Under the Retirement Equity Act of 1984 (REA), a participant in a qualified retirement plan must obtain the written consent of the spouse in order to name a beneficiary other than the spouse. This subject frequently is the subject of prenuptial agreements, and we address it in this chapter. The REA restrictions are inapplicable to IRAs because IRAs are not covered by the applicable parts of Employee Retirement Income Security Act (ERISA) and are not included in Internal Revenue Code Section 401(a)(11).
IRC Section 401(a)(9) — and, specifically, the rules concerning when the required minimum distributions must be paid out — apply to qualified retirement plans and IRAs, although the rules are inapplicable to Roth IRAs during the lifetimes of the account holder and the account holder’s spouse (if the spouse survives the account holder and is able to rollover the account).
The first consideration concerns when the account holder dies vis-à-vis that person’s “required beginning date.” The required beginning date is April 1 of the year following the year that the account holder attains the age of 70½ — unless the person is employed at that time and is less than a 5% owner, in which case it is the year in which the employee retires. There are only two possibilities for the account holder from the standpoint of distribution consideration: death before reaching the required beginning date, and death after reaching the required beginning date.
The second consideration is whether the now deceased account holder or participant has named a “designated beneficiary of the benefits.
It is very important to understand that not all named beneficiaries will qualify as “designated beneficiaries” under these rules, which directly affects when the beneficiaries must be forced out of the plan or IRA.
Again, there are only two available possibilities: either the decedent named a designated beneficiary, or there is no designated beneficiary, either because the decedent failed to name one or where the named beneficiary does not qualify as a designated beneficiary under the rules.
The third consideration is the identity of the designated beneficiary. The two options are, first, the surviving spouse, and, second, everyone else. As a general rule, in order to qualify as a designated beneficiary, one must be an individual, i.e., estates, entities such as corporations and a charity will not qualify as a designated beneficiary. The regulations make it clear that one cannot go beyond the beneficiary designation or the plan or IRA document, i.e., someone who obtains the benefits due to the laws of descent and distribution is not a designated beneficiary.
Death Before the Required Beginning Date
If the decedent dies before reaching the required beginning date, no minimum required minimum distribution need be made for the year following death of the account holder or participant if the designated beneficiary is the surviving spouse.
If the designated beneficiary is the surviving spouse, required minimum distributions need not commence before the year in which the deceased account holder would have attained age 70½ had he or she lived until then.
However, this is not the case for non-spouse beneficiaries. Non spouse beneficiaries must commence receiving required minimum distributions on or before the end of the calendar year immediately following the calendar year in which the account holder died.
Designated beneficiary: If there is a designated beneficiary, under current law, the general rule is that the beneficiary can “stretch out” receipt of minimum required distributions over the beneficiary’s remaining life expectancy determined as of the beneficiary’s age in the year following the year of the account holder’s death. However, if the surviving spouse is the designated beneficiary, then the applicable distribution period is measured by the surviving spouse’s life expectancy using the surviving spouse’s birthday for each distribution calendar year after the calendar year of the account holder’s death up through the calendar year of the surviving spouse’s death. This means that a surviving spouse who is the sole designated beneficiary is able to recalculate life expectancy each year, something that no one else can do. Being able to recalculate life expectancy has the effect of further stretching out distribution of the benefits because the surviving spouse is in essence rewarded for having survived another year. That is because life expectancy still reaches out further in the future even for an elderly person who has continued to survive, i.e., a living person has some remaining life expectancy irrespective of age.
No designated beneficiary: Where there is no designated beneficiary, the plan benefits must be paid out by the fifth anniversary of the account holder’s death. We will call this the “five-year rule” in this chapter. The five-year rule essentially eliminates the right to stretch out the benefits.
Death after the Required Beginning Date
If the account holder survived until the required beginning date, then the following rules apply:
Designated beneficiary: If there is a designated beneficiary, then the requirements depend upon whether the surviving spouse is the designated beneficiary and whether or not the surviving spouse treated the IRA as inherited or whether the surviving spouse elected to roll over the benefits into a new IRA.
If the surviving spouse simply inherited the IRA and did not elect to treat the IRA as his or her own IRA, which the surviving spouse often has the right to do, then the surviving spouse must take the required minimum distribution for the year of the account holder’s death based upon the account holder’s life expectancy. However, thereafter, the minimum required distribution will be based upon the surviving spouse’s remaining life expectancy, as recalculated for each year of the surviving spouse’s over life, or the account holder’s remaining life expectancy had he or she survived, if longer.
If the surviving spouse rolled the account holder’s benefits into his or her own IRA, then the decedent’s required minimum distribution for the year of death must be taken if not taken prior to death. But, thereafter, the required minimum distributions will be based upon the surviving spouse’s remaining life expectancy, as recalculated annually.
With respect to designated beneficiaries other than the surviving spouse, the beneficiary must take the required minimum distribution for the year of the decedent’s death if it was not taken prior to death. Thereafter, the required minimum distributions will be based upon the beneficiary’s remaining life expectancy for the year following death. This life expectancy is fixed and is reduced by one year for each year of the beneficiary’s over life, or the account holder’s remaining life expectancy, if longer. The IRC Section 401(a)(9) regulations permit a single account to be divided into separate sub-accounts, each having different required minimum distribution provisions, provided that separate accounting, including allocation of investment income, gains and losses, is established. Where there are multiple beneficiaries, it usually makes sense to divide the account, particularly where there is some age disparity between the beneficiaries.
No designated beneficiary: If there is no designated beneficiary, then the applicable distribution period measured by the account holder’s remaining life expectancy is the life expectancy of the account holder using the age of the account holder as of the account holder’s birthday in the calendar year of the account holder’s death. In subsequent calendar years, the applicable distribution period is reduced by one for each calendar year that has elapsed after the calendar year of the account holder’s death. If the account holder names no beneficiary, which can happen even where the primary beneficiary predeceases the account holder without a contingent beneficiary, then the deceased account holder’s age must continue to be used.
— Read Avoid These 6 Common RMD Errors on ThinkAdvisor.