Beneficiary Designations for Individual Retirement Accounts and Qualified Plans
Many persons today have relatively large accrued benefits in a qualified employee benefit plan (QP, for example, a 401(k)), or an individual retirement account (IRA). The value of these qualified plans or accounts often constitutes a large portion of the value of their estates.
A QP is usually rolled over into an IRA after an employee retires. A person’s main goal while still alive is to keep the assets inside the IRA for as long as possible in order to defer income taxation of the assets, and to continue to use the IRA as a tax shelter. There are minimum distribution rules that require that assets in an IRA must be distributed out of an IRA by April 1 of the year following the calendar year in which a person attains age 701/2. The amount which must be distributed each year is determined by one simple table, the uniform lifetime table under Treasury Regulation § 1.401(a)(9)-5, Q and A 4(a), subject to the one exception where the sole designated beneficiary is the spouse. All distributions from an IRA are taxed as income.
A person may designate an individual or individuals as beneficiaries of an IRA, or may designate a trust as a beneficiary. The designation of beneficiaries for QPs or IRAs not only governs who receives the QP or IRA upon death, but also affects how rapidly the IRA or QP must be distributed after death. There are therefore serious tax factors implicated in designating beneficiaries.
A person’s after death goals with respect to designating beneficiaries includes, (1) determining to whom it should be given, and whether outright or in trust, (2) maximizing the distributions over as long a period of time as possible in order to defer income taxation of such distributions, (3) qualifying the IRA for the estate tax marital deduction in order to defer and minimize estate tax on the IRA, and (4) if the IRA is used to fund a trust, to avoid recognizing income in respect of a decedent. The selection of a beneficiary will affect these goals which may conflict with each other.
A person should seek professional advice in determining the proper designation of a beneficiary or beneficiaries of an IRA, which may include the combined advice of a financial planner, estate planning attorney, and CPA.
After the death of a person, required minimum distributions are made according to Treasury Regulation § 1.401(a)(9)-5, Q and A 5. If the IRA owner dies before his required beginning date (70 ½) , the distribution period is over the life expectancy of the designated beneficiary. If the IRA owner dies after the required beginning date, then the distribution period is the longer of (1) the life expectancy of the designated beneficiary, or (2) the life expectancy of the IRA owner. A client’s goals may include designating a beneficiary or beneficiaries where the IRA is paid out over a longer period of time after his or her death.
Generally, the beneficiaries of a trust will be considered to be the beneficiaries of the IRA for the purpose of determining the life expectancy payout from the IRA even though the trust is the beneficiary of the IRA. If an IRA has multiple beneficiaries, the general rule is that the designated beneficiary with the shortest life expectancy will be used in determining the required minimum distributions from the IRA (the “separate account rule”). For example, if the beneficiary of the IRA is a QTIP marital trust that pays income to the spouse for life, with the remainder to the children, the spouse and children are all designated beneficiaries of the trust, and the life expectancy of the spouse is then used in determining the required minimum distributions from the IRA.
An IRA is an ideal asset to qualify for the marital deduction. In addition, since an IRA is a shrinking asset due to its built-in income tax liability, a person should consider giving other assets that increase in value to a credit shelter bypass trust. An IRA should not be used to satisfy a pecuniary formula trust, since such use results in the premature recognition of income in respect of a decedent (IRD) for income tax purposes.
If a person is willing to relinquish control of an IRA after death, designating the person’s spouse as the sole beneficiary of the IRA produces the best tax results. The estate tax benefit of this beneficiary designation is that the IRA qualifies for the marital deduction in the person’s estate, and also declines in value because of its built-in income tax liability.
The QTIP trust is a standard way that persons may control property after death and still qualify for the marital deduction. A person may also control the disposition of the IRA by designating a QTIP trust as the beneficiary. Persons normally designate the surviving spouse as the outright beneficiary of their IRAs, but a decision needs to be made as to whether an IRA should be given outright to a spouse where a person desires to control the disposition of the IRA for the benefit of other beneficiaries. Since there are serious income and estate tax considerations, professionals should be consulted in making such designations.
In community property states, like Arizona, an IRA account is community property if it is funded with tax-deferred compensation that a person earned while he and his spouse were residents of a community property state. If so, then the surviving spouse has a ½ community property interest in the IRA regardless of the beneficiary designation for the IRA. The surviving spouse owns ½ of the IRA outright. The surviving spouse may have signed a spousal consent form in which such spouse agreed to the designation of other beneficiaries which disposes of all of the IRA, including the surviving spouse’s community property interest. The question then arises as to whether such waiver is valid absent representation by independent counsel.
Beneficiary designations for IRA accounts therefore raise significant questions, and implicate income tax and estate tax factors. Resolution of such issues, and the satisfaction of a person’s goals, will often require the combined professional advice of financial planners, estate planning attorneys, and CPAs.
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