2002 Planning Pointers

The following planning pointers illustrate various required distribution issues under the final regulations published on April 17, 2002 dealing with qualified retirement plans, IRA's and §403(b) plans. They are identical to the alerts listed in the second part of "Financial and Estate Planning Implications of the "Final" Minimum Distribution Rules." The 2002 Rules of the Road spelled out in the first portion of that lengthy document outline various facets of the final regulations. The 2002 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.

2002 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. (See item "T" below for inportant information if a minor is named as a beneficiary.)

B. If a non-DB is a beneficiary of an income or remainder interest as of September 30 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, however, 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 under the heading “Separate Accounts” in the “Technical Terms” section of this manuscript. 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)-4, A-3 & §1.401(a)(9)-8, A-2(a)(2)]

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. The same recommendation holds true when a non-spouse beneficiary of a pension, profit sharing or stock bonus plan (QRP's) executes a postmortem trustee-to-trustee transfer of a QRP into an inherited IRA. (See "Can the Qualified Plan Limit Your Planning Options?" in the 2002 Rules of the Road and item "G" below.)

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 qualified 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 that is entitled to a pecuniary interest from a qualified retirement plan, IRA or §403(b) plan fails to remove its share of the account prior to September 30 of the year following the year of the participant’s death, the other beneficiaries will lose valuable stretch-out potential. One way to avoid such a trap is to provide the non-DB with a fractional or percentage interest. By using this alternate means of allocation, it is permissible to establish separate accounts by December 31 of the year following the year of death and, hence, use the life expectancy of the oldest DB of each respective separate share when computing required distributions -- even though the non-DB fails to receive its fractional or percentage interest before the Designation Date. This issue is important regardless of the participant’s age. (See items “B”, “H” and “P”.)

F. Every case involving a participant that died before January 1, 2003 should be reviewed to make sure that MRD’s for years 2003 and later are based on the life expectancy of the correct calculation-DB as well as the new single life expectancy table in the final regulations. For a further discussion of this very important point, please refer to the “Redesignation/Reconstruction Rule” in the “Technical Terms” section of the 2002 Rules of the Road.

G. Unlike a spouse who is named as beneficiary of a pension, profit sharing or stock bonus plan (QRP's), a non-spouse beneficiary of such plans is not allowed to roll over the QRP into an IRA in their own name, à la a spousal rollover IRA. Effective for distributions made after 2006, however, a non-spouse beneficiary of a pension, profit sharing or stock bonus plan may execute a trustee-to-trustee transfer of the QRP assets into an inherited IRA. The latter must be titled in the name of the deceased participant for the benefit of the same beneficiary and list that beneficiary's Social Security Account Number (SSAN) as the Taxpayer Identification Number (TIN) for the account. The same rules apply if a trust, rather than an individual, is the non-spouse beneficiary.

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 1 and §1.401(a)(9)-8, A-2(a)(2)]

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 final 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, the ultimate recipients of the account, most likely the couple’s children, will be forced to use the considerably shorter single life expectancy of the second deceased parent when computing required distributions. [§1.401(a)(9)-4, A-4(c) and §1.401(a)(9)-5, A-5] There is one possible remedy if the non-participant spouse beneficiary happens to die within nine months of the participant. Provided state law permits, the executor for the surviving spouse can disclaim that second decedent’s rights to the qualified plan benefits. Such action effectively returns control of the assets to the participant’s own beneficiary election form. If the couple’s children are listed as contingent beneficiaries on that form, the qualified plan assets will pass directly to them. As a minimum, the latter will also be able to use the oldest sibling’s life expectancy to stretch out required distributions.

J. The final regulations 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 qualified disclaimer by the nine-month deadline following the participant’s death will not be considered a beneficiary when it comes 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 qualified 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 final regulations, in a timely manner to the plan administrator. For more details, peruse the “Trust As Beneficiary” discussion in the “Technical Terms” section of the 2002 Rules of the Road. Then be sure to review the language of §1.401(a)(9)-4, A-5 and A-6 in the final regulations. Lastly, be sure to peruse Chapter 6 in the 6^th edition 2006 of Natalie Choate's Life and Death Planning for Retirement Benefits.

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 qualified under I.R.C. §2518, 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. 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 final regulations mentioned above. In fact, at least one private letter ruling (LTR 199903050) appears to embrace this conclusion. However, the final 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 35.0% 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 bypass 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 that 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 spouse or 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 only a surviving spouse was allowed to name a subsequent beneficiary. Fortunately, §1.401(a)(9)-4, A-4(c) and §1.401(a)(9)-5, A-7(c)(2) of the final regulations grant the same privilege to non-spouse DB's.

R. A surviving spouse that is the sole primary beneficiary of a decedent’s account may decide NOT to elect to treat the account as the spouse's own. In essence, the survivor maintains his or her status as beneficiary of the decedent's account. This is possible even if the surviving spouse rolls over the decedent's qualified retirement plan into an IRA or transfers the decedent's IRA directly to a new IRA. [§1.408-8, A-7] By remaining the beneficiary of the account, rather than becoming its owner, the survivor is permitted to postpone required distributions until the year the deceased participant would have attained age 70½. Using this Spousal Exception under §401(a)(9)(B)(iv) to delay mandatory withdrawals is often considered when the surviving spouse is younger than age 59½ because the 10% Federal excise tax on pre-59½ distributions will NOT apply if he or she taps the account. In contrast, the excise tax will apply to early withdrawals from a spousal rollover account. 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 subsequently transfer the deceased participant’s qualified plan to a spousal rollover IRA of his/her own at any time. [§1.408-8, A-5(a)] Please keep in mind that when required distributions finally begin under 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 Lifetime Table that would apply if the surviving spouse were to treat the account as his or her own. During the survivor’s lifetime, that differential could produce a significant disadvantage in the form of larger taxable distributions. [§1.401(a)(9)-5, A-5(c)(2)] The Spousal Exception is also detrimental if the survivor dies after commencement of required withdrawals. Under those circumstances, the final regulations force the ultimate beneficiaries (probably the couple’s children) to complete those required distributions based on the fixed-period single life expectancy of the surviving spouse established on his or her birthday in the year of death. [§1.401(a)(9)-5, A-5] This 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 an account that the surviving spouse elected to treat as his or her own.

S. The final 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 escape from the clutches of the Five-Year Rule by switching to the General Exception under §401(a)(9)(B)(iii). To accomplish that change, any amounts that would have been required to be distributed under the General Exception for all distribution calendar years before 2004 must be distributed by the earlier of December 31, 2003 or the end of the fifth year following the year of the participant’s death. (See §1.401(a)(9)-3, A-4, §1.401(a)(9)-1, A-2(b)(2) and Table 24 on this web site.

T. If a participant wishes to name a minor as beneficiary of his or her qualified retirement plan (QRP), individual retirement account or §403(b) tax sheltered annuity (TSA) contract, difficulties often arise because state laws restrict the transfer of assets to anyone that has not yet attained a certain age. While a minor can be listed as a beneficiary, IRA custodians and plan administrators will not distribute assets directly to a minor. They will distribute assets to a court-appointed legal guardian of a minor or the custodian of an account established for a minor under the Uniform Transfers to Minors Act. In addition, IRA custodians and QRP administrators are happy to make postmortem distributions to the trustee of a trust for the benefit of a minor. While the options outlined in the two preceding sentences may appear to resolve the dilemma, each introduces its own list of complications and considerations that are beyond the scope of this Planning Pointer. Fortunately, an in-depth discussion of this topic is available in ¶6.3.12 of the 6^th edition 2006 of Natalie Choate's Life and Death Planning for Retirement Benefits.

U. If a participant dies on or after his or her required beginning date, the required distribution for the year of death (YOD) must be taken on or before December 31 of that same year. The Code and Regulations do not provide a grace period for the participant's beneficiaries. That is to say, the beneficiaries need to withdraw the required distribution by the same deadline the participant would face if he or she were alive. The year-of-death's required distribution is computed as if the participant were alive throughout the entire year -- even if he or she died on January 1. If a participant withdrew a portion of the year's required distribution prior to dying sometime during that year, the beneficiaries must withdraw the remainder of the required distribution by year's end. Although the remainder of the required distribution belongs to the beneficiaries, it is includable in the decedent's estate and represents income in respect of a decedent (IRD). Note too that 100% of the YOD's required distribution must be taken before effecting a spousal rollover or trustee-to-trustee transfer of a qualified retirement plan by a non-spouse beneficiary to an inherited IRA.

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