When good IRAs go bad: common pre- and post- mortem IRA problems with uncommonly bad results.

• Author: Lynch, Kristen M.
• Position: Individual retirement accounts

It is imperative for the IRA owner and their professionals to periodically review the IRA agreements that govern their accounts and review the statements as well.

Individual Retirement Accounts are tax-deferred accounts that, handled properly, can be an effective vehicle for retirement and can be passed on to a surviving spouse or other heirs while retaining the deferral of income tax. The new IRA rules enacted a few years ago provide postmortem planning opportunities in an area that previously had little flexibility. To take full advantage of these new opportunities, IRA owners and their professional consultants must pay special attention to the planning details. A lack of proper attention to details can have near disastrous results. The purpose of this article is to point out some potential perils and pitfalls.

IRA Planning in General

The Internal Revenue Service released new proposed Treasury regulations on January 12, 2001, and new final IRA regulations on April 16, 2002. (1) These rules simplify administration during the IRA owner's lifetime and provide new post-mortem planning opportunities. The basic rules provide for required minimum distributions (RMDs) to the IRA owner commencing upon the April 1 immediately following the calendar year in which the IRA owner attained age 70[degrees] (hereafter referred to as the required beginning date or RBD), or to the beneficiaries upon the death of the IRA owner. IRA monies are not subject to income tax until distributed to the IRA owner, or after the death of the IRA owner, to the beneficiaries. Distributions are taxed at the recipient's income tax rate.

The amount of deferral available depends on whether a beneficiary is named, and whether that beneficiary is considered a "designated" beneficiary. Under the new IRA rules, this means a beneficiary must either be an individual or certain trusts. To qualify, a trust must be valid under state law and become irrevocable by its own terms upon the IRA owner's death. In addition, the beneficiary must be listed on the beneficiary designation form to be considered "designated." Estates and charities are not considered "designated" beneficiaries in this context. The new post-death distribution period is based on the life expectancy of the designated beneficiary or beneficiaries (if there are separate shares) that remain as of September 30 of the year after the calendar year of the IRA owner's death. This could be substantial in the case of a young beneficiary. If there is no designated beneficiary, the distribution period is significantly shorter.

Spouses are normally the preferred choice to be designated as the primary IRA beneficiary. Spouses are the only beneficiaries allowed to roll IRAs over into their own name. However, this may be undesirable if it is a multiple marriage; if there are family or financial issues; if the surviving spouse cannot manage money; if the surviving spouse is susceptible to pressure from children; or the surviving spouse has a different dispositive intent than the decedent spouse. Spouses also have the ability to leave the IRA titled in the name of the decedent spouse and take distributions based on the remaining life expectancy of the decedent, but normally this is only used when the surviving spouse is significantly older than the decedent spouse because this severely limits deferral opportunities for the ultimate beneficiaries.

Properly drafted trusts can be used to ensure that the IRA owner's dispositive intent is followed. For example, a marital trust as primary IRA beneficiary in a second marriage situation would allow IRA distributions to pass through the trust to the surviving spouse for life, with the remaining balance paid to children from the first marriage after the surviving spouse's death. The downside to such a plan is that the spouse will be deemed the oldest beneficiary of the trust and, hence, the measuring life for RMD purposes; but the surviving spouse will have the benefit of income from the IRA for life without the ability to change the ultimate beneficiaries.

The new IRA rules also specifically provide for three new postmortem planning tools: disclaimer, distribution, or division. To avoid a taxable gift, disclaimers must be done in compliance with IRC [section] 2518 as well as state statutes. Generally, this is within nine months of the decedent's date of death. This time deadline is not extended to the September 30 beneficiary determination deadline. A complete distribution to a beneficiary prior to such September 30 is disregarded for purposes of determining who will be treated as designated beneficiaries and will preserve the deferral options for the remaining designated beneficiaries. Finally, accounts may be divided at any time after the IRA owner's death but must be divided by December 31 of the year following the year containing the decedent's date of death in order to be eligible for separate share treatment.

The Best Laid Plans

The IRA will be deemed to have no designated beneficiary if an otherwise designated beneficiary predeceases the IRA owner and there is no contingent beneficiary named; or the estate is named, or if there are multiple beneficiaries and one is not an individual; or there is some other breakdown in the planning process. For an IRA owner that dies after attaining RMD status, all of the above would result in a deferral limited to the remaining single nonrecalculated life expectancy of the decedent. (2) If the IRA owner dies prior to reaching RMD status and there is no designated beneficiary, distribution must be made by December 31 of the calendar year containing the fifth anniversary of the decedent's date of death. The lack of a designated...