Individual Retirement Accounts are tax-deferred accounts that, if handled properly, can be an effective vehicle for retirement and can be passed on to a surviving spouse or other heirs while retaining the deferral of income tax. The new IRA rules enacted a few years ago provide post-mortem planning opportunities in an area that previously had little flexibility. To take full advantage of these new opportunities, IRA owners and their professional consultants must pay special attention to the planning details. A lack of proper attention to details can have near disastrous results. The purpose of this article is to point out some potential perils and pitfalls.
IRA Planning in General
The Internal Revenue Service released new proposed Treasury regulations on January 12, 2001, and new final IRA regulations on April 16, 2002.1 These rules simplify administration during the IRA owner’s lifetime and provide new post-mortem planning opportunities. The basic rules provide for required minimum distributions (RMDs) to the IRA owner commencing upon the April 1 immediately following the calendar year in which the IRA owner attained age 70 ½ (hereafter referred to as the required beginning date or RBD), or to the beneficiaries upon the death of the IRA owner. IRA monies are not subject to income tax until distributed to the IRA owner, or after the death of the IRA owner, to the beneficiaries. Distributions are taxed at the recipient’s income tax rate.
The amount of deferral available depends on whether a beneficiary is named, and whether that beneficiary is considered a “designated” beneficiary. Under the new IRA rules, this means a beneficiary must either be an individual or certain trusts. To qualify, a trust must be valid under state law and become irrevocable by its own terms upon the IRA owner’s death. In addition, the beneficiary must be listed on the beneficiary designation form to be considered “designated.” Estates and charities are not considered “designated” beneficiaries in this context. The new post-death distribution period is based on the life expectancy of the designated beneficiary or beneficiaries (if there are separate shares) that remain as of September 30 of the year after the calendar year of the IRA owner’s death. This could be substantial in the case of a young beneficiary. If there is no designated beneficiary, the distribution period is significantly shorter.
Spouses are normally the preferred choice to be designated as the primary IRA beneficiary. Spouses are the only beneficiaries allowed to roll IRAs over into their own name. However, this may be undesirable if it is a multiple marriage; if there are family or financial issues; if the surviving spouse cannot manage money; if the surviving spouse is susceptible to pressure from children; or the surviving spouse has a different dispositive intent than the decedent spouse. Spouses also have the ability to leave the IRA titled in the name of the decedent spouse and take distributions based on the remaining life expectancy of the decedent, but normally this is only used when the surviving spouse is significantly older than the decedent spouse because this severely limits deferral opportunities for the ultimate beneficiaries.
Properly drafted trusts can be used to ensure that the IRA owner’s dispositive intent is followed. For example, a marital trust as primary IRA beneficiary in a second marriage situation would allow IRA distributions to pass through the trust to the surviving spouse for life, with the remaining balance paid to children from the first marriage after the surviving spouse’s death. The downside to such a plan is that the spouse will be deemed the oldest beneficiary of the trust and, hence, the measuring life for RMD purposes; but the surviving spouse will have the benefit of income from the IRA for life without the ability to change the ultimate beneficiaries.
The new IRA rules also specifically provide for three new post-mortem planning tools: disclaimer, distribution, or division. To avoid a taxable gift, disclaimers must be done in compliance with IRC §2518 as well as state statutes. Generally, this is within nine months of the decedent’s date of death. This time deadline is not extended to the September 30 beneficiary determination deadline. A complete distribution to a beneficiary prior to such September 30 is disregarded for purposes of determining who will be treated as designated beneficiaries and will preserve the deferral options for the remaining designated beneficiaries. Finally, accounts may be divided at any time after the IRA owner’s death but must be divided by December 31 of the year following the year containing the decedent’s date of death in order to be eligible for separate share treatment.
The Best Laid Plans
The IRA will be deemed to have no designated beneficiary if an otherwise designated beneficiary predeceases the IRA owner and there is no contingent beneficiary named; or the estate is named, or if there are multiple beneficiaries and one is not an individual; or there is some other breakdown in the planning process. For an IRA owner that dies after attaining RMD status, all of the above would result in a deferral limited to the remaining single nonrecalculated life expectancy of the decedent.2 If the IRA owner dies prior to reaching RMD status and there is no designated beneficiary, distribution must be made by December 31 of the calendar year containing the fifth anniversary of the decedent’s date of death. The lack of a designated beneficiary (other than a charity) normally indicates a breakdown in the planning process, especially in light of the new rules. This article presents several common situations to avoid that illustrate a breakdown in the planning process or unanticipated post-mortem complications.
The Ideal Family and the Perfect Plan
In an ideal pre-mortem planning situation, the IRA owner is in a first marriage; all of the children are of common descent and financially responsible with no drug, alcohol, or looming divorce issues; and the surviving spouse is financially knowledgeable and responsible, and will survive long enough to roll the IRA over. Few families meet these criteria. However, in such an ideal situation, the IRA owner would name the surviving spouse as the primary beneficiary and the children as contingent beneficiaries. If the beneficiary spouse survives the IRA owner, the surviving spouse would then be able to roll over the IRA and designate the children as primary beneficiaries. Upon the death of the surviving spouse, the children will be treated as designated beneficiaries and will be eligible to take distributions from the IRA based upon their individual life expectancies. In this scenario, even if the beneficiary spouse predeceases the IRA owner, the children are designated properly as the contingent beneficiaries and will be able to take distributions based upon their individual life expectancies. All of this presumes, of course, that all RMDs are made timely and that all relevant deadlines are complied with.
The Case of the Untimely Demise
What would happen if the beneficiary survives the IRA owner but not long enough to take any action? Presumably, the beneficiary survived long enough to inherit the IRA unless the IRA agreement contains other provisions. Pursuant to the IRA rules, the deceased beneficiary is the designated beneficiary unless the estate of the deceased beneficiary disclaims the interest in the IRA. Absent some action on the part of the deceased beneficiary’s personal representative to disclaim, RMDs made from the IRA of the deceased owner will be payable to the estate of the deceased beneficiary, and will be based upon the single nonrecalculated life expectancy of the deceased beneficiary. The IRA will become a probate asset of the deceased beneficiary because it is payable to that estate. In a spousal situation this is not fatal to the IRA, but there will be no additional deferral available to the children This has the potential to complicate an otherwise well-executed estate plan, because the ultimate IRA recipients will be determined by the deceased spouse beneficiary’s will, or if none, by the intestacy laws of the state of residence. There may be additional concerns if there is a deceased nonspouse beneficiary involved. As is the case with a deceased spouse beneficiary, the will should determine the ultimate recipient of the proceeds and, absent a will, the applicable state intestacy statute will apply. Through intestacy, the spouse of the deceased beneficiary, a half-blood sibling, adopted child, or other unanticipated heir might inherit as opposed to keeping the IRA in the chain of lineal descent of the deceased IRA owner.
In most instances, these unintended results can be completely avoided with a combination of proper estate planning and proactive post-mortem planning. First, beneficiary designations should always be layered to provide maximum flexibility if circumstances change. Second, surviving spouse beneficiaries should roll over an inherited IRA or name their own beneficiaries as soon as possible after the death of the IRA owner. Third, nonspouse beneficiaries should also designate their own beneficiaries to avoid the possibility that an inherited IRA could pass through or create a probate estate upon the beneficiary’s death. Finally, a timely disclaimer of the IRA interest by the personal representative of the deceased beneficiary might be able to correct the problem. If a situation arises where an IRA is payable to an estate, be aware that PLR 200234019 concluded that the personal representative of an estate could distribute shares of the IRA in kind to the subsequent beneficiaries of the estate without changing the tax status of these accounts. The personal representative assigned the interests in the IRA to the subsequent beneficiaries, and trustee to trustee transfers were done. The IRAs were established in the name of the decedent for the benefit of (FBO) the estate beneficiaries. There was no additional deferral or acceleration of tax liability but, rather, the ability to distribute over the remaining nonrecalculated life expectancy of the IRA owner. Be aware that although the IRS allowed it, not all IRA trustees or custodians (providers) are willing to divide the IRA or allow continued deferral, and contractually limit this option.
The Case of the Disappearing Beneficiary Designation
One common situation that arises is when the original beneficiary designation has been misplaced. Many times, for investment reasons unrelated to dispositive intent, IRAs are moved by the IRA owner, either within the same institution or between institutions. Accounts may be combined for individual asset management or, conversely, divided into separate accounts for use of mutual funds, hedge funds, or similar investments. It is important not to disturb any beneficiary planning that has been put into place when an IRA owner moves or transfers an account for nondispositive reasons.
In the event that the original beneficiary designation cannot be found, the IRA agreement normally provides for a default beneficiary. The majority of agreements provide that the default beneficiary is the IRA owner’s estate. As such, the IRA will be treated as though there is no designated beneficiary and tax deferral will depend upon the age of the IRA owner at death. As discussed earlier, if the IRA owner died testate, the recipients will be determined by will; if intestate, then by statute. If there is a surviving spouse, there may be an elective share issue. In Florida, IRAs and qualified plans now fall under the second tier of the priority system imposed by statute to fund payment of the elective share.3 A surviving spouse potentially has the right to elect 30 percent of the augmented estate, including IRAs. The timing for filing for the elective share is critical in light of the September 30 deadline for IRA beneficiary determination.
In the alternative, some institutions provide a default presuming the surviving spouse to be the beneficiary, absent a valid beneficiary designation. This can be a positive result in a first marriage or other uncomplicated situation; however, if there is a pre-nuptial or post-nuptial agreement, this may open the door for a spouse to argue that the IRA was intended to be left to them despite any prior agreements. It is important to note that there is no federal or state law requirement that an IRA be left to a spouse. A spouse has no ownership rights to an IRA unless the IRA owner and spouse have resided in a community property state. Even if the spouse is originally designated as a beneficiary, there is no duty on the part of the IRA owner or the IRA provider to inform the spouse if the IRA owner changes the beneficiary designation.4
The Case of Conflicting Intent
Often there are conflicting testamentary provisions. There is prolific case law, in Florida and across the country, addressing conflicting testamentary provisions. In Florida, IRAs are not probate assets unless left to the estate intentionally or by default as discussed previously. IRAs are governed by the beneficiary designation rather than by will or probate.5 Most cases hinge upon whether there were specific steps required by the IRA provider to effect a change of beneficiary, whether they were followed, and whether there was intent and substantial compliance.6 It is common for the IRA provider to require that the change be made in writing, in a form prescribed by such provider, and delivered to and accepted by the provider. Failure to comply with the requirements of the IRA provider may result in the beneficiary designation being rendered ineffective. At the time of this writing there is only one reported case specifically dealing with the issues of intent and substantial compliance without a written beneficiary designation. In re Estate of Golas, 751 A.2d 229 (Pa. Super. 2000),7the decedent was a cancer patient and made numerous attempts to change his beneficiary designation to name his sister prior to his death. He repeatedly made his intent clear to his attorney as well as two brokers, but died while waiting for the change of beneficiary form. The court found sufficient intent and substantial compliance on the part of the decedent and awarded the IRA to the sister. It is not known how the IRS would view such a beneficiary designation for purposes of deferring distributions.
The Case of the Diminished Distribution
Trusts are often used as an effective and necessary estate planning tool in IRA planning. Sometimes a trust is used for estate planning advantages and sometimes for reasons of necessity. For example, if there are minor children or grandchildren, a trust may be necessary to avoid the cost, expense, and hassle of a guardianship. Other reasons could include heirs with special needs issues, spendthrift issues, substance abuse issues, or just for the purpose of controlling the ultimate disposition of the IRA owner’s assets. Trusts can also be used to layer the beneficiary designation in an attempt to make full use of a credit shelter amount, or to keep money in a marital trust for a second spouse. There are several requirements that must be met in order to obtain maximum income tax deferral.8 To preserve income tax deferral options, it is important that the trust qualify for “look through” treatment, so that the life expectancy of the oldest beneficiary of the trust can be used for distribution purposes.9 Two requirements must be met in order to use separate life expectancies for separate sub-trusts and qualify for separate share treatment under the final IRA rules: 1) the interests of the beneficiaries must be expressed as fractional or percentage interests as of the date of death of the IRA owner; and 2) separate accounts must be established by December 31 of the year after the IRA owner’s death.
If the trust meets all of these requirements, there is yet another issue to be considered: How does one determine trust accounting income and principal for purposes of distributions? While it is understood that all distributions from an IRA are subject to income tax, characterization of the distribution as trust accounting income or principal will determine whether the IRA distribution passes to the trust beneficiary or is taxed within the trust at the potentially higher trust tax rate.
The treatment of such distributions is addressed in Florida’s Uniform Principal and Income Act. F.S. §738.602 prescribes rules for determination of the trust accounting income of deferred compensation plans. The statute provides that if the IRA provider reports how much income was earned within the IRA, then that portion of the distribution shall be treated as trust accounting income and the balance will be treated as trust accounting principal. If the IRA provider does not report this information, the default rule requires that 10 percent of the distribution be allocated to income and 90 percent be allocated to principal. However, to the extent that the distribution is not a RMD or is a lump sum distribution, the default rule requires that the entire distribution be treated as principal. There is an exception carved out in the statute regarding qualification of the marital deduction.
For illustration, consider a situation where both spouses have assets equal to the current credit shelter amount. If the IRA owner spouse had no other assets to fund the credit, the IRA owner might name a credit shelter trust as the primary beneficiary of the IRA. If the surviving spouse is an income beneficiary of the credit shelter trust, then the surviving spouse will be the measuring life for RMD purposes. Suppose that, in a given year, the RMD for the IRA is $20,000 but the IRA is invested for growth and only earns $5,000 that particular year that can be characterized as income. The $20,000 RMD would be distributed to the trust. The $5,000 characterized as income would be passed out as an income distribution to the surviving spouse, taxable at his or her applicable income tax rate. The remaining $15,000 would be left in the trust as accounting principal. The trust would be responsible for paying the income tax on $15,000 which would, of course, probably be taxed at the higher trust tax rate.
This is not a total disaster, but if the surviving spouse is dependent upon receiving all of the RMD as part of such spouse’s annual income, it may be a surprise that only $5,000 is paid as opposed to $20,000. In the ideal family situation where the remainder beneficiaries are children of both spouses, this should not cause a problem; but in a multiple marriage scenario where the surviving spouse and step-children may not get along, this may be a source of some contention. It is possible and prudent to draft out of this situation by making provision in the trust document that all RMDs are to be treated as income and shall be distributed as such, so long as doing so would not violate the underlying intent of the trust.
The Case of the Reappearing Former Spouse
As in many states, F.S. §61.075 requires equitable distribution in the event of divorce. The estate planning issue most commonly overlooked after divorce is changing beneficiary designations. An Internet search of case law on IRAs reveals a proliferation of cases involving this very issue. The seminal case in Florida regarding this issue is Cooper v. Muccitelli, 661 So.2d 52 (Fla. 2d DCA 1995). The couple divorced and the husband subsequently died without changing his beneficiary designation to remove his former spouse. A question was certified to the Florida Supreme Court regarding the court’s holding that, without specific reference in a property settlement to life insurance proceeds, the beneficiary of the proceeds is determined by looking only to the insurance contract. The Florida Supreme Court examined the dissolution terms as well as the insurance documentation. The court’s analysis concluded that the husband had the ability to name anyone of his choosing as beneficiary and that clear instructions were provided to him regarding making a change of beneficiary. He took no action after the divorce to effectuate a change and, therefore, the former spouse remained as the beneficiary. This situation may be avoided with specific language regarding division of the IRA in the separation agreement10 or by simply executing a new IRA beneficiary designation.
Currently, the Florida Statutes provide that when someone fails to change their revocable trust or will after divorce,11 the former spouse will be treated as having predeceased the decedent. The statutes do not, however, govern any account whose disposition is determined by a beneficiary designation, such as an IRA.12 A proposed statute is currently being contemplated by the Real Property, Probate and Trust Law Section of The Florida Bar that would provide a similar presumption for IRAs and other pay-on-death accounts
The Case of the Beneficiaries Who Really Weren’t
There is a growing area of concern in the world of IRA administration regarding IRA annuities. Notwithstanding any opinions as to investment suitability or duplication of benefits in regard to creditor protection or tax deferral, the fact is that many IRA owners also own IRA annuities. In most cases, if an IRA owner wants to consolidate accounts for ease of record keeping, it is possible to transfer the IRA annuity into another IRA. If handled correctly, the IRA owner is still the annuitant, but the IRA is the owner and beneficiary of the annuity. The annuity becomes an asset of the IRA. If the ownership and beneficiary designation cannot be changed to reflect the IRA, the IRA owner should be advised of such and the IRA annuity should be handled as a totally separate account; but we do not live in an ideal world.
Consider a situation in which the parents have an extensive estate and the children are all quite successful in their own regard. The IRA owner decides to leave the IRA, valued at $1,500,000, to grandchildren, and signs a new beneficiary designation form. The next month’s IRA statement reflects the grandchildren as the beneficiaries of the IRA. Two months later, the IRA owner dies. Shortly thereafter, the IRA owner’s CPA and attorney discover that the bulk of the IRA is composed of five different IRA annuities with five different beneficiaries at four different companies. Some beneficiary forms named children and some named a defunct irrevocable trust listed as contingent beneficiary. How could the professionals preserve the IRA owner’s intent? The primary beneficiaries all disclaimed; the trustees of the irrevocable trust disclaimed; the estate of the deceased IRA owner disclaim; and finally, a settlement agreement was drafted and agreed to by all parties and filed in the probate court, documenting the IRA owner’s intent. Court orders were issued; all of the various annuities were eventually paid into the IRA; and the grandchildren all received death benefit IRAs just as the IRA owner intended. This story had a happy ending, with the possible exception of the attorneys’ fees, time, and court costs associated with resolving the problem, but not all families are ideal.
The outcome might have been dramatically different if the family had not been in agreement. This case could have potentially been tied up in court for several years. The expense in terms of legal fees and time could have been tremendous. The brokerage firm in question lists the annuities on the statement as a courtesy, but the market value of the annuities is reflected in the total market value, shown in the same place as the listed beneficiaries. To the untrained eye, and to the IRA owner, it would appear everything was in order. There is a disclaimer on the page where the annuities are individually listed stating that the brokerage firm is not responsible for the investment performance of the annuities; but there is no disclaimer stating that the annuities may have different beneficiaries than the rest of the IRA.
The moral of this story is that sometimes it is not enough to review the beneficiary designation forms or even keep copies of them. It is imperative for the IRA owner and their professionals to periodically review the IRA agreements that govern their accounts, and apparently review the statements as well.
Retirement accounts are rapidly becoming one of the largest sources of personal wealth in this state and in the country. Practitioners in this area need to consider not only the applicable tax laws but other issues that may not be as obvious. This article has attempted to address a few of the most common situations, although there are many, many more.
1 The new proposed and final regulations are included in §1.401(a)(9)-0 through §1.401(a)(9)-8; §1.403(b)-2; §1.408-8; and §54.4974-2.
2 Prop. Reg. §1.401(a)(9)-4, A-3(b) and §1.401(a)(9)-5, A-5(c)(3).
3 Fla. Stat. §732.2075(1), (2).
4 Anton v. Merrill Lynch, 36 S.W. 3d 251 (Tex.App.-Austin, 2001).
5 31 Am. Jur. 2d Executors and Administrators §502 (1989).
6 See Goter v. Brown, 682 So. 2d 155 (Fla. 4th D.C.A., 1996); Bielat v. Bielat, 721 N.E. 2d 28 (Ohio 2000); In re Estate of McIntosh, 733 A. 2d 649 (N.H. 2001); In re Estate of Gloege, 649 N.W. 2d 468 (Minn. App. 2002).
7 See also In re Estate of McIntosh, 773 A.2d 649 (N.H. 2001); In re Estate of Eastman, 760 A.2d 16 (Pa. Super. 2000).
8 Regs. §§1.401(a)(9)-4 A-5 and 1.401(a)(9)-5, A-7.
9 Regs. §§1.401(a)(9)-4 A-5 and 1.401(a)(9)-5. A-7.
10 See also Vaughan v. Vaughan,741 So.2d 1221 (Fla. 2d D.C.A. 1999); In re Estate of Dellinger, 760 So.2d 1016 (Fla. 4th D.C.A. 2000); Luszcz v. Lavoie, 787 So.2d245 (Fla. 2d D.C.A. 2001).
11 Fla. Stat. §737.106 and Fla. Stat §732.507.
12 See also Schultz v. Schultz, 591 N.W. 2d 212 (Iowa 1999); Pinkard v. Confederation Life Insurance Company, 647 N.W. 2d 85 (Neb. 2002).