Retirement accounts can be valuable assets, but passing them to beneficiaries can be frustrating. Brokers and other custodians of individual retirement accounts can cause problems by insisting on following their own inflexible rules, rather than the family's wishes. Internal Revenue Service regulations have gaps and ambiguities that create practical problems. What's more, four recent IRS private letter rulings have exacerbated problems. Fortunately, there are strategies to cope with some of the more vexing difficulties.

IRA BENEFICIARIES

Brokers and other custodians and trustees of individual retirement accounts have developed their own fixed rules, to the frustration of many planners. For instance, some IRA custodians and trustees insist that if a trust or estate is the beneficiary, distributions must be made in a lump sum and, consequently, subject to immediate income tax.

Why?

It's just their “policy.”

Maybe so, but it's not required. In fact, the final regulations state that a lump sum distribution is not the only alternative available.

Consider what happens when a participant dies without naming a beneficiary and, under the terms of the IRA, the estate is the default beneficiary. The Treasury Department's final regulations on the required minimum distributions1 provide that the decedent's interest may be distributed to the beneficiary over five years if the decedent died before the required beginning date,2 or over the decedent's remaining life expectancy if the decedent died after the required beginning date.3 This means that if the participant died at age 65, distributions could be made over five years; if the participant died at age 75, distributions could be made over 13.4 years.4

If a surviving spouse is either the personal representative of the estate or the trustee of the trust as well as a beneficiary of the estate or trust, perhaps that spouse can roll over the IRA to his rollover IRA.5 If there is no surviving spouse, no rollover is available.6 However, the estate can transfer an interest in the IRA through a trustee-to-trustee transfer from the estate to the estate's beneficiaries or from the trust to the trust's beneficiaries without triggering income taxes.7 Indeed, the estate or trust could create new IRAs to reflect the beneficiaries' shares.

Each of the IRAs would be titled in the decedent's name for the benefit of a particular beneficiary. Beneficiaries must put their own social security number — and not the decedent's — on the account. After the transfer, the beneficiaries could continue to take distributions in installments over the number of years remaining in the original term. The estate could be closed, or the trust could be terminated according to its terms. There would be no taxable distribution.

Nonetheless, some custodians and trustees still refuse to budge. In this case, the only alternative might be to transfer to a new custodian or trustee.8

FINAL REGULATIONS

Some quirks in the final regulations are confusing, and create potentially expensive traps for planners.

One oddity involves determining the life expectancy of a surviving spouse for purposes of required minimum distributions (RMDs). Do not assume that you always calculate a surviving spouse's life expectancy in the same manner. There are three different ways to do it:

  • •Under the Uniform Table,9 calculate each year if the surviving spouse rolls over the decedent's account to a spousal IRA;

  • •Under the Single Life Table,10 calculate each year if the surviving spouse is the sole beneficiary; if a trust is named as beneficiary, the surviving spouse is treated only as the sole beneficiary of a trust provided there are no distributions from the retirement plan or IRA that can be accumulated in the trust for any beneficiary other than the spouse during the spouse's lifetime;11 and

  • •Under the Single Life Table, calculate once and subtract one from the life expectancy period for each year thereafter if the surviving spouse is not the sole beneficiary but is the oldest beneficiary and all other beneficiaries are individuals.12 (See “Minimum Distributions,” page 92).

For example, if the surviving spouse was 74 years old in the distribution year and the IRA account balance on the prior Dec. 31 was $1 million, the RMD for the distribution year would be $42,017 from a spousal IRA rollover; $70,922 from the decedent's IRA (if the spouse was the sole beneficiary of the decedent's account); and $79,365 from the decedent's IRA (if the spouse was not the sole beneficiary of the decedent's account). Remember: A 50 percent excise tax applies to the amount that should have been withdrawn as an RMD, but was not.13

Another quirk involves determining the designated beneficiary. Under the final regulations, the designated beneficiary is determined on Sept. 30 of the year following the year of the death of the participant.14 However, separate accounts can be established on or before Dec. 31 of that same year.15 If a separate account is established in a timely manner, the oldest beneficiary of each separate account is the designated beneficiary, effective as of the following year.16 But how can one comply with the Sept. 30 deadline if designated beneficiaries can still be established on Dec. 31 of the same year?

One possible solution is to create the separate shares on or before Dec. 31 of the year of death, effective as of the following year, which is the first distribution year. If this is not possible, there is another solution. Recognize different designated beneficiaries for different years. The Sept. 30 date would be used for determining the designated beneficiary for the first distribution year following the year of the owner's death. If separate accounts are established on or before Dec. 31 of that same year, separate account treatment will be effective beginning the following year, that is, the second distribution year. It is therefore possible to have one designated beneficiary in the year following the death of the owner and different designated beneficiaries in the second year following the death of the owner.

For example: Dad dies Dec. 31, 2002. Dad has named his three children as beneficiaries in equal shares. Separate accounts are created by the three children in November 2003, effective as of 2004. However, a distribution must be made on or before Dec. 31, 2003. The age of the oldest beneficiary would determine the RMD for 2003, and the ages of each of the beneficiaries of the separate accounts would determine the RMDs for 2004. Until the regulations are changed to allow separate accounts to be effective retroactive to the first of the year in which they are created, we will have the possibility of different designated beneficiaries for different years.

This dilemma can be solved if a beneficiary establishes separate accounts in the year of death so that they are effective for the first distribution year — that is, for the year following the year of the participant's death.

RECENT RULINGS

Four recent private letter rulings have caused a great deal of concern among practitioners. (See “Reductio Ad Absurdum,” T&E, September 2003)

In PLR 200228025 (issued April 18, 2002), the decedent named a trust as beneficiary of her IRA accounts. Two minor grandchildren were beneficiaries of the trust. In each case, the grandchild was entitled to distributions of income and principal at the trustee's discretion until age 30. When the grandchild reached 30, he'd be entitled to his entire share of the trust. If one grandchild did not survive to age 30, his share would pass to the other grandchild. If neither grandchild survived to age 30, the balance would go to their aunt, who was 67 years old at the end of the year following the decedent's death.

The IRS noted that distributions from the IRA could be accumulated in the trust, and disregarded the likelihood that both grandchildren — or at least one of them — would live to age 30 and would receive the entire trust and accumulations. The IRS ruled that since distributions from the IRA could be accumulated in the trust, the contingent beneficiaries must be taken into account in determining the designated beneficiary. As the aunt was the oldest of all the beneficiaries, she was the designated beneficiary and her life expectancy was used for purposes of RMDs. The result is much larger RMDs than would have been required if a grandchild were the designated beneficiary.

The American College of Trust & Estate Counsel and the Estate & Gift Tax Committee of the California Bar Taxation Section have asked the IRS to reconsider the regulations on which the ruling was based.17 Hopefully, the final regulations will be amended to achieve a more reasonable result — one allowing contingent beneficiaries with only a remote chance of taking the benefit to be disregarded when determining the designated beneficiary.

For now, however, one safe way to name a younger beneficiary as the designated beneficiary is by making any contingent beneficiaries younger than the beneficiary. In the alternative, use a conduit trust, which requires that all distributions from the IRA to the trust while the designated beneficiary is alive will be distributed directly to the beneficiary upon receipt by the trustee.

In Private Letter Rulings 200317041, 200317043 and 200317044 (Dec. 19, 2002), the decedent named his revocable trust as beneficiary of his IRA. The trustee of the revocable trust was directed to create three separate trusts. The rulings requested that the IRS recognize that three separate accounts had been created from the original IRA, and that RMDs could be paid over the life expectancy of the oldest beneficiary of each of the three separate trusts. The IRA was distributed directly to each subtrust.

The IRS ruled that separate accounts were not created based upon the final regulations, which preclude “separate account” treatment for Internal Revenue Code Section 401(a)(9) purposes in cases where amounts pass “through a trust.” The final regulations provide that the separate account rules of Reg. 1.401(a)(9)-8, A-2 “are not available to beneficiaries of a trust with respect to the trust's interests in the employee's benefit.”18 The IRS ruled that even though the IRA had been divided into three IRAs, the oldest beneficiary of all the IRAs was the designated beneficiary for purposes of RMDs.

This means that plan participants and IRA owners should not name more than one trust as beneficiary if the intent is to create separate accounts. Instead, they should name each separate trust as a beneficiary in the beneficiary designation. The simple phrase, “In equal shares to Trust A, Trust B and Trust C,” might suffice, although there is no statutory or regulatory authority directly on point. The safer course is to create three separate IRAs during life and name a separate trust as beneficiary of each.

The laws governing retirement planning are still evolving — and have a considerable way to go. In the meantime, it would help for IRA custodians and trustees to be flexible. The IRS also needs to provide more guidance and to simplify the regulations to ensure a reasonable and workable system for determining designated beneficiaries and required minimum distributions.

Endnotes

  1. The final regulations were published in the Federal Register on April 17, 2002. Reg. Sections 1.401(a)(9)-0 through -9; Section 1.403(b)-3; Section 1.408-8 and Section 54-4974-2.

  2. IRC Section 401(a)(9)(B)(ii); Reg. Section 1.401(a)(9)-3, A-4(2).

  3. Reg. Section 1.401(a)(9)-5, A-5(c)(3).

  4. The Single Life Table at Reg. Section 1.401(a)(9)-9, A-1.

  5. PLRs 200236052 (June 18, 2002) and 200305030 (Nov. 4, 2002) regarding distributions from estates and PLRs 199941050 (July 2, 1999) and 200130056 (May 3, 2001) regarding distributions from trusts. Remember that a PLR cannot be cited as precedent except by the taxpayer who received it.

  6. No rollover is available for any amount received from an “inherited IRA” by a beneficiary who is not a surviving spouse. IRC Section 408(d)(3)(c); see also PLR 200228023 (April 15, 2003).

  7. Rev. Rul. 78-406, 1978-2 CB 157

  8. One organization willing to make non-lump sum distributions is Capital Bank and Trust Company, Brea, Calif., the IRA custodian for the American Funds Group.

  9. The Uniform Table at Reg. Section 1.401(a)(9)-9, A-2.

  10. The Single Life Table at Reg. Section 1.401(a)(9)-9, A-1

  11. Reg. Section 1.401(a)(9)-5, A-5(c)(2) and A-7(c)(3), Example 2.

  12. Reg. Section 1.401(a)(9)-5, A-5(c)(1) and (2) and A-7(c)(3), Example 1. The regulations are confusing on this point. A-5(c)(1) deals with “nonspouse designated beneficiary” and A-5(c)(2) deals with “spouse designated beneficiary” and applies if the surviving spouse is the employee's sole beneficiary. Where does the spouse who is not the sole beneficiary fit? Is the spouse's life expectancy calculated each year based on his or her age each year or under a term-certain method? The author has assumed the term certain method.

  13. IRC Section 4974(a).

  14. Reg. Section 1.401(a)(9)-4, A-4.

  15. Reg. Section 1.401(a)(9)-8, A-2(2).

  16. Reg. Section 1.401(a)(9)-8, A-2(2).

  17. In April 2003, the American College of Trust & Estate Counsel submitted comments on trust issues in the final regulations to Marjorie Hoffman of the Office of the Division Counsel/Associated Chief Counsel (Tax Exempt & Government Entities), one of the principal authors of the final regulations. Also, in May 2003, the California Bar Taxation Section, Estate & Gift Tax Committee submitted a proposal to clarify the final regulations to the Treasury Department.

  18. Reg. Section 1.401(a)(9)-4, A-5(c).

Marcia Chadwick Holt, partner, Davis Graham & Stubbs LLP, Denver, Colo.

MINIMUM DISTRIBUTIONS

The time for distributions varies depending on age

Uniform Table (owner) Single Life Table (beneficiary)
SPOUSE'S AGE DURING DISTRIBUTION YEAR IF ROLLOVER IF SOLE BENEFICIARY IF NOT SOLE BENEFICIARY
68 No RMD 18.6 years 18.6 years
69 No RMD 17.8 17.6
70 27.4 years 17.0 16.6
71 26.5 16.3 15.6
72 25.6 15.5 14.6
73 24.7 14.8 13.6
74 23.8 14.1 12.6