Clients with substantial qualified retirement plans have an unparalleled opportunity to benefit their families. By taking advantage of the retirement distribution rules, clients can defer income taxes for up to 70 years. Maximizing estate-planning opportunities means making the best-but not always the most traditional-choice of beneficiary to a qualified retirement plan. Qualified retirement plans include IRAs, 401(k)s, 403(b)s, pension plans, profit-sharing plans, Keoghs, Simplified Employee Pension Plans (SEPs) and a combination of the above or others. Though differences among the plans exist, for our purposes they are treated in a similar fashion. I will refer to the variety of qualified retirement plans as IRAs.

Choosing grandchildren instead of a spouse or children as beneficiaries to an IRA increases the number of years proceeds can grow tax-deferred. The difference between naming a grandchild versus a spouse the sole or part beneficiary of an IRA often translates into millions in additional funds.

Providing For Everyone

The first goal for most couples with long marriages is to provide for the financial well-being of the surviving spouse. Couples will then want to provide for their children; only after the spouse and children are accounted for do most couples consider their grandchildren. Tax savings and even long-term growth are usually secondary considerations. For many estates, leaving the IRA to the children or grandchildren will not serve the first goal, which is protection of the surviving spouse. Predicting how much the surviving spouse will need to live comfortably is not an exact science, so it's often difficult to know if there is enough in an estate to justify naming children and/or grandchildren to IRA accounts.

It's usually best to err on the side of being conservative-over providing rather than under providing for the surviving spouse. Naming children and/or grandchildren beneficiaries of IRAs is appropriate only for estates of $1 million or more. However, there is no precise cutoff amount to determine which clients are appropriate candidates for this strategy because each client has different retirement and planning needs. Some clients with estates valued at $500,000 or greater may find choosing their children or grandchildren as beneficiaries to at least a portion of their IRA preferable.

Just how much can clients earn tax-deferred? Assume that between them, Mr. and Mrs. Wise have more than enough resources to support the surviving spouse comfortably after the death of the first spouse. Additionally, Mr. Wise has a $300,000 IRA, which he divides into three separate $100,000 IRAs, naming three different beneficiaries to each account. He names his 5-year-old grandchild as beneficiary to one $100,000 IRA, his 35-year-old child to the second IRA and his 68-year-old wife to the third IRA.

Mr. Wise dies before reaching age 70 1/2 and before receiving distributions from his IRA. The beneficiaries all opt for taking the minimum distribution allowed. Each beneficiary will be able to receive the following cumulative distributions over his or her lifetime from the inherited IRA.

Over 70 years, the results are staggering. The grandchild's distributions will total over $3.3 million; the child's distributions, $730,000; and the spouse's distributions, $208,000. The reason the grandchild's total distributions are so dramatic lies in the amount of time that the funds can be invested in the tax-deferred environment.

The rate of return on the investment will affect dramatically the total distribution realized by the beneficiary. A 7% average annual rate of return brought the grandchild $3.3 million. At a 9% rate of return, the total distributions for the grandchild are nearly $11 million. At a 5% rate of return, the grandchild's distributions drop to $1 million.

Minimum Annual Distributions

Had Mr. Wise lived, the Internal Revenue Service would have required him to take his first distribution on or before April 1 of the year after he reached age 70 1/2. If Mr. Wise elected to receive the distributions based on his actuarial life expectancy, his minimum first-year withdrawal would be determined by dividing the amount in the IRA by the applicable federal factor. In this case, the calculation would be $300,000 divided by 16 for a minimum distribution of $18,750, or $6,250 per $100,000 in the IRA. As Mr. Wise ages, his minimum distribution would increase because his life expectancy would decrease. If Mr. Wise dies before his distributions start, younger beneficiaries-assuming the proper election-will be required to take out less money per year than would older beneficiaries. If Mr. Wise died, the minimum required annual distributions for each beneficiary over time are shown on the chart below.

EXHIBIT TWO: COMPARISON OF INTEREST RATES: Beginning Fund Balance of $100,000 and Varying the Annual Rate of Return

Since the grandchild has such a long life expectancy, he could take minimal distributions in the early years and larger distributions in later years. The child would have to take larger annual distributions than the grandchild, but less than the spouse's minimum distributions.

Change Of Rules If Owner Starts Receiving Distributions

The rules, however, for the distribution of the inherited IRA change if the IRA owner dies after his required beginning date (April 1 of the year following the year he turned 70 1/2). Substantial deferral opportunities still exist for beneficiaries even if the IRA owner dies after his required beginning date. But the opportunities are not nearly as favorable as in the case of the IRA owner dying before the required beginning date.

Skip Generations To Avoid Tax

Generation-Skipping Transfer Tax (GSTT) is a special tax levied in addition to the regular estate tax. The GSTT applies, for example, when a grandfather leaves money to his grandchild. A $1 million exemption, however, is available to offset otherwise taxable generation-skipping transfers. Naming a grandchild as the beneficiary of an IRA of less than $1 million is a good way to provide the most support for a grandchild and permanently avoid one level of estate tax. Though there are traps with the GSTT for the unwary, proper planning could save one level of estate taxes for transfers up to $1 million, and the IRA is an ideal method of leaving money to grandchildren.

Disclaimer Provisions in the Will

If your client falls in the middle area where they have enough money that there is a federal estate-tax problem (over $600,000)-but not so much that they can easily provide for their spouse and children, consider disclaimer provisions.

Disclaimer provisions add flexibility to an estate plan. Even with a simple will, a spouse always has an option to disclaim a bequest. A spouse can make a qualified disclaimer, in effect saying, "I don't want the property or part of the property that was left to me." The next in line according to the will, usually the children, will receive the property.

With a disclaimer-type will, the spouse has a choice of either disclaiming into a trust where he or she retains a right to the income or disclaiming completely, giving the children the money. The disclaimer-type will gives the most options and power to the surviving spouse. The terms of the trust establish that the spouse receives the income for life and the ability to invade principal for health, maintenance and support. Upon the spouse's death, the property is left to the children.

The provisions of the trust may be almost identical to the unified credit shelter trust provisions, or Qualified Terminable Interest Property (QTIP) provisions, if desirable. The added option of the surviving spouse retaining the income and the right to invade principal for health, maintenance and support could be invaluable for the family. This disclaimer-type will is ideal if the spouse doesn't need the principal, but may need the income.

EXHIBIT THREE:  ANNUAL DISTRIBUTIONS TO IRA BENEFICIARIES:  Beginning Fund Balance of $100,000 and Assuming 7% Annual Return.

The advantage of disclaiming the money either into a trust (but not qualifying for a QTIP) or disclaiming the entire interest to the children is that the property will not be in the second spouse's estate, thus saving estate taxes on the second death. The disadvantage of disclaiming is that after doing so, the spouse loses rights to the property, though with a disclaimer-type will the spouse can retain the income from the property.

Disclaimer-type wills have all the benefits of simple wills and classic A/B trust-type wills, but leave ultimate flexibility with the surviving spouse. The surviving spouse will make the decision of whether-or how much-to disclaim within nine months after the death of the first spouse. The spouse can disclaim as much or little as he or she would like. Also, the spouse can disclaim certain assets and not disclaim others.

Another advantage of the disclaimer-type will is that the surviving spouse is able to assess financial needs after a death before determining an appropriate action. Estate planners call this "getting a second look." The disadvantage is that the first spouse may not want to give the surviving spouse that much control. For example, a disclaimer-type will would be a bad choice for a second marriage where there are children from a first marriage, because it gives the surviving spouse the option to keep all the money at the expense of those children. While the concepts of disclaimers are good for many married couples with long marriages and complete trust, they are clearly not for everyone.

Disclaimer Provisions in the Named Beneficiary of the IRA

If giving the surviving spouse the flexibility to disclaim assets is an appropriate strategy for your client, consider naming a trust as the contingent or secondary beneficiary to the IRA. The IRA owner still retains control of the plan while alive. In addition, the beneficiary designation of an IRA is revocable until death. The funds in the IRA could be used to qualify for either the marital deduction or to fill the unified credit shelter amount, or both. Naming a trust as beneficiary to an IRA is particularly important if the estate does not have other assets that qualify for the unified credit amount. More importantly, this type of trust will not immediately accelerate income taxes on the amounts in the IRA and can be used to fund the unified credit equivalent and the unlimited marital deduction.

Alternately, if the spouse is the first beneficiary, a trust will be the contingent beneficiary. The spouse then has the option of disclaiming to the trust. The terms of the trust-practically the same as under the will-assure that the surviving spouse receives the income for life and the right to invade principal for health maintenance and support. At the surviving spouse's death, the money is distributed to the children.

The most important widely cited authority for allowing a trust to be the beneficiary of an IRA and still preserve the marital deduction is Revenue Ruling 89-89 (1989-2 C.B. 231). The Revenue Ruling also describes all the steps the planner and the executor utilized to achieve the desired result. Private Letter Ruling 9317025 provides additional guidance on the intricate rules of drafting a trust where the trust is the named recipient of an IRA. The grantor was the primary beneficiary and the spouse was the secondary beneficiary. This is an example where the Trustee, on the grantor's death, can spread remaining payments from the IRA over the spouse's life expectancy.

If the trust is properly drafted and the appropriate elections are made, this is an effective way of giving the surviving spouse ultimate flexibility. Using this disclaimer strategy postpones the tough decisions of allocating money between surviving spouse and children until after the first spouse dies. An estate planner, however, must meticulously follow special language and rules to make this technique work.

Plans For Spousal Rollovers vs. Naming Children Or Grandchildren

For younger clients whose primary goal is long-term tax deferral, it may be best to name a spouse the beneficiary of the IRA. The surviving spouse then has the option of rolling over the IRA into their own IRA and not receiving any distributions until the surviving spouse reaches 71 1/2. If the spouse is 50 years old, there will be an additional 22 years of tax deferral.

The disadvantage of naming a surviving spouse to try to get additional tax deferral is that the IRA will be included in the surviving spouse's estate. In this case, the savings due to the tax deferral may be surpassed by an increase in the estate taxes at the time of the surviving spouse's death.

Inherited IRA vs. Outright Gift

Compare the choice of leaving a 5-year-old grandchild $100,000 in an IRA to leaving $100,000 in an account that is not tax-deferred. Assume that the grandchild withdraws the same amount from both accounts at the same time over the years. The withdrawal amount is the required minimum distribution from the IRA. Distributions are identical, but the grandchild with the outright gift will run out of money 14 years earlier than will the grandchild with the IRA. The grandchild with the IRA receives an additional $1.5 million after income tax over the next 14 years after distributions from the outright gift end.

EXHIBIT FOUR:  IRA VS. OUTRIGHT GIFT AFTER INCOME TAX COMPARISON:  Beginning Fund Balance of $100,000 and Assuming 7% Annual Return

Critical Choices and Elections

To develop the optimal estate plan, there are several crucial choices and elections that IRA owners and their beneficiaries must make. Timing is essential. A successful estate plan requires that the right choices and elections be made at the right time by both the IRA owner and the beneficiary.

When the IRA beneficiary misses the election to receive the minimum annual distribution, the opportunity is lost forever. The IRA beneficiary will have to withdraw all of the money out of the IRA within five years instead of over the beneficiary's lifetime.

Before an IRA owner receives any distributions, he or she is faced with an election to withdraw funds using the "life expectancy recalculation" method or the "term certain" method. The life expectancy recalculation method usually works best if the IRA owner survives for many years. By naming a younger beneficiary, the IRA owner reduces the amount of the minimum distributions. The term-certain method usually works best if there is a shorter period between the time of the IRA owner's first distribution to the time of the IRA owner's death.

If the IRA owner fails to make an election or makes the wrong election, there may be a considerable acceleration of tax and reduced total distributions. Special care in examining the controlling qualified retirement plan document is needed. The recalculation election is available only if it is specified in the plan or the qualified retirement plan agreement.

In both examples, choosing the wrong election ruins the master plan for deferring taxes, potentially exposing the family to disastrous financial consequences. To make matters more confusing, the regulations do not offer a prescribed form in which to make several of the recommended elections, so it is important to be specific when spelling out the intent of the election. Additionally, estate planners may want to send the election via certified mail, return receipt requested, to the financial institution holding the IRA for documentation purposes.

Before Changing Beneficiaries

If the inherited IRA is the grandchild's primary source of income, then the minimum distribution amounts may be insufficient to meet basic needs. The grandchild is permitted to take distributions above the minimum amount without paying the premature distribution penalty. The tax-deferral benefits, however, may be significantly reduced. When the grandchild withdraws significantly more than the minimum distribution, it often defeats the plan for long-term tax deferral. Leaving tax-deferred dollars to the grandchild makes sense as long as he or she will not need to deplete the fund within the first 25 years after the death of the IRA owner.

Requirements for Spousal Consent

Naming children, grandchildren or trusts as beneficiaries of qualified retirement plans can maximize family wealth. The decision to use this as an estate-planning tool may have to be a family decision rather than a decision of the owner of the plan. Federal law requires that spouses explicitly waive their right to receive benefits from most qualified plans before any other beneficiary can be designated. This requirement does not apply to IRAs.

Estate Tax On Excess Accumulation In An IRA

In addition to estate taxes, a 15% tax is levied on excess accumulations in qualified plans, including IRAs. The excess in the plan is the balance exceeding the value of an annuity paying $150,000 per year as adjusted for inflation based on the decedent's life expectancy immediately prior to death.

Example: Mr. Wise, now age 72, dies with a 401(k) plan valued at $500,000 and a 403(b) plan of $500,000. Multiply the factor 5.7261 (IRC 7520) times $150,000, which equals $858,915. The excess accumulation is $141,085 ($1 million minus $858,915). The excess accumulation tax is $21,163 (15% times $141,085).

This tax is not subject to the unified credit shelter amount. The surviving spouse can make an IRC 4980 A(d)(5) election to defer paying the excess accumulation tax. The spouse's estate, however, can be forced to pay a higher tax on the second death if the surviving spouse has his or her own IRA or if the inherited IRA grows. Once an estate is subject to the excess accumulations tax, the IRA is never again subject to the tax.

Another concern is the excise tax on excess distributions from an IRA while the client is alive. The planning complications are hair raising. Planners involved with an estate plan with a substantial IRA should consider the pitfalls and opportunities of the estate tax on excess accumulations and excess distributions.

Is My State Different?

State income tax and state transfer taxes are factors in choosing IRA beneficiaries. State taxes, however, are so small in scope compared to the federal tax, they are not a critical factor. One facet of the estate plan that should be considered is making sure that all the disclaimer provisions and distribution provisions of any trust created are valid under the laws of the client's state residence and consistent with the document controlling the client's plan whether it be a Keogh, 403(b), profit sharing plan, IRA, etc.

Conclusion

Under the right circumstances, clients with substantial IRAs can utilize the retirement distribution rules to defer income taxes for many years after their death. Disclaimer type wills and disclaimer type beneficiary designations should be considered by planners who want to retain flexibility in estate plans. The combination strategies of deferring income taxes and using disclaimers is something planners should consider to meet the needs of married clients with large IRAs.

Reprinted with permission of Financial Planning, The Official Magazine Of The International Association For Financial Planning. The layout and other changes have been adapted for reproduction.

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.