New Planning Pointers

The following planning pointers illustrate various required distribution issues under the new proposed regulations released on January 11, 2001 dealing with IRA's, qualified retirement plans and TSA's. They are identical to the alerts listed in the second part of "Financial and Estate Planning Implications of the New Minimum Distribution Rules." The New Rules of the Road spelled out in the first portion of that lengthy document outline various facets of the new proposed regulations. The New Planning Pointers, on the other hand, apply those rules to everyday circumstances that confront people in the real world. The author welcomes suggested additions.

Disclaimer

Readers must take note that information presented in this document reflects the author’s attempt to describe various points of the Federal tax law. Some important topics have been omitted. Keep in mind that state tax laws may differ from the Federal rules. While every effort has been made to accurately report the provisions of the Internal Revenue Code and the Regulations pertaining thereto, it is possible that a misrepresentation has occurred. Naturally, the Code and Regulations control the tax treatment of any situation, not the author’s interpretation. Therefore, taxpayers should rely on the tax law rather than positions put forth in this paper.

New Assorted Planning Pointers

A. Always have a beneficiary designation on file with the plan administrator regardless of the age of the participant. Whenever possible, the named beneficiary should also qualify as a Designated Beneficiary so there will be added stretch-out potential for the postmortem required distributions. This is especially important if a participant dies before the required beginning date. Under those circumstances the absence of a Designated Beneficiary will force a complete distribution of the entire account by the end of the fifth year following the year the participant dies.

B. If a non-DB is a beneficiary of an income and/or remainder interest as of December 31 of the year following the participant’s death, NONE of the beneficiaries will be treated as a Designated Beneficiary, even if the rest of the named beneficiaries would otherwise qualify as DB’s. This is true under all circumstances controlled by §401(a)(9). Please remember that each separate account is independent of all others when the time comes to determine its designated beneficiaries. A further explanation of this point appears on page 10 of this manuscript. Also see item “E” below for examples of beneficiaries that do not qualify as DB’s and an explanation of the implications. [§1.401(a)(9)-5, A-7(a) & §11.401(a)(9)-7, A-2(b)]

C. When a surviving spouse opens a spousal rollover IRA, be sure to simultaneously select beneficiaries that qualify as Designated Beneficiaries. The reasons parallel those stated in items “A” and “B” above.

D. Whenever possible, a secondary and tertiary beneficiary should be named for each account in case the primary beneficiary predeceases the participant. In addition, well-planned contingent beneficiary designations will help facilitate postmortem planning by beneficiaries who might wish to execute disclaimers. (See item "J" for a discussion of valid disclaimers.)

E. Extra care should be taken if you are considering using an estate, charity, partnership or corporation as a beneficiary. Those four entities do not qualify as a Designated Beneficiary. (See item “B”.) If a non-DB fails to remove its share of the account prior to the end of the year following the year of the participant’s death, the other beneficiaries will lose valuable stretch-out potential. One sure way to avoid this possible trap is to establish a separate account exclusively for qualified plan assets that will fund gifts to charity. This is important regardless of the participant’s age. (See items “B”, “H” and “P”.)

F. Avoid naming members of two generations as joint beneficiaries of the same account. If a large age differential exists among beneficiaries of the same generation, even siblings, split the assets into multiple accounts before the RBD. This will prevent the younger beneficiaries from being penalized by the shorter life expectancy of the oldest beneficiary. Use non-prorated MRD’s each year to keep the various accounts proportionately balanced. Please remember that there is still some doubt about whether it is possible to split a qualified plan into separate shares following a participant’s death after his or her RBD. (See the discussion of “separate accounts” on the page of this web site entitled New Technical Terms.)

G. Terminally ill participants in corporate qualified plans should seriously consider taking a lump sum distribution so the assets can be rolled over into one or more IRA’s -- especially if there is a non-spouse beneficiary. An IRA will provide the heirs greater flexibility than a pension, profit sharing or stock bonus plan following the participant’s death. Make sure the client will not lose valuable medical, dental, life and other insurance coverage if it is necessary to separate from service to become eligible for a lump sum distribution.

H. The spousal exception to the five-year rule in pre-RBD death cases is prohibited if the spouse is not the sole primary beneficiary of a separate account. Assuming the other beneficiaries qualify as DB’s, the spouse and the other beneficiaries could use the general exception to the five-year rule -- provided it is permitted under the plan provisions. If one or more of the other primary beneficiaries do not meet the DB requirements, ALL beneficiaries must use the five-year rule. (See item “B”.) [§1.401(a)(9)-5, A-7(c)(3), Example 2(iii) and §1.401(a)(9)-8, A-2(b)]

I. Letter Ruling 9237038 points out that an EXECUTOR for a surviving spouse that dies before making an election to treat the first deceased spouse’s IRA as his or her own IRA cannot make that election for the deceased surviving spouse. In other words, an executor for the second to die cannot carry out a spousal rollover if the surviving marriage partner fails to do so before his or her own death. Even under the more generous rules of the new proposed regulations, this could result in the loss of valuable tax deferral. Had the rollover to the spousal IRA taken place, the surviving spouse would likely have specified the couple’s children as his or her own beneficiaries. Following the death of the surviving spouse, the beneficiaries of that spousal rollover IRA would be eligible to compute MRD’s using the life expectancy of the oldest DB. Without a spousal rollover there is a reasonable chance that the surviving spouse may have been unable or failed, due to incapacity or procrastination, to name his or her own beneficiaries of the inherited account. In that event there will be no DB when the second spouse dies because his or her estate is likely to be the beneficiary of the inherited account by default. That sequence of events will force the heirs of the estate, most likely the couple’s children, to use the considerably shorter single life expectancy of the second deceased parent when computing required distributions. [§1.401(a)(9)-5, A-5(a)(1)]

J. The new proposed regulations issued on January 11, 2001 clearly establish the Service's willingness to recognize disclaimers for purposes of required distributions under IRC §401(a)(9). [§1.401(a)(9)-4, A-4(a)] Hence, a primary beneficiary that executes a valid disclaimer by the nine-month deadline following the participant's death will not be considered a beneficiary when it come time to determine DB's on the designation date. This technique creates a number of postmortem planning opportunities. Unfortunately, most beneficiary election forms provided by qualified retirement plans, IRA's and TSA's do not readily accommodate disclaimers if several individuals (children) are listed as primary beneficiaries. In the event one of the latter executes a valid disclaimer, his or her share is usually divided among the other primary beneficiaries (siblings). This occurs even if the participant named contingent beneficiaries(grandchildren). In order to overcome this dilemma, planning professionals need to encourage 401(k) administrators, IRA custodians and TSA trustees to add language to their beneficiary forms that will allow participants to direct benefits to specific contingent beneficiaries if a particular primary beneficiary elects to disclaim his or her rights.

K. If a trust is to be used as a beneficiary for a qualified plan, do so only after a thorough review of the distribution rules and how they interact with the other estate planning needs. Pay special attention to the possibility that a trust may contain language that prevents it from qualifying under the Designated Beneficiary Rules. Finally, be sure to deliver a copy of the trust instrument, or the substitute documentation specified in §1.401(a)(9)-4, A-6 of the new proposed regulations, in a timely manner to the plan administrator. For more details refer to "Trust As Beneficiary" on the New Technical Terms page of this web site. Then be sure to review the language of §1.401(a)(9)-4, A-5 and A-6 in the new proposed regulations.

L. If a QTIP trust is to be used as a beneficiary for qualified plans, peruse Rev. Rul. 2000-2. The ruling provides specific guidance to insure that such a trust agreement qualifies for the martial deduction while simultaneously satisfying the rules for minimum annual withdrawals from qualified plans. Please note that the executor needs to make the QTIP election under §2056(b)(7) for BOTH the qualified retirement plan or IRA as well as the trust that is named as its beneficiary. Remember too, a QTIP trust must adhere to all the normal distribution rules for trusts. (See item "K".)

M. Although an irrevocable trust may be named as the beneficiary of a qualified plan, it is permissible to change to a new irrevocable trust as often as necessary to facilitate alterations in the estate plan.

N. Married participants often select their spouse as the primary beneficiary for qualified plans and specify a family trust as the contingent. However, it may cause problems if the non-participant spouse wishes to disclaim all or a portion of the plan benefits. (See item “J”.) While the disclaimer may be valid, one portion (the survivor's trust) of the typical family trust that is named as the contingent beneficiary remains revocable after the death of the first trustor. Proposed Regulation §1.401(a)(9)-4, A-5(b)(2) states that a trust named as the beneficiary of a retirement plan or IRA must become irrevocable on or before the participant's death to satisfy the Designated Beneficiary Rules. Failure to achieve DB status can severely limit the stretch-out potential of distributions to a living trust regardless of the participant’s age at death. Of particular concern is the five-year rule described in §401(a)(9)(B)(ii) when the participant dies before his or her required beginning date. Please note that some commentators feel that the grantor trust provisions spelled out in IRC §671-679 allow the survivor's trust under these circumstances to overcome the irrevocability clause of the new proposed regulations mentioned above. In fact, at least one private letter ruling (LTR 199903050) appears to embrace this conclusion. However, the new proposed regulations mention no exceptions to §1.401(a)(9)-4, A-5(b)(2). Fortunately, there is one sure means by which a plan participant can preserve his or her survivors' right to use the general exception under §401(a)(9)(B)(iii) when a trust is named as the contingent beneficiary and the surviving spouse is the primary beneficiary. To do so, make the contingent beneficiary the portion of the family trust that becomes irrevocable upon death of the plan participant -- not the whole family trust. That is to say, be specific by naming the bypass, credit shelter or QTIP trust as the contingent beneficiary. [§1.401-(a)(9)-4, A-5]

O. If the rights to receive plan assets pass to a trust upon the death of a participant, the required distributions will eventually exceed the income earnings of the qualified plan. From then on, the trust will be forced to recognize the principal portion of the required distributions as taxable income to the trust. If the trust in turn passes out that principal to the income beneficiary to avoid a potential 39.6% Federal tax rate, the basic purpose of the trust may be compromised. Imagine the uproar that would emanate from the beneficiary of a remainder interest in a CST or QTIP trust if the surviving spouse, in a second marriage situation, started receiving principal. If a trust needs to be the beneficiary for a qualified plan, be sure the trust defines income and principal as the two words apply to distributions from a qualified plan. This last tip may also help overcome the artificial assumption built into many state uniform principal and income acts that limit income to a very small percentage (only 10% in California) of a required distribution from qualified plans.

P. Beneficiaries of the remainder interest in a bypass or credit shelter trust as well as a QTIP trust may have to wait for the death of the income beneficiary, usually the surviving spouse, before receiving benefits, but that is only a timing issue. The remainder persons will receive something, albeit delayed. Therefore, the life expectancy of the remainder beneficiaries must be considered when deciding the Designated Beneficiary with the shortest life expectancy. [§1.401(a)(9)-5, A-7(c), Example 2(iii)] Remember that if a charity or other non-DB has a remainder interest, you have “non-DB status”. (See items “B” and “E”.)

Q. Following the death of a participant, a non-spouse DB may name a beneficiary of his/her own to receive the balance of the participant's account if the original DB dies before withdrawing all the funds. The beneficiary's action does not impact the required distribution calculations. For a prolonged period many IRA custodians and trustees felt that this action was not permissible. Fortunately, the new proposed regulations expressly bless it in §1.401(a)(9)-5, A-7(d)(1).

R. Rather than execute a spousal rollover, a surviving spouse that is the sole primary beneficiary of a decedent's qualified plan is permitted to leave the assets in that account and postpone required distributions until the year the deceased participant would have attained age 70½. [§401(a)(9)(B)(iv)] This Spousal Exception is often considered when the survivor is younger than age 59½ because the 10% Federal excise tax on pre-59½ distributions does NOT apply when he or she taps the account. In contrast, the exercise tax will apply to early withdrawals from a spousal rollover account. Unfortunately, a surviving spouse that has avoided the 10% excise tax on early distributions because of the exclusion under IRC §72(t)(2)(A)(ii) may lose the right to subsequently transfer the deceased participant's qualified plan to a spousal rollover IRA of his/her own. (See LTR's 9418034 and 9608042 but be sure to contrast them with LTR 200110033.) Please keep in mind that when required distributions finally begin under the Spousal Exception in IRC §401(a)(9)(B)(iv), minimum withdrawals must be computed using the surviving spouse's single life expectancy on an attained age basis, rather than the more favorable values found on the Uniform Table that would apply to a spousal rollover. During the survivor's lifetime, that differential could produce a significant disadvantage in the form of larger taxable distributions. The Spousal Exception is also detrimental if the survivor dies after commencement of required withdrawals. At that point the new proposed regulations force the ultimate beneficiaries (probably the couple's children) to complete those required distributions based on the single fixed-period life expectancy of the surviving spouse established on that person's birthday in the year of death. [§1.401(a)(9)-5, A-5(b)] The new rule effectively compels the children to greatly accelerate withdrawals and, hence, forego the tremendous stretch-out potential that would have been available to them as beneficiaries of a spousal rollover.

S. The new proposed regulations list the life expectancy rule as the default method when participants die before the RBD -- provided there is a Designated Beneficiary. This change may prevent non-spouse DB's from being forced to adhere to the Five-Year Rule if they forget to withdraw the first required distribution by December 31 of the year after the participant's death. Unfortunately, there is no escape from that quicksand if a qualified plan mandates the Five-Year Rule or uses it as its default in the event a beneficiary fails to make an election to the contrary. However, rescue is possible in cases where a plan stipulates that a non-spouse DB must use the General Exception to the Five-Year Rule, lists that exception as the plan's default if the DB forgets to make an election to use it, or is silent as to what method must be followed if no election is made. In each of the latter three scenarios, the DB may be liable for a 50% excise tax under §4974 on the undistributed required distribution, but he or she will no longer fall victim to the Five-Year Rule. (See §1.401(a)(9)-3, A-4 and Table 24)