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EXECUTIVE
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The owner of a traditional IRA is required to withdraw a minimum amount from the account each year after reaching age 70½. If the owner dies before the complete withdrawal of assets from the IRA, several options are available to beneficiaries regarding the timing of future distributions. Post-death distributions made to beneficiaries are subject to the general income tax treatment of all IRA distributions, with nondeductible contributions withdrawn tax free and all other amounts subject to tax as ordinary income under the annuity rules of Sec. 72. In light of these tax consequences, many beneficiaries will prefer to maximize the deferral period for receiving taxable IRA distributions.
The options available for deferring post-death distributions depend on the IRA plan rules, the beneficiary’s relationship to the deceased owner, and whether death occurred before or after the date the owner was required to begin receiving distributions from the IRA. These factors affect both the starting date and the amount of required minimum distributions (RMDs) following the IRA owner’s death. While the selection of a plan and beneficiary should be part of the owner’s estate planning before death, strategic postmortem planning also requires careful consideration of alternative distribution options available to beneficiaries. In many cases timely action is necessary to avoid unexpected and unnecessary tax costs. This article discusses the distribution options available to IRA beneficiaries, with an emphasis on opportunities to control the timing of the distribution period and actions that must be taken on a timely basis to achieve the desired outcome.
RMDs in General
Sec. 401(a)(9) mandates that on or before the IRA owner’s required beginning date, the entire account balance must be (1) distributed in full, (2) distributed over the actual life of the owner or the actual joint lives of the owner and a designated beneficiary, or (3) distributed over the life expectancy of the owner or the joint life expectancy of the owner and a designated beneficiary. The required beginning date is April 1 of the year following the calendar year in which the IRA owner attains age 70½. 1 For all subsequent years, the minimum distribution must be made by December 31 of that year. Unlike certain qualified plan participants, IRA owners cannot delay distributions beyond the required beginning date because they continue to be employed. 2
For each calendar year, beginning with the required beginning date, the minimum distribution is calculated by dividing the December 31 account balance (from the preceding year) by the remaining life expectancy of the account owner or, in some cases, the joint life expectancy of the owner and the designated beneficiary. 3 In general, the IRA owner will use the Uniform Lifetime Table to determine the life expectancy used in calculating the required distribution. 4 If the spouse is the sole beneficiary and is more than 10 years younger, the IRA owner may use their joint life expectancy from the Joint Life and Last Survivor Expectancy Table. 5 This table provides a longer distribution period by including the longer life expectancy of the younger spouse. Thus, the selection of a spouse as beneficiary may influence the lifetime distributions required of the IRA owner. 6
The owner of multiple IRAs must calculate the minimum distribution for each account separately. These amounts may be aggregated into a total amount to be withdrawn from one or more of the IRAs. This rule does not apply to inherited IRAs, which may not be aggregated with other IRAs owned by a beneficiary. It is, however, permissible to aggregate inherited IRAs from the same decedent. 7
The RMD provides a floor for the amount to be withdrawn for a specific tax year. The IRA owner or the beneficiary of a deceased owner always has the option of taking a lump-sum distribution or any distribution amount in excess of this minimum. If the owner or beneficiary does not withdraw the required minimum amount, however, the consequence is a penalty tax of 50% imposed on the difference between the RMD and the lesser actual distribution. 8 Proper application of the rules is important to avoid unexpected tax liabilities and penalties when maximizing the deferral of distributions.
IRA Beneficiaries
The choice of an IRA beneficiary may affect the lifetime RMDs when that choice is a spouse who is more than 10 years younger than the owner. The beneficiary selection also affects post-death distribution requirements. The effect depends on whether the beneficiary is an individual and whether that individual is a surviving spouse who is the sole beneficiary of the account.
For purposes of measuring post-death distribution requirements, a beneficiary must be a designated beneficiary. In most cases, the designated beneficiary’s life expectancy will be used to determine minimum distributions from the account. A designated beneficiary is one who was a beneficiary at the date of death and remains a beneficiary as of September 30 of the year following death (the determination date). Beneficiaries may be removed during this 9- to 21-month window by issuing a disclaimer or receiving their entire share of the distribution before the determination date. If a beneficiary dies before the determination date without making a disclaimer or receiving the full benefit, he or she continues to be treated as a beneficiary (i.e., he or she is not replaced by a successor beneficiary). 9
A designated beneficiary must be an individual and may be affirmatively named by the owner or defined under the terms of the plan. An estate or trust cannot be a beneficiary for this purpose. The designated beneficiary does not have to be identified by name but must be identifiable as of the determination date. An individual who is not a named beneficiary but inherits an interest under a will or by state law is not considered a designated beneficiary. 10
IRA beneficiaries are divided into two categories for application of the distribution rules. A unique set of rules is available to a surviving spouse who is the sole beneficiary of the IRA with an unlimited right to withdraw funds (surviving spouse IRAs). All other beneficiaries fall into a second category with a more limited set of distribution alternatives (inherited IRAs). Within each category, the applicable distribution rules will depend on whether the owner died before or after the required beginning date.
Most IRA plans call for the owner to name a primary and often a secondary beneficiary. Plan rules will indicate the default beneficiary if the owner does not name one. If the named beneficiary is significantly younger than the owner and applies the life expectancy rule or the ownership rule in the case of a surviving spouse (discussed below), this lengthens the IRA’s distribution period. The owner’s selection of a beneficiary will affect the life expectancy used in calculating the distribution period and thereby also will affect the overall tax cost of IRA distributions.
Distribution Rules Applicable After IRA Owner’s Death
The minimum distribution rules that apply to an inherited IRA or a surviving spouse beneficiary depend on whether the IRA owner had reached his or her required beginning date. There is generally greater flexibility if the owner dies before the required beginning date. Available alternatives depend on the identity of the designated beneficiary or the absence of such a beneficiary.
Inherited IRAs
The beneficiary of an inherited IRA does not have the option of treating the IRA as his or her own. This is the case whether the IRA owner dies before or after the required beginning date. Although rollovers of inherited IRAs are not permitted, a trustee-to-trustee transfer by the beneficiary is allowed as long as the IRA account is in the deceased owner’s name for the benefit of the beneficiary. It is imperative that the title of the account remain in the deceased owner’s name throughout the entire distribution period. 11
If the IRA owner dies before the required beginning date, a beneficiary receiving distributions from the inherited IRA does so under the five-year rule or the life expectancy rule. If the beneficiary is not a designated beneficiary, the five-year rule applies. If the beneficiary is a designated beneficiary, the life expectancy rule applies, unless the plan specifies that the five-year rule applies or allows the beneficiary to elect which rule applies. 12
The five-year rule requires the entire interest to be distributed within five years after the IRA owner’s date of death. 13 This permits periodic payments over five years or a lump-sum withdrawal at any point during that time period. In either case, the entire account balance must be distributed by the last day of the fifth year following the owner’s death. This alternative limits deferral of any taxable withdrawals to a five-year distribution period but gives the beneficiary some control over the starting date within that time period. In most cases, this will not maximize the deferral period to the extent of the life expectancy alternative.
The life expectancy rule permits withdrawals based on the single life expectancy of the designated beneficiary. This calculation is made by obtaining the designated beneficiary’s life expectancy from the Single Life Expectancy Table, using the age of the designated beneficiary in the year following the IRA owner’s death and reducing that life expectancy by one in each subsequent distribution year. 14 This approach is often referred to as a “fixed” life expectancy since it applies the initial multiple obtained from the table as a fixed amount reduced by one each year, rather than using the multiple given in the table for the beneficiary’s age in each distribution year.
Example 1: T’s father died in 2010 at age 60 and bequeathed his IRA, with a balance of $100,000, to his son. T turns 30 in 2011 and will begin distributions in that year. T’s life expectancy from the Single Life Expectancy Table is 53.3. His initial minimum distribution of $1,876 will be calculated by dividing the $100,000 by the life expectancy multiple. The 2012 minimum distribution will be calculated by dividing the IRA balance as of the end of 2011 by 52.3 (53.3 minus 1, rather than the 52.4 multiple that is given in the table). This methodology will continue to determine T’s minimum distributions until the account is exhausted.
If the beneficiary’s life expectancy exceeds five years, this alternative offers greater deferral opportunities than the five-year rule. Under the life expectancy rule, the beneficiary must begin receiving distributions by the end of the year following the year of the owner’s death. If the IRA owner’s death occurs on or after the required beginning date, distributions must continue, and the required minimum will be determined using the longer of the life expectancy of the deceased owner or the designated beneficiary from the Single Life Expectancy Table. The calculation will be based on a fixed life expectancy that is reduced by a factor of one for each calendar year in the distribution period. 15
Example 2: D’s father dies after his required beginning date at age 72. D compares her father’s life expectancy of 15.5 (from the Single Life Expectancy Table) with her own life expectancy of 53.3 and uses the higher number to determine her minimum distributions. The methodology of reducing the life expectancy by a factor of one for each year of distribution applies. D’s distributions in this case would begin in 2011, the year following her father’s death.
An IRA that is inherited after the required beginning date does not afford any flexibility regarding the starting date for the minimum distributions. The rules maximize the deferral period by allowing the longest life expectancy to be employed in the distribution calculation.
Surviving Spouse IRAs
Owner dies before required beginning date: A surviving spouse has more flexibility regarding distribution options. If the deceased owner had not reached the required beginning date prior to death, surviving spouses have two alternatives that affect the timing of required distributions from the IRA. A surviving spouse may choose not to treat the account as his or her own, which invokes rules similar to the inherited IRA rules. Alternatively, if the surviving spouse is the sole beneficiary and has an unlimited right to withdraw amounts from the IRA, the surviving spouse can choose to treat the account as his or her own account. 16
If a spouse takes ownership of the account, all the general rules apply as if the spouse were the original owner. This means that required distributions would begin at the surviving spouse’s required beginning date. For a spouse beneficiary who is significantly younger than the deceased IRA owner, this could substantially defer distributions. However, if a surviving spouse under age 59½ needs to make a withdrawal, it will be subject to the 10% penalty of Sec. 72(t), which would be avoidable if the spouse did not take ownership.
Spouses who choose to make the IRA their own may do so by affirmatively making themselves the designated owner of the IRA or by rolling over the IRA assets to their own IRA or qualified plan account. Spouses also become owners if they make a contribution to the IRA or do not take an RMD. The surviving spouse can make the ownership election at any time after the IRA owner’s death, even if distributions have begun under one of the other alternatives. In order to make this election, however, the spouse must be the sole beneficiary and have an unlimited right to withdraw amounts from the IRA. 17
If ownership is not elected, minimum distributions must be made over the surviving spouse’s life expectancy as long as distributions begin by the later of (1) December 31 of the year following the year of death or (2) December 31 of the year in which the IRA owner would have attained age 70½. 18 The minimum distribution is calculated using the surviving spouse’s life expectancy for the age reached in each distribution year (i.e., this is not a fixed life expectancy). 19 Alternatively, a surviving spouse could apply the five-year rule.
Owner dies on or after required beginning date: If the deceased IRA owner dies on or after his or her required beginning date, the surviving spouse still has the option of treating the IRA as his or her own. Any required distributions that were due to the deceased owner must be paid out to the surviving spouse in the year of death; however, the timing of any future distributions will depend on the election made by the surviving spouse.
If the spouse does not elect to assume ownership of the IRA, he or she must continue the RMDs by using the longer of his or her life expectancy or the life expectancy of the IRA owner (as of the date of death) from the Single Life Expectancy Table. This is not a fixed life expectancy. 20
Multiple Beneficiaries and Separate Accounts
The life expectancy of the designated beneficiary is used in calculating post-death RMDs. If there are multiple individual beneficiaries for the same account on the designation date, the oldest one (i.e., with the shortest life expectancy) will become the designated beneficiary. If any one of the beneficiaries is not an individual, the account is treated as if there is no designated beneficiary. 21
There is an exception to both of these rules when an IRA with multiple beneficiaries is divided into separate accounts either before or after the owner’s death. If separate accounts representing the separate interests of the beneficiaries are established no later than the last day of the year following the year of death, the distribution rules will apply individually to the beneficiary of each separate account. 22 Although the deadline to set up separate accounts extends to December 31 of the year following death (a delay of three months beyond the determination date for designated beneficiaries), each beneficiary of a separate account will be the designated beneficiary of that account as long as he or she would have been qualified on the determination date. 23 Separating the accounts allows each beneficiary to apply his or her own life expectancy to determine the distribution period. It also allows individual beneficiaries to avoid the “no beneficiary” rules despite the fact that the original group included a beneficiary that was not an individual.
In order to satisfy the provision governing separate accounts, there must be a separate pro-rata allocation of all investment gains and losses, contributions, and forfeitures that accumulate in the period prior to the establishment of separate accounts. This must be done in a “reasonable and consistent manner.” 24 If these conditions are not met, the life expectancy of the oldest beneficiary will determine the distribution period applicable to all the separate accounts, or the “no beneficiary” rules will apply if any nonindividuals are included in the group.
No Beneficiary
The minimum distribution rules for accounts with no designated beneficiary require the five-year rule to be followed if death occurred before the required beginning date. No other alternatives are available. 25 If death occurred on or after the required beginning date, distributions are to continue, with the distribution period calculated using the deceased owner’s life expectancy in the year of death as given in the Single Life Expectancy Table, reduced by a factor of one for each year in the distribution period. 26
A designated beneficiary must be an individual. An entity such as an estate, trust (with the exceptions noted below), or charitable organization cannot be a designated beneficiary. In cases where these entities are the named beneficiary or the default beneficiary, the applicable tax rules are the same as if there were no beneficiary. 27
In some circumstances, the beneficiaries of a trust (but not the trust itself) may be treated as designated beneficiaries. This is referred to in practice as a lookthrough trust and is applicable when the trust meets specific criteria:
- It is a valid trust under state law;
- It is irrevocable or becomes irrevocable upon the owner’s death;
- Its beneficiaries are identifiable from the trust instrument; and
- Proper documentation has been provided to the plan administrator. 28
In the case of a lookthrough trust, the beneficiary with the shortest life span determines the distribution period under the same rule that is applied to inherited IRAs with multiple beneficiaries. The beneficiaries of the trust cannot take advantage of the separate account rule. 29
Points to Consider
Unless there is an urgent need for the liquidity provided by the IRA funds, most beneficiaries will prefer to exploit any opportunities to minimize the tax cost of withdrawals by deferring distributions. The applicable rules for the various possible circumstances requiring post-death IRA distributions are summarized in the exhibit. A review of these rules highlights the two elements of the required distribution over which the beneficiary may exercise some control: the starting date and the length of the distribution period. Some plans may establish restrictions about which option applies; however, most traditional IRAs will permit the beneficiary to select the preferred option. The appropriate alternative for each beneficiary must be determined on a case-by-case basis, but it should be noted that certain actions must be taken on a timely basis.
Choosing Between the Five-Year and Life Expectancy Rules
If the life expectancy of the designated beneficiary is less than five years, the five-year rule may not only permit a delay in the starting date but provide more discretion as to the amount of funds that will be withdrawn each year, since there is no annual required distribution until the fifth year. This flexibility in the timing of withdrawals may be an advantage if the beneficiary’s tax rate changes during that period. For example, if the beneficiary prefers to have no distribution in the first three years following the IRA owner’s death, the five-year rule could permit this. The life expectancy rule may stretch the payments over a longer deferral period, but it restricts the minimum withdrawal to a specific calculated amount. If the life expectancy alternative is to apply, distributions must begin by the end of the year following the IRA owner’s death.
Surviving Spouse Ownership Alternative
Surviving spouses, who have the option of using their own life expectancy whether or not they choose to assume ownership of the account, have the greatest flexibility in using that choice to maximize the distribution period. It is not just the longer life expectancy of a younger spouse that expands the deferral. When a spouse takes ownership of the IRA, the future distributions are based on his or her life expectancy from the Uniform Lifetime Table, which provides longer distribution periods than the Single Life Expectancy Table used by beneficiaries. For example, a 70-year-old spouse would have a 17-year life expectancy from the Single Life Expectancy Table as a beneficiary but a 27.4-year life expectancy from the Uniform Lifetime Table as an IRA owner.
The ownership alternative is available to the surviving spouse at any time after the IRA owner’s death. This provides great flexibility in manipulating the timing of distributions. When the surviving spouse makes the ownership election, it applies to the entire remaining interest of the spouse. Before choosing this alternative, however, a surviving spouse should carefully consider the potential necessity of early withdrawals that may become subject to the 10% penalty on distributions before age 59½. If there is a significant probability of making such a withdrawal, maintaining the account as an inherited IRA rather than taking ownership will avoid this penalty.
Alternative Actions for Multiple Beneficiaries
When multiple beneficiaries exist, the regulations are very clear that the designated beneficiary will be the one with the shortest life expectancy on the designation date. Actions can be taken, however, that would allow younger beneficiaries to use their own life expectancy. The designation date provides a 9- to 21-month window from the date of death to accomplish any maneuvers that are to be made before that date. Beneficiaries with shorter life expectancies can be removed in one of three ways. Any beneficiary who receives his or her entire share of the IRA as a distribution before the designation date will not be considered a beneficiary at the time of the designation. Another option is for that individual to make a disclaimer, essentially refusing to accept his or her share of the IRA. The third possible action is to set up separate accounts in compliance with all requirements. This would allow each beneficiary to be the designated beneficiary of their separate accounts and thus use their own life expectancies to determine distributions. It is important to note that separate accounts must be established by December 31 of the year following death.
Naming a Beneficiary and Selecting a Plan
Certain estate planning measures will be critical to extending the required distribution period. Perhaps the most important decision is the naming of the beneficiary. This can be especially crucial when the IRA owner dies before the required beginning date. Without a beneficiary, the funds would have to be distributed entirely within the five-year rule. Not naming a beneficiary presents a missed opportunity to defer distributions over a younger, longer life expectancy. In addition, careful consideration should be given to the status of a surviving spouse beneficiary. By separating the interest of a spouse (in a separate account) from other beneficiaries, the IRA owner protects the spouse’s ability to choose ownership of the account. In order to have the ownership option, the spouse must be the sole beneficiary of the account.
Plan selection is another crucial consideration in preserving an extended distribution period. While most IRA plans do offer the opportunity for the beneficiary to make the elections permitted by the Code, the regulations clearly indicate that the beneficiary’s opportunity to make those elections is governed by the plan provisions. Another important feature is that the plan should solicit a beneficiary or define a beneficiary that is satisfactory to the IRA owner.
Conclusion
The rules applicable to post-death IRA distributions often permit deferral significantly beyond the distribution period that would apply if the IRA owner had survived. This extension of the deferral period over a longer life span of a younger beneficiary requires strategic planning both before and after the death of the owner. In addition to extending the distribution period, there may be an opportunity in some cases to delay the starting date of post-death distributions.
The factors that determine available options after the owner’s death include the plan rules and the designated beneficiary. A clear understanding of the impact of these factors on distribution options will improve estate planning for the owner and allow beneficiaries to take necessary actions on a timely basis in making the choices most suitable for their needs.
Footnotes
1 Regs. Sec. 1.408-8, Q&A-3.
2 Sec. 409(a)(9)(C).
3 Regs. Sec. 1.408-8, Q&A-1, referring to Regs. Sec. 1.401(a)(9)-5.
4 Regs. Sec. 1.401(a)(9)-9, Q&A-2.
5 Regs. Sec. 1.401(a)(9)-9, Q&A-3.
6 If the IRA owner’s spouse dies during the distribution year, even though a new beneficiary is named to the account, the deceased spouse’s life expectancy is used to determine the required distribution for that year. A divorced spouse’s life expectancy is used for the year of divorce, unless a new beneficiary is named in that distribution year (Regs. Sec. 1.401(a)(9)-5, Q&A-4(b)(2)).
7 Regs. Sec. 1.408-8, Q&A-9.
8 Secs. 4974(a) and (b).
9 Regs. Sec. 1.401(a)(9)-4, Q&A-4(a).
10 Regs. Sec. 1.401(a)(9)-4, Q&A-1 and Q&A-3.
11 Sec. 408(d)(3)(C) and Rev. Rul. 78-406, 1978-2 C.B. 157; see also IRS Letter Ruling 200616039 (4/21/06).
12 Regs. Sec. 1.401(a)(9)-3, Q&A-4(a)–(c).
13 Secs. 401(a)(9)(B)(ii) and (iii); Regs. Sec. 1.401(a)(9)-3, Q&A-1(a).
14 Regs. Sec. 1.401(a)(9)-5, Q&A-5(c)(1) and Q&A-6.
15 Regs. Sec. 1.401(a)(9)-5, Q&A-5(a)(1).
16 Regs. Sec. 1.408-8, Q&A-5.
17 Id.
18 Sec. 401(a)(9)(B)(iv); Regs. Sec. 1.401(a)(9)-3, Q&A-3(b).
19 Regs. Sec. 1.401(a)(9)-5, Q&A-5(c)(2).
20 Regs. Sec. 1.401(a)(9)-5, Q&A-5(a)(1) and (c)(2).
21 Regs. Secs. 1.401(a)(9)-5, Q&A-7, and 1.401(a)(9)-4, Q&A-3.
22 Regs. Sec. 1.401(a)(9)-8, Q&A-2(a)(2).
23 Id.
24 Regs. Sec. 1.401(a)(9)-8, Q&A-3.
25 Sec. 401(a)(9)(B)(iii).
26 Regs. Sec. 1.401(a)(9)-5, Q&A-5(c)(3).
27 Regs. Sec. 1.401(a)(9)-4, Q&A-3.
28 Regs. Sec. 1.401(a)(9)-4, Q&A-5(b).
29 Regs. Sec. 1.401(a)(9)-4, Q&A-5(c)(3).
EditorNotes
Linda Burilovich is a professor in the Department of Accounting and Finance at Eastern Michigan University in Ypsilanti, MI. For more information about this article, contact Prof. Burilovich at lburilovi@emich.edu.
