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.

For more information, see my Estate Planning Services section. This article is subject to the Terms, Conditions and Privacy Policy posted on my web site.

Estate planning involves the preparation of a will, or wills for a married couple, and usually a revocable trust, especially for estates which are or would otherwise be subject to the federal estate tax, or, for example, for second marriages with blended families. A revocable trust is a trust created by an individual or married couple during life to hold assets over which he and/or she retains complete control, which can be amended from time to time, or even revoked, but which becomes irrevocable upon the death of an individual, or first spouse to die, at least with respect to that spouse’s assets which are part of the trust. A revocable trust is also called a “living” trust, since it goes into effect when executed and funded, as opposed to a testamentary trust which only becomes effective upon death, and is also subject to probate. Testamentary trusts have become highly disfavored as compared to living revocable trusts.

A revocable trust has several advantages over a will. If the trustor becomes disabled, the designated successor trustee of the trust is able to manage the trustor’s assets for his or her benefit, without court appointed guardian and/or conservatorship proceedings, which are very expensive. In addition, the use of a trust means that the trustor’s assets are distributed in accordance with the provisions of the trust, and are not subject to probate administration and public disclosure. Probate administration is expensive, and also untimely delays the distribution of assets. A trust is also generally harder to challenge than a will. A trust can also protect assets from creditors. A revocable trust also maintains its validity even if trustors change the state in which they reside. A trust, unlike a will, can be used to administer and distribute assets (both income and principal) over an extended period of time after death for children and grandchildren, or other beneficiaries, unlike a will. A revocable trust can also provide for professional fiduciary management of assets by trust companies or banks either initially, or upon the death of the decedent or surviving spouse.

In addition to preparing a will(s) and/or revocable trust, other legal documents are also usually prepared as part of the estate planning process, including a “living will;” a healthcare power of attorney; and a financial “durable” power of attorney for each individual. A durable power of attorney enables an individual called the principal to designate someone as his or her agent to continue to handle his or her financial and personal affairs in the event of disability.

If a revocable trust is created, legal title to property must be changed to that of the trust. In the case of real property, deeds must be prepared and recorded to convey title to the trust. At the same time, the form of ownership in real estate may be changed to that of community property (without right of survivorship) to minimize both federal estate and income taxes. Title to other assets, such as, bank and investment accounts, must also be changed to that of the trust. Life insurance polices must also be changed to name the trust as the beneficiary. Separate personal property owned by spouses might also be changed to that of community property for tax purposes through a separate document known as a “declaration of community property.”

This process is known as the “funding” and “titling” of the revocable trust, and is time-consuming, but constitutes an essential part of the proper establishment of a revocable trust as soon as the revocable trust has been executed. Revocable trusts are only effective as to property that the trustor(s) transfer to the trust. Attorneys and clients usually work together during this funding process, and attorneys customarily charge some additional fees for arranging title transfers and working on funding the trust. Integration of retirement benefits, such as, IRAs, and retirement plans, is also an important part of the estate planning process to accomplish the primary objectives of the parties, while maximizing income tax deferral and achieving estate tax minimization. The use and advice of C.P.A.s and wealth managers is often recommended or even required as an essential part of the over-all estate planning process, especially with respect to the integration of IRAs, retirement benefits, and other investments.

A revocable trust can save literally hundreds of thousands of dollars in federal estate taxes, by incorporating a “marital trust” which primarily benefits the surviving spouse, and transfers part of the decedent’s estate (that part which exceeds the decedent’s applicable exclusion amount, currently $2,000,000) to a marital trust, which is then not included in the decedent’s gross estate for estate tax purposes because of the marital deduction. The marital trust is usually established as a “qualified terminable interest property trust” (”QTIP” trust) under IRC (Internal Revenue Code) § 2056(b)(7). When a QTIP marital trust is used, there are then three separate trusts created for married couples which are part of a revocable trust, namely, the decedent’s trust, the marital trust, and the surviving spouse’s trust, consisting of his or her separate property, and his or her one-half interest in community property.

To qualify a QTIP trust for the marital deduction, the surviving spouse must be entitled to all of the income for life, payable annually or at more frequent intervals; no one, including the surviving spouse, may appoint the property to any person during the spouse’s life; and the decedent’s personal representative (executor) must make an irrevocable election on the estate tax return. The decedent, not the surviving spouse, however, controls the ultimate disposition of assets in the marital trust after the surviving spouse’s death. QTIP trusts usually also permit discretionary distributions of trust principal to the spouse by the trustee, which can be limited to a certain standard, such as, health, maintenance, support, and education. The trust can also provide, however, that there shall not be any invasion of principle from the martial trust as long as there are any readily marketable assets in the survivor’s trust, to attempt to preserve principal in the marital trust for the benefit of the decedent’s beneficiaries upon the surviving spouse’s death. Any remaining assets in the marital trust at the death of the surviving spouse also constitutes part of his or her estate, and is subject to estate taxes if the value of the entire estate exceeds the applicable exclusion amount.

A revocable trust can therefore provide income to the surviving spouse for life from all trust assets, including the marital trust, the decedent’s trust, and the survivor’s trust, and also provide for the invasion of principal for the surviving spouse from decedent’s trust and the marital trust, subject, for example, to an ascertainable standard of living, such as, health, maintenance, support, and education. Upon the surviving spouse’s death, the remainder of all trust assets are then distributed to all beneficiaries, according to the distribution provisions of the revocable trust.

While the creation of a revocable trust involves an initial investment of time, considerable thought, expense, periodic review and potential modifications to the trust, the intangible and tangible benefits, including the saving of expenses to avoid probate, guardianship, and conservatorship proceedings, and the minimization of estate and income taxes, are often compelling reasons to establish a revocable trust. Once a person becomes mentally incapacitated, it is then too late to establish such a trust.

For more information, see my Estate Planning Services section. This article is subject to the Terms, Conditions and Privacy Policy posted on my web site.