IRAS and Estate Planning (Part 2)

Death of a Client before the Required Beginning Date (RBD)

If the beneficiary is not a designated beneficiary, the balance of the IRA must be completely distributed before Dcc. 31 of the year of the fifth anniversary of the client’s death (“the five-year rule”). If the beneficiary is a designated beneficiary, the balance of the IRA can also be distributed through required minimum distributions (RMD) calculated using the life expectancy payout based on the age of the designated beneficiary.

If the client has selected a nonspouse designated beneficiary, RMDs must begin by Dec. 31 of the year following the year of the client’s death. If the designated beneficiary fails to receive his or her RMD by that time, the entire IRA balance must be distributed under the five-year rule.

With multiple beneficiaries, if any single beneficiary does not qualify as a designated beneficiary by the designation date, then the IRA must be distributed under the five-year rule. If all of the beneficiaries qualify as designated beneficiaries as of the designation date, the RMDs must be calculated using the oldest designated beneficiary’s life expectancy. If a qualifying trust is a designated beneficiary, the RMD must be calculated using the life expectancy of the oldest trust beneficiary. See the section titled “Separate Account Treatment” for possible postmortem planning opportunities,

Death of a Client on or afte the RBD

The RMD is calculated in the year of the client’s death as it would have been had the client not died. Any RMD not distributed before the death of the client must be distributed to the beneficiary by Dec. 31 of the year of the client’s death.

If the beneficiary is not a designated beneficiary, he or she may take a total distribution of the account or may take RMDs over a period no longer than the client’s remaining life expectancy in the year of the client’s death, beginning Dec. 31 of the year following the year of the client’s death using the Single Life Expectancy Table.

With a nonspouse designated beneficiary, all post-death RMDs must begin by Dec. 31 of the year following the year of the client’s death. The designated beneficiary may choose to calculate the RMDs based upon his or her life expectancy or upon the client’s remaining life expectancy in the year of death if the client Was younger,

If there are multiple beneficiaries and one or more are not designated beneficiaries by the designation date, the client is treated as having no designated beneficiary, and the account must be distributed over a period no longer than the client’s remaining life expectancy. If all of the beneficiaries qualify as¬†designated beneficiaries, the RMDs may be calculated using the oldest beneficiary’s life expectancy or the client’s life expectancy if the client was younger than the oldest beneficiary. If a qualifying trust is the designated beneficiary, the RMDs may be calculated using the life expectancy of the oldest trust beneficiary or the client’s life expectancy if the client was younger than the oldest trust beneficiary.

Separate Account Treatment

Death of a Client on or after the RBDRegardless of whether the client dies before or after the RBD, the RMDs will be calculated using the life expectancy of the oldest beneficiary if there are multiple designated beneficiaries. However, there is an opportunity for some beneficial postmortem planning by using the separate account rules. H separate accounts are created for the designated beneficiaries prior to Dec. 31 of the year following the year of the client’s death, each designated beneficiary may calculate RMDs using his or her own life expectancy. In the case of a spouse beneficiary, he or she has all the same options for the new separate IRA as if the spouse were the sole beneficiary of the decedent’s IRA. Separate accounts may be created by segregating assets within a single decedent IRA or, more simply, by dividing the decedent IRA into a separate account for each beneficiary.

The regulations provide that the separate account rules are available only if the investment gains and losses accruing after the date of death are allocated pro rata among the beneficiary shares. Therefore, the client and professional should calculate shares by using a percentage or fractional formula. Separate account treatment could be problematic if the shares are determined under a pecuniary formula and the beneficiary designation language does not specifically provide for pro rata allocations of investment gains and losses.

The separate account rules are not available to the beneficiaries of a trust. For example, if a trust is named as beneficiary and the trust agreement provides for distribution of the trust assets equally among three children, the IRA may be divided into a separate decedent IRA for the benefit of each child. However, the RMDs for all three decedent IRAs would be calculated using the life expectancy of the oldest trust beneficiary, and the separate account rules could not be used to allow each child to use his or her own life expectancy for the decedent IRA.

Designating the Beneficiary

Many clients believe that the selection of an IRA beneficiary is a simple matter of deciding who should receive the benefits of the DRA. However, that is only the first step in the selection process. The second step is to determine if there are any special estate-planning factors that should be considered. For example, a client may have decided that his or her child should receive the benefits of the IRA.

However, the client may also¬†have concerns regarding the child’s ability to handle money. In such a case, the client may Consider naming a trust as the IRA beneficiary as opposed to naming the child outright. This¬†would enable the child to enjoy¬†the benefits of the IRA but also allow the client to put restrictions on the benefits to ensure that the child does not mismanage the funds.

The third step is to determine the consequences of the beneficiary designation. upon the RMD rules. For example, a client may prefer to name a marital trust as the beneficiary to ensure that children from a prior marriage have the possibility of receiving unused benefits upon the spouse’s death. However, by naming the marital trust as the beneficiary, the client’s spouse will be denied the opportunity to benefit from the spousal rollover rules.

The estate- and tax-planning considerations should also be¬†evaluated considering the size of: the IRA relative to other client assets. For example, if the client is charitably inclined, it may be beneficial to name a charity as¬†the beneficiary of a small IRA.¬†This would allow the charity to I¬†receive the IRA with no income tax consequences and allow the¬†client’s other beneficiaries to¬†receive after-tax dollars from¬†other assets. Another example can be illustrated in a second marriage situation. If the IRA is smaller, it may be more beneficial to name the spouse outright if there are enough other assets to eventually benefit children from a prior marriage through the credit shelter trust and marital trust. This would allow the client to benefit from the variety of spousal options. This also has the advantage of simplicity, so the professional does not need to be concerned with some of the complex rules associated with qualifying a trust as a designated beneficiary. However, the beneficiary designations in both examples may become less appropriate as the size of the IRA increases.

Combinations of the various estate- and tax-planning factors are far too numerous for discussion here. The facts and circumstances of the client as well as his or her desires make each situation unique. Sometimes it may be possible to balance the various estate- and tax-planning considerations. Unfortunately, there will be other times when the client must decide among competing considerations.

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