Retirement benefits are typically left to the participant's surviving spouse with the expectation that she1 will “do something” with them: either roll the benefits over to her own retirement plan to continue maximum income tax deferral, or disclaim the benefits so they can flow to the participant's children or a credit shelter trust as the contingent beneficiary.

But what happens if the spouse, having survived the participant, dies without accomplishing either task?

The answer is not pretty.

THE ROLLOVER PLAN

Leaving benefits outright to the surviving spouse, with the expectation that she'll roll them over to her own IRA2 is an excellent estate-planning approach in most cases. In addition to providing for the spouse financially, it offers the possibility of substantially more income tax deferral than would result from leaving the benefits to a trust for the spouse. This “spousal rollover plan” allows the individual retirement account (IRA) to remain virtually intact until the spouse reaches her late 80s.

The Internal Revenue Code requires the surviving spouse to start withdrawing annual minimum required distributions (MRDs) from her rollover

IRA beginning at age 70 1/2.3 Her MRDs are computed using the Uniform Lifetime Table (ULT) as the Applicable Distribution Period (ADP).4 The ULT is designed to deplete the account over the joint life expectancy of the spouse (as IRA owner) and a hypothetical 10-years-younger beneficiary.5 MRDs under the ULT are so small that the rollover IRA will not drop below its age-70 1/2 value until the spouse reaches age 89, provided she withdraws no more than the MRDs and has a 6 percent or better investment return.6 There is guaranteed to be something left in the rollover IRA when the spouse dies later (though there won't be much if she lives beyond her mid-90s).

In contrast, if the participant leaves his benefits to a typical qualified terminable interminable interest property (QTIP) trust7 for the surviving spouse's benefit (providing income for life to the spouse, with the remainder going to the participant's children), the MRDs from the IRA to the trust must begin the year after the participant's death (rather than when the spouse reaches age 70 1/2).8 Such MRDs will be computed using the spouse's single life expectancy9 rather than the ULT as the ADP, resulting in much larger MRDs and complete depletion of the IRA by the time the spouse reaches her late 80s.

The spousal rollover plan provides potentially longer income tax deferral after the spouse's death, as well as during her life. At her death, the spouse can leave her rollover IRA to a younger beneficiary, such as the couple's child, for a deferred distribution in annual installments over the child's life expectancy.

In contrast, if the participant leaves his IRA to a trust for the spouse's life benefit and the spouse dies prematurely (which would be the only circumstances under which there would be anything left in the trust-owned IRA at her death), that remnant must continue to be paid out over what is left of the spouse's original life expectancy.10 There is no possibility, upon the spouse's death, of changing to the longer life expectancy of the child when the child takes over as remainder beneficiary of the participant's trust rather than as primary beneficiary of the spouse's rollover IRA.

PREMATURE DEATH

The risk in the spousal rollover plan is that the surviving spouse might fail to complete the rollover and die while she still holds the benefits as the participant's beneficiary. This could happen because she is poorly advised, but more often ill health or incapacity are the culprits. Another possible cause is the couple's close-in-time deaths resulting from a common accident, in which she clearly survived (so typical simultaneous death clauses or laws would not apply to create a presumption that she predeceased) — but not long enough to carry out the rollover.

When the spouse dies holding the IRA as the beneficiary (rather than as the owner, which would be the case if she'd completed the rollover before dying), the income tax deferral options are usually dramatically reduced. At that point, the ADP would be the child's life expectancy (that is to say, there will be a good result) only in the following, very unusual circumstances: the participant and the spouse both died before Dec. 31 of the year the participant reached (or would have reached) age 70 1/2, and the plan documents specify that the child is the “successor beneficiary”11 to the spouse's interest.12

Except in those unusual circumstances, the ADP would be, at best, what's left of the surviving spouse's single life expectancy.13 At worst, the benefits would have to be distributed within five years after the surviving spouse's death.14

POSSIBLE SAFEGUARDS

Is there anything the estate planner can do to ameliorate the consequences of a spouse's failure to complete the rollover before dying?

  • Pre-elect rollover? A reasonable approach would be to have the spouse pre-elect the rollover while the participant is still living. Unfortunately, the Internal Revenue Service precluded this option in its final minimum distribution regulations, which specify that the rollover election can be made only after the participant's death.15

  • Charitable remainder trust? If the participant's intended contingent beneficiary is a charity rather than an individual, consider leaving the benefits to a CRT16 for the life benefit of the spouse rather than outright to the spouse. Though this will limit the spouse's access during her life to the unitrust or annuity payments from the CRT and thus is not appropriate for all clients, it will eliminate the income taxes on the benefits (as the CRT is income tax exempt), and eliminate the worry about the spouse's failure to complete a rollover on the participant's death.

  • Name a successor beneficiary? If the participant has not reached age 70 1/2, the participant could name a successor beneficiary to the spouse to take the benefits if she survives him but then dies (1) before the end of the year in which the participant would have reached age 70 1/2 and (2) without naming her own successor beneficiary. The successor beneficiary could be the couple's child or other young individual, and would be treated as the spouse's designated beneficiary for minimum distribution purposes,17 thus allowing a long-term life expectancy payout in those unusual circumstances. However, some IRA providers will not allow participants to name a successor beneficiary.

    Other IRA providers name a successor beneficiary in the plan documents. Choosing such an IRA provider would be a way to solve the problem (although naming a successor beneficiary, either by the participant or by the plan's own documents, might limit disclaimer options after the spouse's death.) In any case, this solution is of no use once the participant lives past the year he reaches age 70 1/2, because the ADP on the death of the surviving spouse after that point would be the surviving spouse's single life expectancy, not the successor beneficiary's life expectancy.

  • Minimum required survival period? Another solution is to include in the beneficiary designation form a requirement of survival for a certain period of time (which can be up to six months without jeopardizing the marital deduction if the spouse lives longer than the required survival period).18 This reduces the risk to the extent it prevents the spouse from inheriting when the spouses' deaths occur as the result of a common disaster.

  • Durable power of attorney? At a minimum, the spouse should, while the participant is still living, sign a durable power of attorney directing or authorizing her attorney to roll over any benefits she inherits from the other spouse, and instructing the attorney whom to name as beneficiary of the rollover IRA. This may save the day if the surviving spouse is incapacitated when the participant dies.

POST-MORTEM PLANNING

If both spouses are already deceased, options are more limited.

  • Rollover by spouse's executor? The IRS in the past has refused to allow the surviving spouse's executor to exercise the spouse's “personal” right to roll over benefits.19 This IRS position has never been tested in court. Judging by some more recent letter rulings,20 if the spouse had actually initiated the rollover during her life but somehow failed to complete it before dying due to circumstances beyond her control, there might be some hope (as described in Revenue Procedure 2003-16)21 of getting the IRS's permission to complete the rollover.

  • Plan documents name a successor. Check whether the plan documents name a successor beneficiary; that may solve the problem if both the participant and the spouse died young.22

  • Disclaimer. If the spouse's death occurs less than nine months after the participant's death and the spouse has not “accepted” the benefits,23 her executor may be able to disclaim the benefits, allowing them to flow to the participant's contingent beneficiaries.24

  • Reformation. Consider whether there is any possibility of a judicially approved reformation of documents to produce the right result. For example, if the participant's will contained a requirement that any named beneficiary survive by 30 days to take his inheritance, a court might conclude he intended to include a similar condition in the beneficiary designation.25

DISCLAIMER ACTIVATION

Another popular planning approach for retirement benefits is to leave the benefits to the surviving spouse with the expectation that she may disclaim them to make use of the deceased participant's federal estate tax exemption (credit shelter).26 The contingent beneficiary, who would take the benefits on the spouse's disclaimer, would be the participant's children or a credit shelter trust. Such a “disclaimer-activated” estate plan is appropriate in these times of constantly changing estate tax laws. However, close-in-time deaths can complicate the disclaimer-activated plan. Consider, for example, this hypothetical:

Ozzie and Harriet each own a $1.5 million IRA and no other assets. The spouses name each other as the primary beneficiary of their IRAs, with their two sons as contingent beneficiaries. At Ozzie's death, Harriet will decide whether to keep both IRAs or disclaim Ozzie's. If she expects to need all the money, or if the estate tax has been repealed, she will keep both IRAs. On the other hand, if she is terminally ill (and thus unlikely to need all that money), and the estate tax is still a factor, she could disclaim Ozzie's IRA, thus allowing it to pass to the sons as contingent beneficiaries (thereby using Ozzie's estate tax exemption). Ozzie and Harriet are in a car accident. Ozzie dies on Monday. Harriet dies on Tuesday, without having rolled over, accepted, or disclaimed Ozzie's IRA. The two sons are the sole beneficiaries and co-executors of both spouses' estates.

The goal is to have the sons substituted for Harriet as beneficiaries of Ozzie's IRA. If the boys inherit Ozzie's IRA as transferees and successor beneficiaries of Harriet, there will be a substantial estate tax (because Harriet's estate will be $3 million, well in excess of the $1.5 estate tax exemption applicable to 2005 deaths); there also will be a poor income tax deferral outcome.27 The boys want, instead, to inherit the IRA as transferees and designated beneficiaries of Ozzie. That way, there will be no estate tax (because there will be two equal estates of $1.5 million, both sheltered by the exemption), and income taxes can be deferred over the sons' life expectancies.

Here are the steps the family should take to obtain the desired outcome:

  • Requirement of survival — First, check whether Ozzie's beneficiary designation form contained a requirement that Harriet survive him by a certain period of time in order to inherit the benefits. That would solve the problem, because the contingent beneficiaries would become the primary beneficiaries. Unfortunately, a requirement of survival for a specified period of time is rare in a beneficiary designation form.

    Also check the plan documents (which might conceivably have a requirement that the beneficiary survive for a certain period of time) and the applicable state law (which might conceivably apply simultaneous-deaths rules in the case of deaths resulting from a common accident).

  • Disclaimer obstacles — Barring such a requirement-of-survival provision, the next question is whether the disclaimer plan can be activated when the proposed disclaimant (Harriet) is herself deceased. The answer is yes, unless (possibly) the plan documents name a successor beneficiary.

Can the sons disclaim when they are beneficiaries of both estates? Assume that the plan documents do not name a “successor beneficiary” for Ozzie's IRA, so the IRA is now owned by Harriet's estate as a result of her death. One requirement of a qualified disclaimer by a beneficiary other than the surviving spouse is that the benefits must pass, as a result of the disclaimer, to someone other than the disclaimant.28 The sons are the beneficial owners of Harriet's estate, so if they don't disclaim, they will inherit Ozzie's IRA through Harriet's estate. If, as her executors, they disclaim on behalf of her estate, Ozzie's IRA will pass to them as Ozzie's contingent beneficiaries. It appears that a disclaimer would cause the IRA to pass from the two sons (as beneficial owners of Harriet's estate) to themselves as Ozzie's contingent beneficiaries, and thus would not be a qualified disclaimer.

However, that is not the correct interpretation. By disclaiming in their capacity as Harriet's executors, they are disclaiming her interest, not theirs. Thus, IRC Section 2518(b)(4) is not violated.29

But what if the documents name a successor beneficiary? Suppose Ozzie's beneficiary designation form (or the IRA plan documents) specify a successor beneficiary who is entitled to ownership of the IRA upon the death of the original beneficiary and before such beneficiary's withdrawing all the benefits. This would appear at first to be a blessing, and it may (if both Ozzie and Harriet died young) allow the sons to use their life expectancy as the ADP. Yet it also could be a curse from the point of view of the desired estate tax result, because it could preclude a qualified disclaimer on two grounds.

First, the Fifth U.S. Circuit Court of Appeals held in 1997 that, when a successor beneficiary is named, the successor beneficiary is automatically entitled to ownership of the benefits upon the death of the original beneficiary, so the estate of the original beneficiary has no standing to disclaim.30 This ruling, Nickel v. Estate of Estes, has been criticized and might not be followed by other courts, but at the moment it's the only law on the subject. If Ozzie's IRA documents name a successor beneficiary other than the two sons, those individuals are likely to claim the benefits, citing this case.

Second, if the sons are the named successor beneficiaries, the results are still bad. Now, the sons are entitled to the benefits in their own right rather than derivatively through Harriet's estate. If Nickel is good law, they own the benefits and accordingly cannot make a qualified disclaimer, because of IRC Section 2518(b)(4).

PLANNING POINTERS

Whenever an estate plan depends for its success on the spouse's taking action after the participant's death (either rolling over or disclaiming the benefits), planners should anticipate the possibility of simultaneous or close-in-time deaths, and take whatever steps necessary to reduce the likelihood of bad results. Including a requirement that the spouse survive the participant for some period of time as a condition of inheriting the benefits could be helpful, if the retirement plan permits it. Naming a successor beneficiary (or using an IRA provider whose documents specify a successor beneficiary) could be helpful for income tax deferral if both spouses are young, but counterproductive if the goal is a disclaimer-activated credit shelter gift. In all cases, though, the durable power of attorney should be both broad and specific to enable the attorney to carry out the plan quickly upon the first spouse's death if the surviving spouse is incapacitated.

Endnotes

  1. In this article, the retirement plan owner is called the “participant” or “he,” and the participant's spouse (or surviving spouse) is called “she.”
    I am indebted to the research of E. Diane Thompson, author of “Disclaimers: When, Why & How to Say No to an Inheritance” (seminar outline, 1998), and the late Mary Moers Wenig, author of Disclaimers (Tax Management, Inc., Estates, Gifts and Trusts Portfolio No. 848) for several cases and rulings cited in this article.
  2. The surviving spouse can rollover benefits she inherits from the deceased participant to any eligible retirement plan, but the usual choice is an individual retirement account. Internal Revenue Code Section 402(c)(9); Treasury Regulation Section 1.408-8, A-5(a). This article assumes the reader is generally familiar with estate and distribution planning options for IRAs and other tax-qualified retirement plans. For explanation of the “spousal rollover,” see Chapter 3 of Natalie B. Choate's Life and Death Planning for Retirement Benefits (Ataxplan Publications; www.ataxplan.com).
  3. IRC Section 401(a)(9)(A).
  4. Treas. Reg. Section 1.401(a)(9)-5, A-4(a).
  5. Treas. Reg. Section 1.401(a)(9)-9, A-2.
  6. Computations have been performed using Brentmark Minimum Distributions Calculator and Number Cruncher software.
  7. See IRC Section 2056(b)(7) for requirements of a qualified terminable interest property (QTIP) marital deduction trust.
  8. See IRC Section 401(a)(9)(B)(iii). Using the spouse's life expectancy as the ADP for the trust is the best-case scenario; it assumes that the trust qualifies as a “see-through trust” under the IRS's minimum distribution trust rules, and that the spouse is the oldest beneficiary of the trust (Treas. Reg. Section 1. 401(a)(9)-4, A-5) and also that the decedent's retirement plan permits a “life expectancy payout” of the participant's benefits to a trust-beneficiary. Though virtually all IRAs permit that form of benefit payout, many 401(k) plans do not.
  9. Treas. Reg. Section 1.401(a)(9)-9, A-1.
  10. Treas. Reg. Section 1.401(a)(9)-5, A-7(c)(2).
  11. A successor beneficiary is a person who succeeds to the interest of the original beneficiary when the original beneficiary (having survived the participant, and so become entitled to the benefits) dies without having either (1) withdrawn all the benefits from the plan, or (2) disclaimed the benefits. See Treas. Reg. Section 1.40(a)(9)-5,A-7(c).
  12. IRC Section 401(a)(9)(B)(iv)(II); Treas. Reg. Section 1.401(a)(9)-3, A-5, A-6.
  13. Treas. Reg. Section 1.401(a)(9)-5, A-5(c)(2).
  14. IRC Section 401(a)(9)(B)(iv)(II); Treas. Reg. Section 1.401(a)(9)-3, A-4(a)(2).
  15. Treas. Reg. Section 1.408-8, A-5(a).
  16. IRC Section 664.
  17. See discussion under “Rollover Plan” and Treas. Reg. Section 1.401(a)(9)-4, A-4(b).
  18. IRC Section 2056(b)(3).
  19. See, for example, Private Letter Ruling 2001-26036.
  20. See PLR 2005-16022, allowing the survivors of a mentally incapacitated deceased surviving spouse to complete the rollover of a distribution the spouse had received during her life from her deceased husband's IRA. The IRS also allowed post-death rollovers of pre-death distributions by survivors who were not the spouses of the deceased participants in PLRs 2005-02050 and 2005-16021. Before these three PLRs, the IRS had never allowed anyone other than a (living) surviving spouse to rollover, after the participant's death, distributions made during the participant's life.
  21. 2003-4 I.R.B. 359.
  22. See discussion of successor beneficiaries under the heading “Possible Safeguards.”
  23. A transfer of property cannot be disclaimed once the would-be disclaimant has accepted the property. IRC Section 2518(b)(3). See Rev. Rul. 2005-36, 2005-26 I.R.B. 1368, holding that a retirement plan beneficiary's acceptance of the MRD for the year of the participant's death does not constitute acceptance of the entire retirement plan.
  24. See discussion of disclaimers under the heading “Disclaimer-Activated Plan.”
  25. The IRS has been known to accept a reformed instrument as sufficient to establish a “designated beneficiary” for MRD purposes; see PLR 2002-18039.
  26. See, for example, “Lange's Cascading Beneficiary Plan,” discussed in an article by James Lange, at www.paytaxeslater.com/fp_mrdefenses.htm.
  27. See discussion under article's section on “Premature Death.”
  28. IRC Section 2518(b)(4).
  29. See Dancy v. Comm'r, 872 F. 2d 84 (4th Cir. 1989) in which a son, as executor of his mother's estate (of which he was sole beneficiary) was allowed to make a qualified disclaimer on her behalf of her interest as surviving joint owner of certain property she held jointly with her predeceased husband, though the son was also the beneficiary of the husband's estate which would receive the property as a result of the disclaimer; and PLR 8749041 (also involving close-in-time deaths of two spouses, where the disclaimant was the fiduciary and beneficiary of both estates).
  30. Nickel v. Estate of Estes, 122 F. 3d 294 (5th Cir. 1997).