Leimberg s Think About It

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1 Leimberg s Think About It Think About It is written by Stephan R. Leimberg, JD, CLU and co-authored by Linas Sudzius OCTOBER 2010 #416 TRUTHING THE STRETCH WHAT FINANCIAL PROFESSIONALS NEED TO KNOW INTRODUCTION Clients see a fair amount of information about stretch IRAs. This can lead to confusion, as they try to understand what stretch might mean in their circumstances. Pensions, IRAs and nonqualified deferred annuities (NQDAs) can all potentially be stretched at the account owner s death. Stretch means that the beneficiary can delay the federal income tax consequences associated with the transfer of the account. Stretch choices may differ based on the Timing of the taxpayer s death, Type of account, Relationship of the beneficiary, and Timing of the stretch election.

2 2 The financial professional will be called on to help a client draft beneficiary designations for IRAs, pensions and annuities. One of the key factors in drafting beneficiary designations is the potential tax consequences to the beneficiary or beneficiaries of the account. Stretching the tax result associated with an IRA, pension or NQDA is not always the right choice for the beneficiary. However, since it s often hard to predict the circumstances that will exist at the account owner s death, keeping the option of stretching open is usually the best help a client can get. In this issue of Think About It, we will discuss the theoretical stretch choices that are available upon the death of the account owner. Understanding how certain beneficiary choices will affect stretch at the death of the taxpayer is critical to giving good advice. PENSIONS AND TRADITIONAL IRAs The stretch options available for pension accounts and traditional IRAs are similar. We will refer to stretch options as they apply to IRAs. Where there are different rules for pension plans, we will point them out. For the purpose of this discussion, pension accounts shall include qualified plans, tax sheltered annuities (Section 403(b) plans) and eligible Section 457 governmental plans. Required Beginning Date The options available to a given beneficiary depend on whether the original account owner had reached the required beginning date (RBD) at the time of death. For IRAs, the RBD is April 1 of the year following the calendar year when the participant attained age 70 ½. That is the deadline for the first required minimum distribution (RMD). For pension accounts, the RBD is deferred to April 1 of the year following the taxpayer s retirement if: 1. the plan is sponsored by the employer for which the participant is employed, and 2. the participant is not a 5% or more owner of the employing company. RMDs from the pension account must start by the relevant RBD. SEP IRAs and SIMPLE IRAs are treated as IRAs, rather than pension plans, for the purpose of determining a participant s RBD.

3 3 The Tables Used to Calculate RMDs Throughout this issue, we will make reference to the following tables used for minimum distribution calculations related to stretch. For your reference, copies of the tables, taken from IRS Publication 590, can be found at the end of this newsletter. The Uniform Lifetime Table The Single Life Expectancy Table A Word About Stretch In discussing stretch, the focus is on the smallest amount that a beneficiary can receive. However, a beneficiary can usually opt to take bigger distributions, even after choosing to stretch, if they are needed. In most cases, bigger distributions simply mean a bigger current income tax result for the beneficiary. Spouse as Beneficiary A surviving spouse will have a number of choices when named the beneficiary of a pension or IRA plan. The choices differ based on whether the deceased spouse had reached the RBD at the time of death. To be certain that these options are available, the surviving spouse should be named individually as the beneficiary, rather than naming a trust as the beneficiary. DECEASED SPOUSE HAD NOT YET REACHED THE RBD First Choice Spousal Continuation A surviving spouse has the unique ability to treat an IRA or pension account balance as the surviving spouse s own account without a current income tax result. This election may be made at any time after the account owner s death. The surviving spouse will be assumed to have made the spousal continuation election if the surviving spouse fails to take the RMDs associated with making another choice. Second Choice Rollover to IRA Spousal continuation is not available for a Section 403(b) tax-sheltered annuity account. However, a spousal beneficiary of a 403(b) account may roll over the account to the spouse s own IRA. A spousal beneficiary who has chosen spousal continuation of a pension or IRA

4 4 account may also roll the decedent s account over to the spouse s own IRA or pension account, if applicable. If the surviving spouse chooses to do a rollover into an IRA (or pension) in the surviving spouse s own name, the required distribution rules will be applied with reference to the surviving spouse s age. If the time is prior to the surviving spouse s RBD, no RMD is required. If the spouse has reached the RBD, RMDs are determined by using the spouse s age and the Uniform Lifetime Table. Example 1: Wife, age 60, dies in 2010, leaving a 401K account balance. Husband, age 60, chooses to do a rollover to his IRA. No RMD is due for 2010, nor would any RMD be due until April 1 the year after the husband attains age 70-1/2. The good news about making the continuation or rollover choice is that distributions and taxes can be deferred until the spouse s RBD. The bad news is that the surviving spouse loses the ability to avoid the 10% premature tax penalty if distributions are taken before age 59 1/2. This penalty does not apply to inherited accounts described in the following sections. If spousal continuation or spousal rollover is chosen, the surviving spouse can name a beneficiary, and the next beneficiary s stretch options will be the same as if the surviving spouse owned the pension or IRA from the beginning. Third Choice - Treat Account As Inherited and Stretch Based on Deceased Spouse s Life The surviving spouse may choose to treat the account as an inherited account. If the deceased had not yet reached the RBD, the first RMD is not due until December 31 of the year the deceased spouse would have attained 70-1/2. If the account is maintained as an inherited account by the surviving spouse, each year s RMD for years after the deceased spouse would have attained age 70-1/2 is calculated by referring to the Single Life Table using the surviving spouse s actual age in that year. Example 2: Wife, age 64, dies in Husband, age 70, chooses to treat the account as an inherited account. No distributions are required until December 31 of 2017, if the deceased spouse would have attained age 70-1/2 in In year 2017, husband is age 77 and the factor from the Single Life Table is The account balance for 12/31/2016 is divided by 12.1 (equivalent to 8.26%) and that s the RMD for For 2018, the RMD is determined by going to the Single Life Table and using the factor for a 78 year old, 11.4.

5 5 After the subsequent death of the beneficiary spouse, the account is payable to the beneficiary named by the beneficiary spouse. The applicable distribution period is the life expectancy of that spouse, using the Single Life Table and the age she attained or would have attained on her birthday in her year of death, reduced by one (1) in each subsequent year. Example 3: Assume the same facts as Example 2 above, except the husband dies in 2018 at the age of 78. A daughter is the beneficiary. The RMD for 2018 would be determined by using the father s age of 78 and the Single Life Table. The factor for a 78 year old is For 2018, the account balance on 12/31/2017 would be divided by 11.4 and that s the RMD. For 2019, the factor would be 10.4, for 2020 the factor would be 9.4, and so forth. Example 3 underscores a dilemma faced by an older surviving spouse. Is it better to continue the account as an inherited account and defer RMDs during the surviving spouse s lifetime, limiting an inheriting child s ability to stretch, or is it preferable to do a rollover to the surviving spouse s own IRA and preserve a child s ability to do a stretch based on the child s life expectancy? The right approach depends on the facts and circumstances facing the surviving spouse at the time of the first spouse s death. DECEASED SPOUSE HAS REACHED RBD When the taxpayer has reached the required beginning date, the choices available to a surviving spouse are slightly different. First Choice Spousal Continuation The named surviving spouse beneficiary still has the ability to choose to treat the pension account as the surviving spouse s own account. Any RMD that was required for the decedent s year of death must be distributed to the surviving spouse. The surviving spouse will be assumed to have made the spousal continuation election if the surviving spouse fails to take the RMDs associated with making another choice. Second Choice Rollover to IRA The named surviving spouse beneficiary may also roll over the account balance to his or her own IRA or eligible pension account either by direct rollover or 60 day rollover.

6 6 Any RMD due to the deceased spouse for the year of death is not eligible for rollover, but must instead be distributed to the named spouse beneficiary prior to rollover. Third Choice Treat Account as Inherited and Stretch Based on the Beneficiary s Life If at the time of death, the account owner has reach the RBD, and the surviving spouse chooses to maintain the account as an inherited account, RMDs for years following the year of death are determined by using a factor which is the longer of: the life expectancy of the deceased spouse under the Single Life Table using his age in the year of death and subtracting one for each subsequent year, or the surviving spouse s life expectancy under the Uniform Lifetime Table, recalculated each year. Here s an example to illustrate the point: Example 4: Wife, 71, dies and her husband, age 90, is the sole beneficiary. The husband chooses to maintain the account as an inherited account. The deceased wife s factor from the Single Life Table in the year of death was 16.3, therefore her factor for the year following death is The husband s factor for the year following the year of death from the Uniform Lifetime Table for a 91 year old is The longer factor, 16.3, would be used. Now jump forward eight years assuming the husband lives. The factor based on the wife s single life expectancy is 6.3 ( ). The husband s factor from the Uniform Lifetime Table for a 98 year old is 7.1 and would be used as the longer factor, so 7.1 would be used. Non-spouse Beneficiary A non-spousal beneficiary must take distributions from a pension or traditional IRA 1. Under the life expectancy rule or 2. Completely by the end of the fifth year after the owner s death. The life expectancy rule means that if the beneficiary is a named individual, and if the beneficiary makes regular RMD-like distributions from the IRA over his lifetime, the beneficiary will be considered to comply. This approach allows the beneficiary to stretch the distributions and the income tax result over his lifetime.

7 7 First Choice - Treat Account As Inherited and Stretch Based on the Beneficiary s Life If the decedent had not reached the RBD at the time of death, and there is a non-spouse individual designated beneficiary, for the years following the year of death the account may be distributed over the designated beneficiary s remaining life expectancy. The RMD for the beneficiary is calculated as follows: Determine the designated beneficiary s life expectancy using the beneficiary s age at the end of the calendar year following the year of the owner s death using the Single Life Table; and in each subsequent year, subtract one year from the number used in the prior year. The younger the named beneficiary is at the time of the account owner s death, the longer the distributions and taxes can be stretched. The deadline to elect to treat the account as inherited is December 31 of the year following the account owner s death. The IRS permitted a later election in Private Letter Ruling , but imposed a 50% penalty for each RMD that the taxpayer failed to take until the time of the election. If the non-spouse beneficiary does not elect to stretch, the beneficiary must take a complete distribution by the end of the fifth year after the owner s death. Second Choice Treat Account As Inherited and Stretch Based on Decedent s RMDs If the decedent had reached the RBD at the time of death, a non-spouse beneficiary has the option to stretch in a slightly different way. The beneficiary s interest is distributed over the longer of the beneficiary s life expectancy, calculated as described in the italicized paragraph earlier, or the remaining life expectancy of the owner, determined using the age of the owner in the calendar year of his death, reduced by one for each calendar year that elapses thereafter. Again, the election to stretch must be made by December 31 of the year following the account owner s death. Here s an example of how the post-rbd stretch works: Example 5: Mother, age 72, dies in 2010 with a daughter, aged 50, named as beneficiary. The Uniform Life Table factor for a 72 year old is The 12/31/2009 account balance would be divided by That amount would have

8 8 to be distributed to the daughter to satisfy her mother s RMD for In 2011, the daughter will be 51 and the Single Life Table factor is Since the Single Life Table factor is higher than the decedent s Uniform Lifetime Table factor, 33.3 will be used. The 12/31/2010 account balance would be divided by 33.3 and this amount would be the 2011 RMD. For 2012, the 12/31/2011 account balance would be divided by 32.3 and so forth. Thus, the account can be stretched out for 33 years following the mother s death. Third Choice Distribute Entire Account Within Five Years of Death If the decedent has not yet reached the RBD, a non-spousal individual beneficiary has the choice to take no immediate distributions, but the account must be totally distributed by December 31 st of the fifth year following the year of death. Here s another example: Example 6: Assume the same facts as in Example 5, except the mother is age 70 rather than 72. No distribution is required for If the daughter chooses to do a stretch, the calculation is the same as in Example 5 and the first RMD is due by December 31 st of Alternatively, the daughter could choose to take no distributions for up to five years. In that instance, the account would have to be totally distributed by December 31 st of How the account is distributed during the five year period is totally up to the daughter. Fourth Choice Rollover to Inherited IRA Account No rollovers are allowed in the case of a non-spouse beneficiary to the beneficiary s own IRA or pension account. However, the non-spouse beneficiary may maintain the account as an inherited account. A non-spouse designated beneficiary of a qualified plan, a tax sheltered annuity, or an eligible Section 457 governmental plan may make a direct rollover into an inherited IRA, including an inherited Roth IRA. The rollover must be direct, and not by means of a 60 day rollover. If the rollover is to an inherited Roth IRA, the qualified plan account will be taxed as a complete distribution to the beneficiary. A non-spouse designated beneficiary of a traditional IRA may make a tax-free direct rollover into another inherited IRA, but may not convert to an inherited Roth IRA. The inherited IRA account must remain in the name of the owner of the original retirement account payable to the designated beneficiary. The inherited traditional or Roth IRA is subject to

9 9 required minimum distributions as for any IRA payable to a designated beneficiary. The new custodian must agree to administer the account consistently with the RMD requirements. Trust as Beneficiary However, the account owner may want to control how the annuity can be accessed by the beneficiary. The account owner may want IRA funds directed to a testamentary trust, for example, for the benefit of his children in the event of his death. If the beneficiary is not a named individual, the stretch option may be lost. If stretch is lost, the entire IRA must be distributed and taxed as income within five years of the account owner s death, if the account owner has not yet reached the RBD. If the account owner is past the RBD at death, and if stretch is unavailable, the distributions must be taken over the remaining life expectancy of the owner, determined using the age of the owner in the calendar year of his death, reduced by one for each calendar year that elapses thereafter. The IRS has issued regulations and letter rulings over the past few years on how trusts may be used in conjunction with stretch planning. Beneficiaries of a trust may be treated as designated beneficiaries and qualify for stretch treatment--if four requirements are met: 1. The trust is valid under state law, 2. The trust is irrevocable, or becomes irrevocable upon the death of the grantor, 3. The beneficiaries of the trust are readily identifiable from the trust itself, and 4. A list of beneficiaries or a copy of the trust is provided to the IRA by October 31 of the year following the date of the grantor s death. These types of trusts are referred to as look-through trusts. The oldest beneficiary of a lookthrough trust is considered to be the designated beneficiary for stretch purposes. If the beneficiaries are widely separated in age, using the oldest as the measuring life for stretch purposes may not give the optimal result. It may make sense to plan on the front end to o Divide the IRA into multiple accounts, and o Direct each of the accounts into separate look-through trusts for each one of the beneficiaries in order to maximize the control and tax aspects of the IRA planning. If one or more of the trust beneficiaries is not a person for example, a charitable or corporate beneficiary the trust is treated as failing the look-through test. However, if a trust has nonnatural beneficiaries or other defects that keep it from being a look-through trust, it s not necessarily fatal to keeping the stretch option. If the trust permits, any defects may be removed

10 10 by September 30 following the date of the decedent s death. If that is done, the trust may then qualify as a look-through trust, and stretch would be available. Estate as Beneficiary If the decedent s estate, a charity or non-look-through trust is the beneficiary of a pension or IRA, it s fatal to a stretch. If the estate is the beneficiary, If the taxpayer had not yet reached the RBD, the entire account must be distributed to the beneficiary by the end of the fifth year after the taxpayer s death, or If the taxpayer had reached the RBD, the account distributions would be due over the remaining life expectancy of the owner, determined using the age of the owner in the calendar year of his death, reduced by one for each calendar year that elapses thereafter. Percentage Beneficiaries If individual beneficiaries are percentage beneficiaries of an IRA or pension account, each beneficiary may make independent stretch decisions, so long as the account custodian permits. ROTH IRAs The RMD rules with regard to Roth IRAs are similar to those associated with traditional IRAs. However, since Roth IRAs have no required beginning date during the lifetime of the initial account owner, all stretch choices assume the taxpayer died prior to the RBD. For named surviving spouse beneficiaries of Roth IRAs, spousal continuation and rollover are available choices. For non-spouse named beneficiaries, the stretch option is based on the beneficiary s age at the time of the account owner s death. The RMD for the non-spouse beneficiary is calculated using the Single Life Table; subtracting one year from the number used in the prior year. The deadline to elect to treat a Roth IRA account as inherited is December 31 of the year following the account owner s death. NQDAs Beneficiaries may have some choices with regard to the timing of the payments from an annuity contract and thus, with the timing of the tax result.

11 11 Spouse as Beneficiary A surviving spouse named as beneficiary generally has the right to continue the deferred annuity as if it is her own after the death of the spousal policyowner. The spouse can choose to defer distributions and the income tax result associated with them until her death. However, as with an IRA or pension account, if a marital trust is named beneficiary instead of the surviving spouse directly the ability to continue the annuity on a tax-deferred basis until the spouse s death is probably lost. If the surviving spouse beneficiary is younger than age 59 ½, if continuation is elected, subsequent early distributions may be subject to the 10% penalty tax. If the surviving spouse expects to need money before reaching age 59 ½ from the decedent s account, she may elect to be treated as a non-spouse beneficiary. Taxable distributions from an inherited NQDA account are not subject to the 10% penalty tax. Non-spouse Beneficiary Stretch Under Revenue Code Section 72(s)(2), a non-spousal beneficiary must take distributions from a nonqualified annuity 1. At least as rapidly as under the method of distribution in effect at the owner s death, or 2. Completely within five years of the owner s death. The IRS offers favorable distribution and taxation rules if the beneficiary is an individual. If the named beneficiary annuitizes the annuity over his lifetime within a year of the owner s death, he ll be considered to be in compliance with the distribution rules. This annuitization has some income tax appeal, as it allows the beneficiary to stretch the income tax result over his lifetime. Further, if annuitized, each annuity payment will be partly a recovery of basis, and partly a taxable distribution. In PLR , the IRS approved of three non-annuitization methods for a non-spouse beneficiary to satisfy the requirements of Section 72(s)(2): Amortization calculation method Annuitization calculation method RMD calculation method Each of these calculation methods is similar to those approved for use under Section 72(t). That Revenue Code section creates an exception to the 10% premature penalty tax where the distributions are substantially equal for the taxpayer s lifetime.

12 12 The RMD method approved by the PLR produces the lowest initial payout to the beneficiary. The non-spouse beneficiary, within a year of the taxpayer s death, must begin taking distributions using the factor from the Single Life Table and the account balance from 12/31 of the prior year. While the IRS did not specify in its PLR, the distributions taken under the RMD-like method are likely to be taxed under normal LIFO annuity taxation rules. Not every insurance carrier allows beneficiaries to elect the RMD-like distribution method because the authority to do so comes from a source that can t be relied on by all taxpayers. If the existing carrier doesn t allow RMD distributions, one might be tempted to change to a carrier that does allow RMD distributions. Unfortunately, it is not clear that a NQDA beneficiary has the right to transfer an inherited account from one insurance company to another on a tax-free basis. Trust as Beneficiary of NQDA A NQDA policyowner may want annuity funds directed to a testamentary trust, for example, for the benefit of his children in the event of his death. Based on current rules, it appears that directing nonqualified annuity proceeds to a trust will require that the annuity be completely distributed and taxed within five years of the policyowner s death. There is no direct published authority that recognizes a look-through trust with a NQDA account. CONCLUSION The rules with regard to beneficiary stretch options are complex, and it s easy for even experienced professionals to get confused. However, here are some general rules for naming beneficiaries of pensions, IRAs and NQDAs: A named surviving spouse beneficiary of the account will have the most options for deferring taxes at the account owner s death If naming the spouse is not desired or possible, an individual non-spouse beneficiary will have the ability to stretch at the account owner s death If the account owner wants to name a trust beneficiary of a qualified account, make sure the client s attorney has drafted the trust as a look-through trust A financial professional who gives his client s beneficiaries plenty of choices with regard to taxation of distributions will maximize the chances of continuing to be the family s trusted advisor.

13 13 Single Life Expectancy Table Age Life Expectancy Age Life Expectancy Age Life Expectancy and over

14 14 Uniform Lifetime Table Age Distribution Period Age Distribution Period and over 1.9