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Retirees who have prudently contributed the maximum amount allowed to their Individual Retirement Accounts and retirement plans are now rewarded with significant accumulations in the tax-deferred environment. The question follows: What should they do now?

Generally, paying taxes in the future is better than paying taxes now. To the extent an IRA owner can afford it, deferring distributions from the IRA as long as possible is also more advantageous. Although some differences exist, this article refers to all IRAs, TIAA/CREF accumulations, 401(k)s, SEPs, Keoghs, SIMPLE plans, 403(b)s, 401(a)s, and defined contribution plans as an IRA for simplicity.

Assume that an IRA owner has access to both an IRA and to after-tax investments. Should the IRA owner make withdrawals from the IRA or spend the after-tax funds first? In most cases, spending the principal from the after-tax investments first is preferable to taking taxable distributions from the IRA. (Please see Exhibit.)

EXHIBIT

Consumption of $87,000 Annually Using
IRAs and After-Tax Savings

One situation, however, where it may be wise to make premature withdrawals from the IRA is when there will be significant estate taxes, and the IRA holds the only funds available to pay the taxes. In certain cases, it may be wise to take premature distributions, pay the income tax, and gift after-tax proceeds to the beneficiaries. Methods of leveraging gifts with Grantor Retained Annuity Trusts (GRATS), Charitable Retained Annuity Trusts (CRATS), second-to-die life insurance policies, family limited partnerships, and other techniques may be appropriate for wealthy individuals. This strategy of prematurely incurring income taxes on IRAs and gifting after-tax proceeds will, in limited circumstances, be beneficial by not only reducing the amount of the estate, but also by providing the beneficiaries with funds to pay the estate taxes.

Retirement Options—Should Employees Annuitize?

Another question facing retirees is: Annuitize or not? Annuitizing IRA accumulations means essentially surrendering all or a portion of the IRA in exchange for receiving regular payments in the future. IRA owners who annuitize often choose to receive payments for the remainder of their and their spouses’ lives. One problem with annuitizing is that the money is rationed out over the years without regard to the IRA owner’s needs. If IRA owners do not need the money, then annuitizing needlessly accelerates the payment of income taxes on the IRA. Furthermore, if more than the annuity amount is needed, then the IRA owner is just plain out of luck.

A larger problem is that annuitizing is not an effective means of providing for an IRA owner’s heirs. By annuitizing, the IRA accumulation will vanish upon the IRA owner’s death unless he or she chooses the surviving spouse or guaranteed period options. Choosing these options will, however, reduce the amount of money that the IRA owner will receive in annuity payments.

In essence, annuitizing is a gamble. Since the annuity is based on life expectancy, IRA owners are gambling that they will outlive their actuarial life expectancies. Thus, if they have reason to believe that they would not survive their actuarial life expectancies, then annuitizing would probably be a mistake.

If IRA owners and/or their spouses think, however, that they are going to substantially outlive their actuarial life expectancies, then annuitizing would probably work well. It is also reassuring that with an annuity, no matter how long a person lives, he or she can be assured of an income stream.

For IRA owners who lack particularly strong opinions about whether they are going to outlive their life expectancies, a reasonable strategy to consider is annuitizing a small portion of their IRAs. Annuitizing a portion, but not all of the IRA, is a method of diversifying retirement assets.

The Required Beginning Date (RBD) is the date when the IRA participant must begin to receive annual distribution amounts withdrawn from his or her retirement accumulations. Under the Small Business Job Protection Act of 1996, the RBD is now the later of April 1st of the calendar year following the year in which the participant (1) reaches age 70½, or (2) retires. Use of the later retirement date for the RBD is not available to IRA owners or owners of five percent or more of the company sponsoring the retirement plan.

Taking Distributions from the IRA

Assuming that an IRA owner would like to retain funds in the tax-deferred environment but does not want to incur a penalty, he or she will take the minimum required distribution. The minimum distribution rules are based on the joint life expectancy of the IRA owner and the IRA owner’s named beneficiary. The minimum distribution is calculated by utilizing actuarial life expectancy tables dictated by the Internal Revenue Service—as reflected in Appendix E of Publication 590, which is likely to be revised next year. Most IRA owners name their spouse as their beneficiary.

For example, assume that an IRA owner, Mr. Wise, is age 71, which, according to the IRS tables, gives him a life expectancy of 15.3 years. The tables indicate that his 65-year-old spouse has a 20-year life expectancy. Their joint life expectancy to determine the minimum distribution amount is 22.8 years. Thus, the minimum required distribution for the first year if Mr. Wise has $2 million in his IRA is $87,719 ($2,000,000 ÷ 22.8).

For subsequent year calculations, the two methods used to calculate the minimum distribution option are the recalculation method and the term certain method. These are different methods for determining the life expectancies of both the IRA owner and the primary beneficiary. Under the term certain method, on each anniversary of the RBD, one year is subtracted from the IRA owner’s original life expectancy. The recalculation method allows the IRA owner to recalculate his or her life expectancy every year. Note that as we age one additional year, our life expectancy decreases, but not by a full year. Using a higher life expectancy will result in a lower minimum required distribution.

To complicate matters further, an IRA owner may choose to recalculate one life and apply term certain to the other life. Contrary to popular belief and the natural intuition of IRA owners who would like to withdraw the minimum amount, the recalculation method for both spouses is often not the best choice. The reason it may be prudent to use the recalculation method for the IRA owner and the term certain method for the beneficiary is that, if the beneficiary predeceases the IRA owner, then the beneficiary’s life expectancy is recalculated to zero. However, this recalculation will force more rapid distributions from the IRA while the owner is alive.

Designated Beneficiaries

If an IRA owner names a non-spouse beneficiary (usually the children), then according to the Minimum Distribution Incidental Benefit (MDIB) rule, no more than a ten-year differential is allowed between the IRA owner’s age and a non-spouse beneficiary’s age in computing their joint life expectancy (although the actual age differential is usually more than ten years). An IRA owner can name a spouse, however, who is more than ten years younger than the IRA owner and, for purposes of the required minimum distribution, include the spouse’s age in determining their joint life expectancy.

Minimum Required Distributions after the IRA Owner’s Death

Upon Mr. Wise’s death, Mrs. Wise could roll over the plan into her own IRA. Mrs. Wise could then use her own and her newly named beneficiary’s life expectancy to calculate her required minimum distribution. Alternatively, if she was older than her deceased spouse, then she could continue to utilize her deceased spouse’s distribution schedule.

For a non-spouse beneficiary, the general rule is that the beneficiary must take distributions at least as rapidly as the deceased IRA owner. If, however, certain conditions are met and the proper elections have been made, then the beneficiary will be able to use his or her own age to determine the required minimum distribution. The life expectancy of the non-spouse is determined as of the date the IRA owner reached age 70½, reduced by one year for each year thereafter (i.e., the term certain method).

Taxpayer Relief Act of 1997

In August 1997, President Clinton signed new tax legislation that will have profound changes with far reaching implications for retirement and estate planning. For wealthy investors with significant balances in their IRAs, the legislation is almost too good to be true. I had to pinch myself.

First, the new legislation permanently eliminated both the excess distribution and excess accumulation taxes. Avoiding these taxes was the major reason that some financial planners have recently recommended prematurely withdrawing funds from IRAs. Since avoiding these two taxes is no longer necessary, there is little motivation to withdraw funds from an IRA before the IRA owner needs the money (except for the gifting strategy previously discussed).

More importantly, the legislation created a new type of IRA. The "Roth IRA," named after Sen. William V. Roth, Jr. (R-Del.), will become effective in 1998 for contributions of after-tax money for married people who have less than $160,000 in income. The money will grow free of tax and withdrawals will be tax-free, if the funds are held for five years and the IRA owner is 59½ when distributions begin. Premature withdrawals are also tax-free if used to purchase a first home (up to $10,000 only). Early indications suggest that the Roth IRA will be irresistible for eligible taxpayers who can afford to make the contribution. In effect, all income and capital gains earned within the IRA are not taxed, which is better than current, regular IRAs where the income and capital gains are only tax-deferred. Another favorable feature is that the minimum distribution rules will not apply to Roth IRAs nor will income taxes be due upon the owner’s death.

In as early as 1998, current IRA owners with an adjusted gross income of less than $100,000 can convert their regular IRAs into Roth IRAs. This conversion is something every IRA owner should seriously consider. Converting, however, requires that income taxes be paid on the entire IRA (less nondeductible contributions) during the year of conversion. This unseemly conversion strays from the general principle that it is usually better to pay taxes later than pay taxes now. In most of the scenarios that we analyzed, however, the retiree will enjoy substantial benefits from the conversion. The huge future income-tax savings will more than offset the current income tax bite. As an incentive, if the conversion is made before January 1, 1999, then payment of the income taxes resulting from the IRA conversion can be spread over four years. Prudence dictates caution for making this conversion without understanding all of the implications.

Beneficiary of the IRA

If a retiree’s IRA is his or her primary asset, then the beneficiary designation of the IRA (not the retiree’s will) will be the primary document that will control the disposition of wealth. Most married retirees name their spouses as the primary beneficiary and their children as secondary or contingent beneficiaries to their IRA. Better options, however, exist.

Naming a spouse as the primary beneficiary of an IRA has several advantages: (1) the spouse is the most likely object of the IRA owner’s affection, (2) the spouse does not have to pay any federal estate tax on the IRA because of the unlimited marital deduction, (3) naming the spouse is likely to decrease the minimum required distribution while the IRA owner is still alive, and 4) the original amount in the IRA can be distributed over a longer period once the IRA owner dies since the spousal beneficiary can use both his or her own life expectancy and the life expectancy of his or her children. This is subject to the MDIB rules once the surviving spouse rolls the deceased spouse’s IRA into his or her own separate IRA.

Plan Benefits Trust Beneficiary

If the total marital estate is more than $600,000 (which under the new law increases in increments to $1 million in the year 2007), then a special trust called a Plan Benefits Trust (PBT) can be created and designated as the second or contingent beneficiary to the IRA. The purpose of the PBT is to fund the unified credit shelter trust.

This PBT is created in addition to any trusts that might be established in a will. The terms of the PBT provide the surviving spouse with income for life, and, subject to the trustee’s discretion, the ability to access principal for health, maintenance, and support. Upon the surviving spouse’s death, the remaining assets are distributed to whomever the IRA owner chooses, usually the children or special minor trusts depending on the age and maturity of the children. If the survivors make the proper election, then the income tax on the money in the PBT can be deferred.

One of the main purposes of the PBT is to save $240,000 (or potentially much more) in estate taxes for the IRA owner’s children, while also protecting his or her surviving spouse. The PBT is especially beneficial to IRA owners whose major asset is their IRA. Conventional thinking dictates that it is not ideal to fund the unified credit shelter trust with IRA money. For many IRA owners, however, the IRA is required to fully fund the unified credit shelter trust. Since a person’s will usually does not control the proceeds of the IRA, the PBT is necessary to utilize the credit shelter trust and maximize the estate tax savings to the heirs upon the surviving spouse’s death.

Disclaimer Strategy

Naming a trust (i.e., the PBT) as the primary beneficiary of the IRA, however, is not the best choice in most circumstances. It is preferable, instead, to name the surviving spouse as the first beneficiary and the PBT as the contingent beneficiary. The surviving spouse could then either choose to retain all of the IRAs proceeds or disclaim the proceeds of the IRA into the PBT. If the spouse is named as the first beneficiary, then he or she will also have the option of rolling over the retirement funds into his or her own IRA. Another advantage of naming the spouse as the primary beneficiary is that the spouse will not be burdened by a trust. In addition, there may be other funds available to fund or partially fund the $600,000 unified credit shelter amount that would make the PBT unnecessary. A final option is that the surviving spouse could keep a portion of the IRA and disclaim the remaining assets into the PBT.

The advantage of the surviving spouse being able to disclaim the full interest of the IRA into the PBT results from the potential savings of $240,000 or more in estate taxes for the children when the surviving spouse dies. The decision of whether the surviving spouse should inherit the IRA outright or whether the family would be better served by utilizing the PBT is often a tough decision. Many couples with long-term, trusting marriages where both spouses have the same children will prefer to let the surviving spouse make the decision after the first death when more relevant financial information is available. The mechanism to accomplish this goal is to name the surviving spouse as the primary beneficiary and the PBT as a contingent beneficiary.

Rather than making restrictive decisions when guessing at future circumstances, the disclaimer/trusts strategy allows an IRA owner’s spouse to make these important decisions with more defined and current information. When will more information be known? At the time of the IRA owner’s death. Additionally, the spouse will have nine months after the IRA owner’s death to make a qualified disclaimer. It is the ability to make a disclaimer of the benefits of the IRA that creates an optimal estate plan. Disclaimers have long been an important part of estate administration. Recently, sophisticated planners have been using the disclaimer as part of the planning process before a death occurs. Disclaimer planning, however, is probably not appropriate for second marriages where each spouse has his or her own children.

For tax and administrative reasons, the plan’s beneficiary designation should not refer to the IRA owner’s estate or a trust in the will. The PBT should be a stand-alone document drafted in conjunction with the will or living trust. The will and PBT can specify that the unified credit shelter trust be funded with both IRA and after-tax assets. The best choice of assets to fund the trust—if future circumstances indicate that the trust needs to be funded—can be made at the time of the IRA owner’s death, not now when less information is known.

If the IRA owner likes the disclaimer strategy, then disclaimer-type wills in addition to disclaimer-type retirement beneficiary designations are recommended. In both cases, everything is left primarily to the spouse, thereby allowing the surviving spouse to disclaim as much or as little as he or she wants into a trust for the spouse’s benefit. The drafter of the documents should provide for coordination of the PBT and the disclaimer trust under the IRA owner’s will. Under most circumstances, we prefer utilizing an integrated fractional formula in both the will and PBT to define the amount that will fund the trust. Note that as the amount of the unified credit shelter trust increases with the new legislation, the integrated formula will fully fund the trust without the necessity of drafting new wills.

Review Existing Wills and PBTs

A potentially enormous problem with existing wills and PBTs that do not utilize disclaimer strategies is that as the unified credit shelter trust amount increases, more money than either spouse intended will be used to fund the trust. For multi-millionaires, the automatic increase in funding the trust will be convenient. For married couples with taxable estates between $600,000 and $2 million, however, funding the trust at the expense of providing the surviving spouse a comfortable amount of money outside the trust could be a significant burden to the surviving spouse, especially since the trust is not available for discretionary spending. If too much money is in the trust, then the lifestyle of the surviving spouse could be dramatically restricted. Most clients agree to fund unified credit shelter trusts only upon realizing the potential estate tax savings which will occur after the death of the second spouse. The disclaimer-type wills and PBTs do a better job of providing for the surviving spouse by providing him or her with the option to fund or partially fund the trust. For clients who already have integrated disclaimer-type wills and PBTs, however, no changes are necessary.

Conclusion

Retirees have a wealth of options regarding their IRAs. In most situations, the IRA owner and the beneficiary will be well-served by retaining as much money as possible in the tax-deferred environment. One possible exception to this rule is to make premature distributions under a gifting strategy. IRA owners should also at least consider converting their regular IRAs into Roth IRAs. Annuitizing is a conservative strategy, but often appropriate for a portion of the IRA funds. Finally, IRA owners should consider establishing a coordinated estate plan that would incorporate disclaimer-type wills and disclaimer-type beneficiary designations.

This article originally appeared in the September 1997 issue 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.