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1 ACCUMULATE WEALTH AND REDUCE TAXES March 2001 MRDefenses Everything you always wanted to know about estate planning with the new minimum required distribution rules James Lange, CPA, Esq. James Lange Law Offices Pittsburgh, PA The recent changes in the minimum distribution rules are a blessing not only for IRA owners and retirement plan participants, but also for their beneficiaries, who will now be able to stretch their inheritances over the course of their own lifetimes. The new laws are very straightforward; for most cases they reduce the minimum required distribution (MRD) for the IRA owner or retirement plan participant, leaving more for his or her beneficiaries to inherit. Obviously this will have significant estate planning ramifications. This article will focus on the changes in the distribution rules for beneficiaries of IRAs after the death of the IRA owner. In the past, it was always advisable for an investor to spend after-tax funds before tapping into an IRA, 403(b), 401(k), 457 or other qualified plan account. The long-term impact was that the IRA owner who spent after-tax assets first had a lot more money and purchasing power. The reason for the additional wealth was that the plan participant was able to invest the money that otherwise would have gone to pay taxes. This strategy is even more advisable now. IRA owners with sufficient income from Social Security and other after-tax assets will not need more than their MRD, so their beneficiaries stand to inherit even more. This assumes the beneficiary does not have an immediate compelling use for the inherited IRA, would prefer to continue investing the inherited IRA in the tax-deferred environment and realizes that by following the maxim, "don't pay taxes now, pay taxes later," he or she will be thousands, perhaps millions of dollars better off in the long run. Now, let's take a look at some of the specific estate planning aspects of the new rules. Spousal beneficiary. The new law is not substantially different from the old law when the IRA owner predeceases the spousal beneficiary. A surviving spouse who is named as the beneficiary of an IRA may (and in most cases is well advised to) roll the inherited IRA into his or her own IRA, then name his or her own beneficiary. For example, let's assume that under either the old or new rules, John names his wife, Mary, as his beneficiary. After John dies, Mary rolls his IRA into her own and names their son, Al, as beneficiary. Before she reaches age 70 1/2, Mary is not required to take a MRD. By April 1 of the year following 1

2 the year she reaches age 70 1/2 -- that is her required beginning date (RBD) -- she must begin taking her MRD based on her life expectancy and the life expectancy of someone deemed 10 years younger than she, as defined by the new Uniform Withdrawal Table or the old MDIB Table. Under the old rules, upon Mary's death, Al could, with the proper election, take distributions based on his life expectancy. (Technically, Al's life expectancy at Mary's RBD minus 1 year for each year he survives.) If Al is 40 and has a life expectancy of 42.5 (according to IRS tables on life expectancy), then his MRD would be the balance in the IRA on Dec. 31 of the prior year divided by The following year, the MRD would be the balance in the account as of Dec. 31 of the prior year divided by 41.5, and so on. Thus, Mary got a good stretch and Al was also able to partially stretch the tax deferral over his life expectancy. This strategy would not change much under the new rules. There are minor differences between the ways Al calculates his life expectancy under the old and new rules, but other than eliminating the requirement to make the election for the stretch, and a few other subtle but not earthshaking distinctions, the new law is not substantially different than the old when the IRA owner predeceases the spousal beneficiary. Non-spouse beneficiary. Here we begin to see some significant changes. Under the old rules, only under certain favorable circumstances was it possible for a non-spousal beneficiary to stretch their required distribution from an inherited IRA over their lifetime. Under the new rules, it is possible to achieve this stretch for almost all situations. Neither the old rules nor the new rules allow a non-spouse beneficiary to roll the inherited IRA into their own IRA. That means that if a non-spouse beneficiary inherits an IRA, he or she will be required to take minimum distributions on the inherited IRA based on his or her life expectancy, just like Al had to take a MRD after his mother Mary died. Under the old rules, the critical planning date for determining a MRD, both while the IRA owner was alive and after he died, was April 1 of the year following the year the IRA owner turns 70 1/2. After that date, the IRA owner could not do anything to slow down their MRD while they were alive. In addition, subject to some exceptions, after the IRA owner died, the beneficiary could not slow down the MRD. For example, assuming the old rules, consider this situation: John names Mary as the primary beneficiary of his IRA on or before April 1 of the year following the year he turned 70 1/2. But Mary predeceases John, who then names Al as primary beneficiary. Al's MRD would be rapidly accelerated and in some cases, the full amount would be taxable the year following John's death. The old rules were a mess. There were too many variables affecting the distribution of the IRA at the owner's death. Factors that had to be considered were: the IRA owner's age when he died, the primary beneficiary's age when the IRA owner hit his or her RBD, the IRA owner's marital status, methods chosen for calculating life expectancies (possibly four combinations of recalculation and term certain), the order of death between the IRA owner and the primary beneficiary, and whether the beneficiary makes the proper election after the original owner dies. The key to practically all these variables under the old rules was to determine the status of the account on April 1 of the year following the year the owner turned 70 1/2. Therefore, even John's MRD while he was alive was determined with reference to the named beneficiary as of his RBD. If he named Mary, who was roughly his age, the MRD would have been calculated using a joint life expectancy of 2

3 approximately their actual ages. On the other hand, if John named Mary but she predeceased him after John reached his RBD, then Al would have an accelerated income tax bite upon John's death. Also under the old rules, if John wanted to lower his MRD, he could name Al as the primary beneficiary before his RBD. That would have significantly lowered his MRD while he was alive and when he died, Al could have elected to stretch the IRA over his life expectancy. But even here precautions had to be taken to protect the surviving spouse. For very wealthy clients who desired a stretch IRA for the beneficiaries, I used to recommend naming a child or grandchild as the primary beneficiary of the IRA, with the idea of reducing the MRD while the owner was alive, but more importantly to get the benefit of the stretch after the IRA owner died. One of the big problems of this approach, however, was that the spouse was not the primary beneficiary of the IRA and that, in order for this strategy to work properly, the beneficiary had to make an affirmative election to take their MRD over their life expectancy. Now, both of those problems are a thing of the past. Note: Many existing 401(k) plans will not allow a stretch IRA for non-spouse beneficiaries but will require the entire plan proceeds be distributed the year after the IRA owner dies. (This isn't an IRS restriction; it is a restriction within the company's plan itself.) This is a marvelous reason to get clients to roll over their 401(k) into an IRA that could be a candidate for assets under management. New rule for beneficiaries. The new law does not look back to the status of the account as of the IRA owner's RBD to determine the MRD. Under the new rules, the age of the beneficiary on Dec. 31 of the year following the year the IRA owner died is the calculating age. So, in the above example where Al had an extreme acceleration of income taxes because of the status of the account at John's RBD, the result under the new rules is that Al will be able to stretch the IRA over his own life expectancy without having to make a formal election. Under the new rules, almost any beneficiary can achieve a stretch based on their own life expectancy. The deciding factor is the life expectancy of the beneficiary of the IRA on Dec. 31 of the year following the year the IRA owner died. Since virtually everyone will be able to enjoy the stretch after the IRA owner's death, you now have the flexibility to recommend to your client that they name anyone as their IRA beneficiary without any impact on their MRD. Therefore, you no longer have to be concerned with the impact of the beneficiary designation of the IRA for the purpose of the clients' MRD while the client is alive, just as long as a beneficiary is named. Multiple beneficiaries. The old rules were wicked when the IRA owner had named several beneficiaries by his RBD. Assume that John had one IRA with the following beneficiary designations: 1/4 to my mother, age 95; 1/4 to my wife, age 68; 1/4 to my son, age 40; and 1/4 to a trust for my granddaughter, age 5. Then, assume that John dies just after passing his RBD. Naturally, all heirs want the longest stretch allowed by law. The usual result (although some attorneys argued the point) was that all the beneficiaries were required to take their distributions based on John's mother's life expectancy. In other words, there 3

4 was a needless and enormous acceleration of income taxes and probably extreme anger at the planner or attorney giving John the advice. Under the new rules you may separate the account after death. For the above example, you would carve out four different accounts sometime between the IRA owner's date of death and Dec. 31 of the year following the year he or she died. Thus, John's mother would take distributions based on her life expectancy. His wife Mary would roll the IRA into her own IRA. Al would have a separate, inherited IRA and would take distributions based on his life expectancy, and the trust for the granddaughter (assuming it is a qualified trust) could take distributions based on her life expectancy. This change will make it much more advantageous to have a beneficiary designation that reads "my children equally, per stirpes." The owner will know that each child will be able to take a MRD based on his or her own life expectancy and not the life expectancy of the oldest child. We add the "per stirpes" to protect the interests of the third-generation child or children (i.e., the IRA owner's grandchild) of a predeceased second-generation child. If the designation only states "my children equally," only the second-generation children who are alive will inherit the IRA. If your client's child dies with children of their own, without the per stirpes language, those children would be disinherited. With the language "per stirpes," the grandchildren will stand in the place of their deceased parent. With the above information as background, let's now take a look at a case study. John, who is 68, has an IRA balance of $2 million. Mary, who is 65, has non-ira investment assets valued at $200,000. John's Social Security income is $16,000; Mary's is $8,000. Their annual spending in today's dollars is $80,000 plus income taxes. The quantitative analysis assumes an inflation rate of 4% and an investment rate of return of 8%. Unless otherwise stated, John dies in 2002, Mary in Of course, the client has no special knowledge of life expectancy when they are in the planning process. Query 1: Who should John name as IRA beneficiary? Query 2: Should John make a Roth IRA conversion? John's first goal in estate planning is to provide for Mary's security and protection. If he predeceases her, the entire proceeds of the IRA will be available for Mary's use. At John's death, the conventional course is for Mary to roll his IRA into her own, naming Al as her beneficiary. If Mary is a U.S. citizen, she will enjoy an unlimited marital deduction, and there will no income or federal estate taxes due at John's death. However, if John names Al as the beneficiary of his IRA, upon John's death Al will be able to take minimum distributions based on his life expectancy. Al's MRD would be lower than Mary's MRD after John's death, (at least after Mary turned 70 1/2) and more money would stay in the tax-deferred environment for the family. If John names a qualified trust for a grandchild, the amount of deferral dramatically increases. (See Exhibit 1.) If John predeceases Mary and she is named as the primary beneficiary of the entire IRA, and then when Mary dies she names Al as her beneficiary, under current estate tax laws there will be a signifi- 4

5 cant estate tax when the family settles Mary's estate. There will not be sufficient funds outside the IRA to pay for the estate tax. Al will have to invade the inherited IRA to pay the estate tax and that invasion will trigger an income tax. The result will be the notorious combined income and estate tax on at least a portion of the IRA. A discussion of the related income in respect of a decedent (IRD) is beyond the scope of this article. However, if some money were left to a combination of children and grandchildren at the first death, those amounts would not be part of the second estate at the second death. There may be a problem with naming a child or grandchild as primary beneficiary. If John names Al or his grandchild, Susie, as his beneficiary, or even as a beneficiary for a portion of the total, that means Mary will not benefit from that part of the IRA. While the desire to save income taxes is compelling, most individuals have a deeper concern for the security and protection of their surviving spouse. Furthermore, naming Al or Susie for more than one unified credit shelter amount (currently $675,000) would also subject John's estate to an enormous estate tax at the first death because the child or grandchild would not qualify for the unlimited marital deduction. What about naming a "B" trust as the beneficiary for one unified credit shelter amount and leave the rest to the spouse? We could set up a B or unified credit shelter equivalent trust where Mary gets the income and at her death the proceeds go to Al. This would keep at least $675,000 (the current unified credit shelter amount) out of the estate of the second to die. This would also do a good job of providing 5

6 for the surviving spouse. The problem is that at Mary's death, there would be a rapid acceleration of taxes for Al on the amount remaining in the B trust. Rather than using his own life expectancy to calculate his MRD from the inherited remainder of the trust, he would be required to use his deceased mother's life expectancy. Furthermore, at the time of this writing there is great uncertainty in whether and how much estate tax reform will come in the future. Is there a way to reconcile these competing forces? The new law invites "disclaimer planning" opportunities. Now more than ever, disclaimer planning will be a significant strategy for individuals with substantial IRAs. Let me introduce cascading beneficiaries with disclaimer options. Consider the following: The primary beneficiary of the IRA would be the surviving spouse. The secondary (or first contingent) beneficiary could be a trust where the surviving spouse gets the income and, at his or her death, the proceeds go to the children equally (a "B" or unified credit or exemption equivalent trust). So far, this is identical to one of my standard old rule plans where I did not name children or grandchildren as primary beneficiaries on separate IRAs. Now, I am suggesting: The third beneficiary (or second contingent beneficiary) would simply be the children equally "per stirpes." The fourth (or third contingent beneficiary) could be a special trust for the grandchildren (either all grandchildren or just the children of the children that would disclaim). Under the old rules you could have had cascading beneficiaries, but it was not helpful in terms of slowing down the MRD of the beneficiary. The critical date for determining a distribution pattern was the IRA owner's RBD, April 1 of the year following the year the IRA owner turned 70 1/2. Under the new rules, the critical date is Dec. 31 of the year following the year the IRA owner dies. The extended time frame allows a family to leave options open for getting the longest stretch IRA. However, if circumstances dictate, it also preserves the safety net for the natural heir of the IRA owner (i.e., the surviving spouse). The cascading beneficiary idea combined with a partial Roth IRA conversion will maximize the value of an IRA or retirement plan for many IRA owners and their families. Under the cascading scheme, the surviving spouse could either keep everything or disclaim all or a portion to a B trust. Alternately they could disclaim all or a portion to their children. The children, if they desired, could keep the inherited IRA and take MRD based on their life expectancies. If the children were themselves in a strong financial position and did not need the inherited IRA, they could disclaim to their children (the IRA owner's grandchildren), who could then take MRD over their quite long life expectancy. Exhibit 2 (on the following page) provides a flowchart of the cascading beneficiary scheme. To optimize the benefits to the entire family (again, using the example above), one approach through postmortem disclaimer or through pre-death planning would be to name Susie on a separate IRA of $675,000, and Mary for a separate IRA of $1,325,000. This strategy would get $675,000 and the 6

7 growth on that amount between John's and Mary's death out of Mary's estate (keeping a careful eye on the account if it approaches $1 million to avoid the generation-skipping tax). In addition, the present value of the cash flows of the minimum distribution, particularly to Susie, would be enormous. Upon John's death, Mary would then name Al as the beneficiary of her IRA. Finally, there would be no estate tax at John's death. However, optimizing wealth is not a good idea if the money is not directed in accordance with the client's desires. Most people want to provide for their spouse, then their children and only after that, for their grandchildren. There is no magic formula for determining how much money to assign each beneficiary, either while 7

8 John is alive or even after he dies. While it is possible to make the quantitative differences more dramatic with higher allocations to Al or Susie, the following allocation, given the current assumptions, seems reasonable as a starting point. Without question, the client's personal wishes must be taken into consideration. The client will benefit from a clear explanation of the information in this article, but ultimately the decision rests with him or her. Please consider the following a starting point that could be accomplished through original pre-death planning or postmortem planning through disclaimer: IRA 1: $1.5 million, Mary as beneficiary. IRA 2: $400,000, Al as beneficiary. IRA 3: $100,000, Susie as beneficiary. The lower two plots on Exhibit 3 quantify the advantage of splitting the IRA up into three separate accounts, either before John's death or after John's death through a series of disclaimers. Without question the value of the total estate in the future is significantly greater by taking advantage of the longer life expectancies and hence lower MRD of younger beneficiaries. While it is beyond the scope of this article to provide a detailed analysis of the benefits of a Roth IRA conversion, converting a portion of the IRA to a Roth IRA would benefit this client and his family. The 8

9 portion converted to a Roth IRA would: 1. provide income tax free growth for the entire family. 2. stop minimum distributions for John and Mary regardless of which spouse dies first. 3. make the minimum distributions for Al and Susie income tax free. Accepting the premise that an IRA conversion is appropriate, the next question is how much should be converted and when should the conversion occur? One excellent software program that does far more than just recommend an optimal amount for the Roth IRA conversion is Brentmark's Roth IRA Analyzer. However, it seems that all the computer programs have significant limitations. It is not prudent to recommend a Roth IRA conversion based solely on the results from any of the currently available software programs but, to their credit, they do provide a reasonable starting point for the analysis. Using a combination of Brentmark's Roth IRA Analyzer, an intricate Excel spreadsheet developed by the author and Steven T. Kohman, CPA, and additional criteria, it would seem reasonable for the client to consider making a $500,000 Roth IRA conversion. The client would pay the income tax on the Roth IRA conversion with the $200,000 of after-tax dollars in Mary's name. Currently, to qualify for the Roth IRA conversion, an individual's modified adjusted gross income must be less than or equal to $100,000. The problem is that, depending on the income from Mary's investments, John's MRD will probably throw him over the $100,000 limitation. John has a one-year window to make the conversion before his Social Security and MRD will likely take him over $100,000 in modified adjusted gross income. Therefore, in this example John makes the entire $500,000 Roth IRA conversion in the year before he is required to take his first MRD. Unfortunately, he dies of a heart attack the following year when he sees the tax bill for converting $500,000 from his traditional IRA to a Roth IRA (roughly $200,000). Two extremely important factors: 1. Will the conversion place the taxpayer in a higher income tax bracket and, if so, how much higher and how long will it be before reaching the break-even point given the higher tax bracket? Please note that without going into a higher tax bracket, the break-even point for a Roth IRA conversion, assuming we are using after-tax funds to pay the taxes measured in total purchasing power, is one day. 2. The sooner the client makes the conversion, the sooner the minimum distributions are eliminated and the sooner the money can start growing income tax free. (Though in many cases it makes sense to do a series of smaller conversions staying in a lower income tax bracket over a number of years. In this case study, the client has only a one-year window of opportunity before his income exceeds $100,000). See Exhibit 3 for the results from combining the dual strategies of naming different beneficiaries for John's traditional IRAs and assuming the $500,000 Roth IRA conversion. The top two plots in Exhibit 3 demonstrate that, after giving the Roth IRA time to grow, the estate's value is significantly greater than the values reflected in the bottom two plots (without the Roth conversion). 9

10 If our analysis had incorporated today's estate tax structure, the increased value of both leaving money to Al or Susie on the first death and the Roth IRA conversion would have considerably strengthened the argument for leaving money to children and grandchildren and converting money to a Roth IRA. Though the new law does not really speak to Roth IRAs, it will substantially impact Roth IRA conversions. 1. More clients will be eligible for the conversion. With a lowered MRD, more clients will fall under the $100,000 limitation that will now allow them to qualify for the Roth IRA conversion. 2. Roth IRA conversions will be slightly less desirable. The Roth IRA itself is no less desirable than it was before. The conversion, however, is less desirable because maintaining the status quo of owning a traditional IRA is a better choice than it has ever been. The IRA owner will have a lower MRD. The heirs will get a stretch. Virtually all the traps and nightmares about massive income tax acceleration are a thing of the past. The new reduced MRD for IRA owners and beneficiaries is extremely favorable and simplifies planning significantly. Consider contacting your clients to: inform them of the changes, encourage them to take advantage of their reduced MRD, and recommend that they roll money out of their 401(k)s (with acceleration of income rules) into IRAs. The new law invites "cascading beneficiary" disclaimer planning that will protect the interest of the surviving spouse while retaining options for enormous tax deferred growth after the death of the IRA owner. With the lowered MRD, more IRA owners will qualify for Roth IRA conversions. IRA owners are advised to review their retirement and estate planning strategies regarding the own MRD, their named beneficiaries of the IRA and whether they should consider a partial Roth IRA conversion. Keynote Speaker I am available for speaking engagements. I present dynamic seminars for financial planners, CPAs, attorneys, bankers and insurance professionals. I also present excellent seminars suitable for individuals actively involved in planning for retirement. If you are looking for a keynote speaker for your next meeting, please call for a "planner's packet" and to talk with me. Visit my speaking engagement page at rothira-advisor.com/speaker.htm for more information, recommendations and testimonials. Law Offices of James Lange 2200 Murray Avenue Pittsburgh, PA Fax 10