Donald M. Thompson - Wills, Trusts, and Estate Planning


IRA and Qualified Retirement Plan
Beneficiary Designations

The object is to keep assets in the qualified plan or IRA and defer tax as long as possible. To do this you delay distributions by the owner and name beneficiaries who qualify for extended payment or who can roll over the benefits to their own IRAs and defer distribution even longer. In some cases the plan assets will have to be withdrawn for living expenses and tax deferral is not the most important thing.

Qualified retirement plans and IRAs turn capital gain into ordinary income and make it impossible to take advantage of stepped up basis on death so you should consider:

a) What is age of client?

b) What type of income do they get on plan assets?

c) Maybe they should not contribute any more.

d) Maybe they should start withdrawing from the plan rather than using other assets which are generating capital gain during their life.

Any planning for these interests must consider:

a) All distributions from an IRA or qualified plan are ordinary income and the plan interest or IRA is subject to estate tax on its fair market value on the date of death or the alternate valuation date.

b) Retirement plan interests cannot be given away irrevocably because of the anti-alienation rules under ERISA. Therefore they are not useful for gifting strategies.

c) Retirement plan benefits are Section 691 income in respect of a decedent so the beneficiary does not receive a stepped up basis on death.

(i) The beneficiary gets a deduction for the estate tax generated by the interest. The deduction is not subject to the 2% of adjusted gross income limitation. Section 67(b)(7).

d) The generation skipping transfer tax (GST) applies to interests passing to beneficiaries assigned to at least two generations below the owner. The exemption is $1,500,000 through 2003, $2 million in 2006-2008 and $3.5 million in 2009.

(i) There is an income tax deduction for GST taxes under Section 691(c)(3).

e) Distributions to the owner before age 59-1/2, except in limited instances, are subject to a 10% penalty.

There are minimum distribution rules - the tax shelter cannot last forever. There are 2 sets of rules. One for distributions during the owner's life and one for distributions after the owner's death.

The same rule is applied regardless of who is the named beneficiary, except if a spouse is the sole beneficiary and is more than 10 years younger than the owner.

During the life of the owner the same rule is applied regardless of who is the named beneficiary, except if a spouse is the sole beneficiary and is more than 10 years younger than the owner. Distributions must begin by April 1st following the calendar year in which the owner reaches age 70-1/2 (or, for a qualified plan, and not an IRA, when the owner retires, if later)

The distributions are calculated each year from a table based on joint life expectancies of the owner and someone 10 years younger. Reg. 1.401(a)(9)-9. If the spouse is the sole beneficiary and more than 10 years younger actual life expectancies can be used to make the calculation. A trust for the spouse can be the beneficiary. If the owner has more than one IRA, generally all the IRAs can all be aggregated to determine the required amount of the distribution which may be taken from one or more of them. For some IRAs, and qualified plans, the required minimum distribution must be calculated for and withdrawn from each separately.

Distributions after death of the owner are governed by another set of rules. One set of rules applies if the owner dies before what would otherwise be the required beginning date for distributions if the owner was alive. Another set of rules applies if the owner dies after the required beginning date. Some general rules apply in both situations. The rules applying to both situations are set forth in the next paragraph.

A surviving spouse who is the sole beneficiary can elect to roll over IRA and qualified plan benefits to the spouse's own IRA or elect to be treated as the owner of the decedent's IRA. Other beneficiaries cannot roll over benefits. However, there are deferred distribution options if there are "designated beneficiaries". "Designated beneficiaries" are one or more individuals who i) are designated on the date of death; and ii) remain as beneficiaries on September 30th of the calendar year following the year of death. This allows for post-mortem estate planning by disclaimer if you designate multiple contingent beneficiaries. An estate does not qualify as a "designated beneficiary". A trust can be a designated a beneficiary if it is valid, irrevocable at the date of death, has only individual beneficiaries by the September 30th deadline, who are identified, and a copy of the trust agreement is provided to the custodian. If the trust qualifies the beneficiaries of the trust will be the designated beneficiaries of the plan or IRA interest. If the trustee can accumulate principal then the remainder or contingent beneficiaries must be considered. If the trust does not use a fractional share marital deduction formula, income will be recognized on finding of the trust, unless the benefits are payable directly to the marital and credit shelter trusts. Section 691(a)(2) and Reg. 1.691(a)-4. Non-qualifying beneficiaries can be beneficiaries if their interest is paid to them in full before the September 30th deadline.

When the owner dies before the beginning date for the owner's required distribution and there is no designated beneficiary, then the benefits must be paid in full by the end of the calendar year containing the fifth anniversary of death. If the owner's spouse is the beneficiary the spouse can elect to have distributions paid over the spouse's life expectancy beginning by the end of the calendar year after the year of death or by the end of the calendar year in which the decedent would have been 70-1/2 without any penalty even if the surviving spouse is under 59-1/2. A non spouse can elect to take payments over his or her life expectancy or may elect the 5 year rule. If there are multiple beneficiaries the life expectancy of the oldest is used unless separate accounts are created. Separate accounts can be established in the name of the owner for the benefit of each one of the several beneficiaries. This can be done by December 31st of the calendar year after the year of death. The separate account exception does not apply in the case of trusts. However, the beneficiary designation can specifically name a separate sub-trust for each, at least if this is done before death of a beneficiary.

When the owner dies after the owner's required beginning date and there is no designated beneficiary benefits must be distributed over the remaining life expectancy of the decedent (according to the single life table as if death had not occurred). If the spouse is the sole beneficiary the distributions must be made over the spouse's remaining life expectancy, recalculated each year. If someone else is the designated beneficiary the distributions must be made over the longer of the beneficiary's life expectancy or the decedent's remaining life expectancy according to the single life table.

For a $1,500,000 Estate the following considerations apply in deciding how to arrange beneficiary designations. If the surviving spouse is designated, the IRA or plan interest will qualify for the marital deduction should estate values grow. The spouse can rollover the interest to a spouse's IRA which allows a new deferral for the surviving spouse until age 70-1/2. On the other hand the benefits cannot be used to fund the credit shelter trust (used for tax tree amount.) However for taxable estates the credit shelter trust can be named as a contingent beneficiary. However for taxable estates the credit shelter trust can be named as a contingent beneficiary and the spouse can disclaim some or all of the benefits if they are needed to fund the credit shelter trust. Or, if the credit shelter trust is not a contingent beneficiary a disclaimer may result in its funding anyway through a will pouring over to a trust which would allocate the benefits to the credit shelter subtrust.

A trust for surviving spouse (rather than the spouse) may be named where there is a second marriage or a spendthrift spouse or just for money management reasons. No rollover so you want to use the maximum deferral period possible under the minimum distribution rules. If the trust allows withdrawal of all income and principal and spouse will be considered the sole beneficiary so the trust can qualify for the marital deduction. If the trust is a Q-Tip (the type of marital deduction trust where all income must be payable to the spouse) the beneficiary designation of the plan or IRA should require distribution of the greater of accounting income or the required minimum distribution. This is because you have to satisfy the Q-Tip rules of all income to the spouse.

If a credit shelter trust is the beneficiary you must keep in mind the amount of estate tax exemption. It is scheduled to increase as follows:

$1.5 million currently

$2 million 2006-2008

$3.5 million 2009

And then who knows

Use a fractional share formula in the trust or income will be realized on funding the trust - unless the beneficiary designation specifies the credit shelter subtrust. Do not specify the trust will pay obligations of the estate which does not qualify as a designated beneficiary. Distributions will be over the life expectancy of the oldest beneficiary unless the separate share rules are utilized. Be careful if the trustee can accumulate principal. GST exemption must be allocated.

The owner's estate does not qualify as a designated beneficiary so do not designate it. Benefits must be distributed in 5 years and may be used to fund a pecuniary amount trust, thus creating realizable income.

Charities were sometimes ideal beneficiaries. They are not taxable on distributions so if the owner has charitable intentions the IRA or plan interest should be given as opposed to other assets. If other beneficiaries are named cash out the charity before the September 30th deadline or use separate accounts. Cash it out before the September 30th deadline.

If the children are designated use separate shares. You can have trusts for their benefit or designate them directly.

If grandchildren are designated use separate shares too. You also have to consider how to allocate the generation skipping tax exemption.

In other modest estate the preferable designation for the married owner will be the surviving spouse or a trust for the spouse with a credit shelter trust or adult children as contingent beneficiaries. The smaller the combined estates of both spouses the more attractive an outright designation of the spouse appears. In taxable estates with no other assets the need to fund the credit shelter amount comes into play.


1. $3,000,000 in IRA and a house worth $300,000.

2. $1,500,000 in an IRA, $1,500,000 in other financial assets and a house worth $300,000.

3. $750,000 in an IRA, $750,000 in other financial assets and a house worth $300,000.

The problem in determining who to name as the beneficiary of a qualified plan or IRA interest is caused by the conflicting needs to designate the spouse to get maximum deferral of income tax and to designate the credit shelter trust to get maximum estate tax savings. To illustrate consider the following.

If the tax free amount if $1,500,000 and the estate is worth $3,000,000 then $1,500,000 given to the kids (credit shelter trust) is free of tax and is not in the surviving spouse's estate when the surviving spouse dies later. The other $1,500,000 escapes tax because it is left to the surviving spouse and qualifies for the marital deduction. When the surviving spouse dies later this second $1,500,000 can be left to the kids tax free in the surviving spouse's estate. In the meantime the surviving spouse can get the income from the credit shelter trust. In this way, even though the tax free amount is $1,500, 000, $3,000,000 can be passed tax free to the children. Qualified plan interests and IRAs complicate this analysis because the whole $3,000,000 or most of it may be composed of these interests. The only way to defer income tax for the longest period is to designate the spouse or spouse's trust as a beneficiary. This leaves nothing to fund the credit shelter trust. If you do find the trust with these interests the minimum distribution rules will cause much earlier income taxation.

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Donald M. Thompson * 55 W. Monroe #3950; Chicago, IL 60603
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