On his death Warren left his grandchildren $1,000,000 from his IRA. After taxes they received $192,000. Could this happen to you? IRA and qualified plan distributions are among the most misunderstood areas of retirement and estate planning. IRA tax regulations are unique and applying them requires experience. If you do not live too long or die too soon then IRA distribution planning may not have a high priority for you. But, good planning can make it possible for you to disinherit your primary beneficiary, the Internal Revenue Service. With good planning the tax bite can be minimized or eliminated. But if you fail to plan you may lose all of the retirement funds you want to pass on to your beneficiaries.
The focus of this article is on IRA estate planning. In order to plan you must first examine your estate planning decisions before you look at your retirement decisions.
These Federal taxes could take some or all of your retirement savings:
1. Estate Tax: this is the price you pay to transfer your property at death. There is no federal estate tax for a transfer to your spouse. The federal estate tax presently has a $600,000 lifetime exemption for U.S. citizens. It begins after the first dollar above $600,000 at 37% and can go as high as 60%. With planning a married couple may transfer $1,200,000 in assets without a federal estate tax. Some States impose an estate tax beyond the Federal tax, while some states take part of the Federal estate tax. Your retirement funds are a part of your taxable estate.
2. Gift Tax: this is the price you pay to transfer your property during lifetime. There is an annual $10,000 gift tax exemption for each person receiving the gift. The gift rate is equal to the estate tax rate. Retirement distributions can be subject to this tax if an irrevocable designation is made of an IRA fund to persons other than a spouse. The life time $600,000 exemption may also be applied to this tax.
3. Estate excess accumulations tax: This is an additional 15% estate tax on amounts more than a computed amount based on age at death and the present value of a single life annuity. For example if you die at age sixty and have over $1,128,563 in your IRA the tax is due on amounts in excess of that figure. The figure changes with the age at death.
4. Excess distributions excise tax during lifetime: This is a 15% excise tax on amounts more than an annual maximum distribution. It increases annually and currently is $150,000 in 1995. If there is a lump sum distribution the figure is $750,000.(five times $150,000.00) Don't confuse distributions with rollovers.
5. Premature Distributions (Early Withdrawals): This is an additional 10% income tax on withdrawals received before you are 59 1/2 years old.
6. Excess accumulations above required distributions excise tax: This is a 50% tax on amounts not withdrawn as required under the minimum distribution rules.
7. Generation Skipping Tax: This additional transfer tax which must be computed but may be thought of as equal to 55 percent on amounts passed on to a second generation such as grandchildren. With planning there is a one-million dollar exemption. It is possible without planning for your grandchildren to lose all of your retirement funds. The Federal government feels entitled to 55 percent of each generation's wealth.
Here are some important IRA distribution terms which define whether these taxes will apply to you:
1. Rollover Distributions: A rollover is a tax deferred pay out from one retirement plan to another. You must make your roll over decision by the 60th day after the day you receive the distribution from your plan.The roll over distribution should be paid directly to the new IRA. You may roll over your IRA to another IRA once a year.
2. Minimum Required Distributions: If you do not withdraw your balance by the required beginning date (usually age 701/2) you must withdraw your balance over one of the following periods 1) your life time 2) the lives of you and your designated beneficiary 3) a period that does not extend beyond your life expectancy or 4) a period that does not extend beyond the joint life and last survivor expectancy of you and your designated beneficiary. To find the dollar amount of the distribution divide the gross amount by the applicable life expectancy.
3. Qualified Terminable Interest Property (QTIP) tax treatment: This is an estate planning treatment which allows an asset owned by one spouse to be treated for estate tax purposes as though it were owned by the other spouse. Allowing the use of the $600,000.00 unified credit exemption by the spouse
who does not own the asset.The asset is controlled by a trustee.
4. MDIB rule: The minimum distribution incidental benefit rule has the effect of limiting determination of life expectancy for minimum distributions during lifetime to a maximum of ten years difference (younger) where your beneficiary is other than your spouse. It is designed to have the IRA owner receive most of the benefit.
5. RBD: The required beginning date is the date that you must begin to receive payments from your IRA. This date is April 1 of the calendar year following the calendar year you reach 701/2. Many decisions made on this date cannot be changed after this date.
6.Recalculating life expectancies: You may elect to recalculate your life expectancy each year to reduce your minimum distribution. If you recalculate, your life expectancy will be zero after the year of your death. This will cause an earlier distribution when compared too not recalculating. You must make this election irrevocably by the RBD. Your IRA terms must allow you to make the election. Usually the plan will provide for an automatic recalculation unless you elect not to recalculate. If you recalculate and withdraw only the minimum amount you would have income for life. Without recalculation you could run out of money from your IRA because your life span is fixed.
7. Treasury Regulations Tables V and VI: These tables are used to find single or joint life expectancy to calculate minimum distributions. For example if you have a life expectancy of 20 years at age 65 and $1,000,000.00 fixed in your IRA you would have a minimum withdrawal of $50,000.00 per year. If your wife were 52 you would have a joint life expectancy of 33 years and a minimum withdrawal of $30,303.03 per year. These figures are subject to recalculation.
Let us take an example and change the facts to see the effect each has on our airline pilot.These examples generally presume that our airline pilot has reached his RBD before starting to withdraw funds from his IRA. Warren is a 747 Captain with a major airline. He is approaching mandatory retirement at age 60. He is married to Mary who is five years younger than Warren and they have three grown children and two grandchildren. He has one million dollars in his company fixed benefit qualified pension plan. Warren also owns a $500,000 home a $50,000 vacation home and has other investments of $300,000 and a life insurance policy payable to Mary for $500,000. The value of his estate for tax purposes is $1,850,000.
Warrens' fixed retirement plan provides two funds, a fixed "A" fund and a directed account "B" fund. The fixed "A" fund pays him $80,000 annually for life. He has several options of taking less than the $80,000 with a portion being paid to his wife on his death for her life. Warren has been advised to take the maximum distribution from the "A" fund and purchase a life insurance policy for Mary. Mary must agree in writing to waive the options that protect her under the plan.
For $7,000 a year Warren can purchase a $500,000 variable, zero cash value life policy. When properly invested this will provide Mary with income of $50,000 and an additional $500,000.00 in family assets. He will purchase this policy in his Irrevocable Life Insurance Trust where he has placed his company insurance and other assets. This trust will keep the assets from being taxed in his estate and pass the principal on to his children or grandchildren.
Warren has elected to roll over his directed account "B" fund directly into an IRA to avoid the 20% withholding tax. Mary has consented in writing to the roll over. The advantage of the roll over is that he has control of the funds. He may now have a larger selection of investments and use experienced money manager's or mutual funds to increase the value of his deferred tax investments. Warren has also amended his IRA terms to allow him not to recalculate his life expectancy.
Example one: Warren retires and rolls over his pension funds. He does not need the money now. Warren knows that he should leave the funds in his IRA at least until age 65 so he can accumulate the fund's growth tax free. Warren has named his wife as the beneficiary of the IRA. One year after reaching his RBD Warren died and he made no election regarding recalculation. Therefore it was automatic that his life expectancy would be recalculated. He had not begun to take any of his IRA distributions. After his death Warrens' life span will now be zero for purposes of minimum withdrawal but because his wife is named as a beneficiary her life expectancy is used. Mary as the sole beneficiary will now have the following spousal choices: to roll over Warrens IRA into her own IRA and wait until age 70 1/2 to begin her distributions, or treat Warrens IRA as her own IRA, or begin the distributions over her lifetime beginning December 31 of the year following Warrens death, or the year when Warren would have reached age 701/2. She chooses to treat Warrens IRA as her own and wants to delay the distribution to allow the funds to grow tax free. She knows that tax free growth can be a very powerful financial tool. Mary will use the income from the Irrevocable Insurance Trust for her daily living expenses. If Mary had her own IRA she must consider the tax effect of increasing her IRA with Warrens' IRA funds.
Example two: Warren waits until he must start mandatory withdrawal from his IRA on April 1st the year after he becomes 70 1/2. Warren begins his withdrawals and dies. Mary can exercise the same options as listed in example one . But if Mary were not the beneficiary the named beneficiary would not have the same spousal options as Mary and must take all of the funds over a period equal to the method being used as if Warren were alive. If Warren had not reached his required RBD and was recalculating his life expectancy then all of the funds must be taken in the year following his death if there were no designated beneficiary. Keep in mind that the purpose of our planning is to allow the funds to grow tax free and avoid large withdrawals subject to income tax.It is often better to allow the funds to grow tax free and pay a penalty than to withdraw them and pay the tax.
Example three: Warren's wife Mary dies and a week later Warren dies. Warren had listed Mary as his beneficiary under the plan and Warrens' life was being recalculated. Warrens life span is recalculated to zero. At age 67 he has not reached his RBD.Under their joint sweetheart simple will all his assets go directly to his children. The one million dollars is subject to an estate tax. Warrens gross taxable estate is $1,850,000 dollars including his IRA. Because he did not properly take advantage of the combined estate tax exemption the estate tax is $520,500 and the income tax is $390,000.00 which is IRD (income in respect to a decedent) his state estate tax is $50,000. The remaining amount $889,500 can be paid to his children.
Example four: Warren begins his withdrawals from his IRA immediately and has elected not to recalculate his life expectancy. Warren dies at age 69. He had not reached his RBD and would not have reached it by December 31 of the year after the year of his death. For IRA tax planning purposes withdrawals do not commence before the RBD even if they have actually begun.
His named beneficiaries must take the funds over 5 years by December 31 of the 5th year following the year of Warrens death. If an irrevocable trust were the named beneficiary then the funds could be paid through the trust to the beneficiaries using the age or the oldest beneficiary to determine the minimum distributions.
Example five: Warren is unmarried and has three nephews that he designates as beneficiaries. Bill is 10 years younger than Warren. The others are 15 and 18 years younger. Warren dies at age 65 not having withdrawn any funds from his IRA. If Warren chose to recalculate then his life span would be zero. With his nephews designated as beneficiaries the funds can be distributed over five years unless Warren died at age 70 then the life span of the beneficiaries would be used under an exception but not longer than the life span of Bill under the MDIB rule.
There is no general rule that will fit every situation. Your particular plan must fit your needs. We can come close with this example for a married couple. But we would still have to know more about them. Do they need the money now? Will the spouse sign the required waiver? What are the terms of the retirement plan? What are the payment methods if you die before your RBD? Remember you can design significant provisions of your plan. This is particularly important were there has been a second marriage. Are there any potential lawsuits that should keep savings in a protected pension plan and away from creditors?
Making several assumptions you would roll over your qualified plan into an IRA when you retire. If the additional funds are not needed postpone withdrawals from your IRA as long as possible. Purchase a life insurance policy which will pay sufficient income from the invested principle to your spouse upon your death. Recalculate your life expectancy unless you are ill or there is a family history of early death. Do not recalculate your spouses life expectancy. The planning is not complete at this stage. A few months before Warren reaches his RBD he should again review his financial plan with his advisor. They should finalize his needs and method of withdrawal of IRA funds. The next planning stage is after Warrens death. The beneficiaries or spouse should then review their options and designation of new beneficiaries under the plan.
It is not possible to review every law and circumstance in this article. You should not use this article as a planning tool. The purpose of this article is to bring these potential problems to your attention.