“Be Careful Planning For Your IRA And Retirement Plan Beneficiaries” by John M. Carnahan, III

A recent Private Letter Ruling issued by the Internal Revenue Service in late 2011 (Letter Ruling 201208039) only serves as another example of the importance of planning the beneficiaries designated on your IRA or Retirement Plan Beneficiary Designation form. First, one must remember that Private Letter Rulings are only binding between the government and the taxpayer who requested the Ruling and other taxpayers are not entitled to rely on it. However, Private Letter Rulings do serve as excellent examples of the IRS’s current analysis and enforcement position on tax issues.
IRA accounts, whether Roth, traditional or non-deductible, all have similarities with qualified retirement plans (whether they be 401(k), profit sharing or ESOPs). All have what are known as “Designation of Beneficiary” Forms. These are very similar to the forms used for purposes of the “Designation of Beneficiary” on your life insurance policies. The forms speak in terms of the Primary Beneficiaries and then the Contingent Beneficiaries if for some reason the primary beneficiary or beneficiaries predecease the account holder. The forms usually allow you to designate multiple beneficiaries, for example, equally among your children or issue per stirpes or other variations thereof, or a portion to a spouse and a portion to children, or in some cases charitable beneficiaries (which is an excellent estate and income tax planning tool for some taxpayers). Also, most plan documents have default provisions to the participant’s probate estate.
In the Private Letter Ruling under analysis, a decedent, let us call her Linda, died in 2010, and had already reached her “Required Beginning Date” defined in Section 401 of the Internal Revenue Code (which means Linda had attained the age that required her to begin taking distributions out of the plan) before her death. Linda was survived by four children and she was the owner of an individual retirement account. The Designation of Beneficiary form she had filled out named her “estate” as the beneficiary of the IRA account balance; therefore, she had a probate estate. Linda had a Last Will and Testament that in our practice we would call a “Pour Over Will”, meaning whatever assets went through probate were to be distributed or transferred to a trust. Linda had set up a Revocable Trust which divided her trust into two separate shares at death. One share was a Credit Shelter Trust and the other share a Survivors Trust. Her four children were the beneficiaries of both trusts. The Survivors Trust provided that after Linda’s bills and expenses were paid, the trust would terminate and the assets in the trust were to be distributed equally among her four children.
The problem or the tax issue here is that the children were seeking to rollover their mother’s IRA account balance (an “inherited” IRA), in a tax friendly manner, so that they would be allowed to take the benefits over their remaining life expectancy and not their mother’s or a shorter period. Since Linda, their mother, had already started receiving benefits the children were permitted to continue using her life expectancy for determining the minimum distribution required each year. (Note, if Linda had not reached her Required Beginning Date and started taking distributions, the 5-year rule would have applied requiring the entire IRA account balance to be distributed within 5-years of Linda’s death.) Let’s assume the children were 25 years or younger. That makes a substantial difference in the amount of the required distributions each year, and one must remember that as a general rule, all distributions from a retirement plan or IRA are fully taxable at the time of receipt. Therefore, the shorter life expectancy of Linda accelerates the payment of the income tax. Restated, it is a time value of money calculation, which is one of the theories behind sound tax planning (i.e., normally delay the payment of the tax and leave the assets inside in a non-taxable format to grow and accumulate over an extended period of time). The longer the asset remains in a tax-deferred status, the more money that will accumulate even if you ultimately pay more taxes at the end when you receive the distribution.
The Internal Revenue Service also ruled that the beneficiaries (i.e., the children) would be allowed to divide their mother’s IRA account into four separate shares, which permitted each child to make an individual decision as to how they wanted to administer and invest the funds, but subject to the ruling that the maximum period that the payments could be taken out must be calculated using their mother’s life expectancy. However, by permitting the account to be segregated into four separate accounts, each child was allowed to transfer their share to their own investment advisor, and one child could take their share immediately and pay the tax up front, while the other three might take it out as slowly as permitted, which, once again, is over their mother’s remaining life expectancy in the year of her death.
Unfortunately, with a little bit of planning, Linda could have divided her account into four separate shares for each of her children by making her children the primary beneficiaries on the Designation of Beneficiary form for the IRA rather than her estate. This would have solved all the issues here, i.e., each child would have been allowed to deal with their share the way they wanted, take it to their own investment advisor, and distribute it over their own life expectancy, a much longer life expectancy, not their mother Linda’s shorter life expectancy.
There are numerous alternatives available in how you can use trusts and Designation of Beneficiary forms designating trusts for the benefit of your family, even if you are dealing with minor beneficiaries, for example grandchildren. It takes planning and drafting in order to complete the beneficiary forms in an appropriate manner. However, from a tax planning perspective this is usually money well spent.