For many financial service professionals, CPAs, trust departments and attorneys, estate distribution planning for clients with $1million to $2 million of qualified plan assets is a daily event. In fact, it is not uncommon for these professionals to be involved in planning discussions with clients holding $3 million to $4 million of QRP/IRA assets alone. The planned distribution of these qualified plan “inheritances” to heirs has become a prime topic of estate planning. The Uniform Distribution Table can help to streamline this “inheritance” process by simplifying minimum required distributions (MRDs).
Of course, the primary barrier to passing these valuable tax-deferred assets to heirs lies in the so-called “double tax.” QRP/IRA accounts are subject to the federal estate tax upon the death of the participant or account owner. The effective rates of estate taxation range from 41 percent to 50 percent at the margin. In addition, any distributions from qualified accounts to the plan beneficiary after the owner's death are treated as income in respect of decedent. The beneficiary must report the distribution as taxable income. An income tax deduction for federal estate taxes attributed to the plan is allowed. The net effect is a “double tax” that can easily reach 70 percent to 75 percent of the account value. Add state income taxes to the mix, and combined tax rates above 75 percent are common.
Proper designation of sequential IRA beneficiaries can maximize income to second- or third-generation heirs over an extended period.
What planning options are available to mitigate or financially offset the impact of this “double tax”? A survivorship life insurance policy owned by an irrevocable trust can restore qualified assets lost to estate taxes. The payment of estate taxes from this source allows the IRA to continue its income-tax-deferred investment growth with relatively low MRDs. In some cases, the favorable distributions can continue from 25 to 40 years beyond the death of an account owner where children are the beneficiaries, and 50 to 80 years where grandchildren are the beneficiaries. (Where grandchildren or trusts for the benefit of grandchildren are the beneficiary, particular attention should be paid to generation-skipping tax issues.) Hence, the proper designation of sequential IRA beneficiaries can maximize an income stream to second- or even third-generation heirs over an extended period of time.
Let's look at an example we will refer to throughout this article.
Facts of the Case: We have a $2 million IRA as part of a $5 million gross estate. The participant has designated a spouse as the sole beneficiary. Approximately $2 million of estate taxes will be due at the surviving spouse's death. Assume an 8 percent rate of return on the IRA. Also, assume the Uniform Distribution Table is used while the participant and spouse are alive.
Phase 1: Lifetime of the participant (Uniform Table)
Assume the participant is 71 years old and the spouse is 67 at the required beginning date for MRDs. Their child is 37. The Uniform Distribution Table life expectancy starts at 26.5 years. At the participant's death, no estate taxes are due since the spouse is entitled to an unlimited estate tax marital deduction. Assume the participant dies in six years at age 77. The account value subject to spousal rollover has grown to $2,510,161.
|Phase 1||8% Growth Rate||Beginning Balance: $2 million|
|Year||Age of Client||Age of Spouse||Table Life Expectancy||Account Earnings||Minimum Distributions||Account Balance|
(The projections illustrated above are hypothetical and not guaranteed.)
Phase 2: Remaining lifetime of surviving spouse (Uniform
The participant dies when he is 77 years old, and the spouse, aged 73, completes a spousal rollover of the $2,510,161 account. The child, now aged 43, is named as the new designated beneficiary. The Uniform Distribution Table life expectancy is now 24.7 years based on the surviving spouse's age at rollover. Phase Two ends at the surviving spouse's death. Estate taxes are due within nine months. Assume the spouse dies at age 79, six years later. The account value inherited by the child has grown to $3,091,351.
|Phase 2||8% Growth Rate||Beginning Balance: $2 million|
|Year||Age of Client||Table Life Expectancy||Account Earnings||Minimum Distributions||Account Balance|
(The projections illustrated above are hypothetical and not guaranteed.)
Phase 3 : Remaining life expectancy of child
The child now has the legal status as beneficiary of an inherited IRA of $3,091,351. This status will remain with the child until the account is fully distributed. The single life distribution table life expectancy of the child is 35.1 years, reduced by one for each year the child lives. If desired, the remaining account value may be distributed over 35.1 years to the child. The account value grows to well over $6 million before being rapidly depleted as the child nears life expectancy.
Because earnings in the IRA may potentially grow at a much faster rate than the relatively low MRD to the child, the IRA value and the income stream produced grow to significantly large amounts. The key that unlocks this potential for maximum IRA deferral is a separate source of funds, like survivorship insurance in an irrevocable trust, allocated to finance the payment of second-death estate taxes. If no separate liquid fund is available to pay estate taxes, the IRA itself may need to be liquidated to pay the taxes.
This large distribution of upwards of $2 million, in our example, will trigger income in respect of decedent (IRD) to the beneficiary. The beneficiary will be entitled to an income tax deduction for federal estate taxes attributed to the IRA, but the resulting “double tax” will destroy the financial viability of the inherited IRA concept. The opportunity for continued income tax deferral on excess account growth will be irretrievably lost to the heirs.
What if estate taxes are permanently
Much has been written about the effect of a permanent, estate tax repeal on the sale of survivorship life insurance to pay estate taxes or “double taxes.” President Bush has stated he would favor a permanent repeal. If the estate tax is ever permanently repealed, a $2 million current IRA could very easily be worth $3 million to $4 million over the next 10 years. Naturally, the confiscatory “double tax” on QRP/IRA accounts of 70 percent to 75 percent would cease to exist. However, there would also cease to exist an income tax deduction for estate taxes attributed to QRP/IRA IRD distributions in respect of decedent distributions. Thus, the beneficiary would be responsible for full federal and state income tax rates that could exceed 40 percent on distributions from qualified accounts.
On the chance that the estate tax is permanently repealed, it would still make financial sense to buy insurance to pay the income taxes attributed to large IRA distributions so that 100 percent of the IRA value can pass undiminished to heirs. The insured account owner could even be the owner of the survivorship life policy as there would be no estate taxes on the insurance death proceeds. Of course, the death proceeds would also be income tax free. The beneficiary of the policy could be the heirs outright or a trust for their benefit, if the account owner felt that professional trust investment management over an extended period was important for the heirs. Remember that an IRA beneficiary of an inherited IRA can always take more than the MRD. An accelerated distribution scheme by an individual beneficiary could quickly deplete the account and thwart the original intent of the account owner.
In contrast, an institutional trustee as IRA beneficiary could provide both professional investment management and a long-term MRD payout, which matches the maximum distribution period based on the life expectancies involved in the actual case. Indeed, with multi-million-dollar-inherited IRAs becoming common in the future, the sheer magnitude of the account values may dictate an institutional trustee as the best choice to manage those seven- or eight-figure accounts. Detailed trust language should clearly give specific guidance or discretionary powers to the trustee on how to distribute MRD to trust beneficiaries in the most tax-efficient manner. Detailed Form 1041 Trust Income Tax returns and Beneficiary K-1s will need to be filed for each year the inherited IRA payout continues.
Russell E. Towers, J.D., CLU, ChFC, is vice president of business and estate planning at Brokers' Service Marketing Group in Providence, R.I. You may reach him at 401-751-9400.