Author(s): M. Sean Fosmire

Garan Lucow Miller, P.C.
Marquette, Michigan

A slightly shorter version was published
in the Michigan Lawyers Weekly April 3, 2000

IRAs and other tax-deferred retirement accounts (Keogh, SEP, 401(k) and SIMPLE plans among them) have become very popular in the last ten years, and indeed are now the primary retirement savings vehicle for most Americans. The tax-deferred nature of these accounts, however, presents a number of complications when they are included in estate plans. These complications are compounded by the statutory and regulatory twists that have been grafted onto what should be a simple retirement-planning idea.

An IRA is, in many senses, a trust, one whose terms are dictated by Federal statutes and regulations and for which there is very little flexibility. An approved “custodian” holds the funds, which may be invested as the custodian chooses or, in the case of a self-directed IRA, as the owner directs. The owner of the funds, sometimes referred to as the “participant”, incurs no tax liability of any kind for either ordinary income or capital gains generated within the account. Thus, the holdings may be freely traded without concern for the tax implications attendant upon any gain or loss.

When distributions are made, the proceeds are subject to income tax at ordinary income rates. Even if the majority of the growth in the account’s value has been generated by capital gains, the distributions are made as ordinary income. Theoretically, the participant will be generating less income in his retirement years and will therefore be in a lower tax bracket than he was when the funds were first contributed to the account or when they were generating gains.

Distributions from an IRA may not be made until the participant has reached age 59½. If premature distributions are made, they are subject to a 10% penalty, on top of the tax imposed on the distributions. There are some exceptions, including use of the funds to pay medical insurance premiums during a period of unemployment or to pay medical expenses in excess of the 7.5% floor, to pay for certain “qualified” education expenses, or to finance first-time home purchases (subject to a $10,000 lifetime limit). There is also an option at any time to begin payouts based on “substantially equal periodic payments” over the lifetime of the participant.

After the Required Beginning Date (RBD), April 1 of the year after the participant has reached age 70½ (later in some cases), minimum annual distributions become mandatory. The schedule of distributions depends upon a number of choices made by the participant, and the distribution schedule becomes fixed by those choices at that time. After the participant’s death, distributions to his or her heirs will depend upon who is chosen as the designated beneficiary (DB) and which payout choices were made before the RBD.

It is the schedule of mandatory distributions of taxable income and its interplay with the exposure to estate taxes which creates most of the complications for estate planning purposes.

Note that Roth IRAs are subject to some different rules. The primary difference between Roth accounts and standard IRAs is that (1) the distributions are never taxed, and (2) they are not subject to the minimum distribution rules after the RBD. For these reasons, some of the considerations noted in this article do not apply to Roth IRAs.

Note also that the funds held in an IRA are typically payable to a designated beneficiary and thus pass outside of the probate estate. Nonetheless, like insurance proceeds and joint accounts, they are included within the “taxable estate” for purposes of calculating estate tax liability.

The credit shelter trust

The primary goal of estate planning for married couples with assets between $600,000 and $2 million is to maximize the amount protected from estate taxes by using the exemption amount granted to each of them under the Internal Revenue Code. This is usually done by using a “credit shelter trust” (CST), also known as a “bypass trust” or “AB trust”, to take advantage of the available exemption amount for each individual. The unified exemption amount is $675,000 for persons dying in 2000 and 2001, and will be rising to $1 million by 2006. If a large proportion of the assets are held in an IRA, the funding of the credit shelter trust can become complicated.

It is usually not desirable to use the money in an IRA to fund the credit shelter trust. If an IRA is worth $675,000 and is used to fund the credit shelter trust, or if the participant uses it directly to fund the exemption amount without using a credit shelter trust, the value of the exemption amount is lost by an amount corresponding to the beneficiary’s marginal tax rate. If the beneficiary is in the 31% tax bracket, the beneficiary will owe over $209,000 in income taxes, and less than $466,000 will pass to him (assuming an immediate payout). By contrast, if funds owned outright are used to fund the CST, the entire $675,000 passes to the beneficiary, free of income taxes and free of estate taxes.

There is one scenario, however, under which using an IRA to fund the exemption amount can provide a significant advantage over any trust-based plan. If the recipient is a child or a young adult, then the distributions after the death of the participant can be based on the recipient’s much longer life expectancy, and the minimum annual distributions will be quite small by comparison with the continued tax-free growth of the account. In that case, the liability for income tax on the distributions is a reasonable trade-off for decades of further tax-free growth of the funds. (Careful attention to the generation-skipping rules is essential in this scenario.)

There are other problems with trying to use a large IRA to fund the CST. The documents should be drafted so that they use a fractional formula to divide the account after the death of the participant. Most planners believe that dividing the account using a pecuniary formula will result in the recognition of the entire account as income to the CST beneficiary at the time that the trust is funded, as income in respect of a decedent (IRD). This will probably not occur, however, if a smaller IRA is assigned in toto to the CST along with other assets as part of a pecuniary funding formula.

Designation of beneficiary

The choice of a designated beneficiary (DB) is important, and it is essential that the choice be properly made before the RBD. A beneficiary designation can be changed after the RBD, but that change cannot be used to lengthen the schedule of minimum distributions once they begin, until the participant’s death.

Most often, the participant will want to name his spouse as the DB. The spouse has a number of options that no other person has when named as DB. On the death of the participant, the spouse has the option of converting the account to her own name. She may also identify her own DB. A person other than a spouse may not convert the IRA to his or her own, and may not designate another beneficary.

The single, divorced, or widowed participant should name one or more individuals as DBs, and should not simply name his estate or leave the line blank. If he does not have a proper DB, the entire account will have to be paid out to his heirs as taxable income within five years of his death. An unpleasant surprise awaits his family if he includes a beneficiary other than a natural person (such as a church or charity) as one of several DBs: the IRS treats him as having “no DB”, and the mandatory five-year distribution rule applies.

Minimum distributions

The mandatory distribution amounts required by law after age 70½ are only minimums. Any additional funds may be taken from the IRA at any time. For this reason, the client should usually follow the plan which will result in the smallest minimum distributions; he can always take more if and when they are needed.

Once the participant reaches his Required Beginning Date (RBD), distributions must begin according to an established schedule. It is important to act before the RBD to choose a DB and to select the proper method for calculating minimum distributions. The participant who has a DB will use the joint life expectancy of himself and his DB for purposes of determining minimum distributions. Without a DB, his single life expectancy must be used.

The participant has the option of choosing a “term certain” or a schedule under which one or both life expectancies are recalculated each year. The issue of recalculation is quite complex, and in many cases consultation with a knowledgeable attorney should be sought to consider all of the options before the decision is made. In the absence of a full consultation, a quick rule of thumb is to avoid recalculation of life expectancies. Recalculation in some cases forces a mandatory payout of the entire account as taxable income within one year of the participant’s death. This is nearly always an undesirable outcome, and in many cases it can be catastrophic for the family.

If distributions are based on the joint life expectancy of the participant and the DB, and if the DB is significantly younger than the participant, then the Minimum Distribution Incidental Death Benefit (MDIB) Rule under IRC 401(a)(9)(G) comes into play. This rule essentially provides that a DB cannot be treated as being more than ten years younger than the participant for purposes of determining the minimum distributions during the lifetime of the participant.

After the participant’s death, however, the MDIB rules no longer apply, and the actual life expectancy of the DB is used to calculate minimum distributions. Thus, there are significant tax-deferral advantages to using a young DB, even with the MDIB rule.

Death of the participant

The general rules as to distributions after the death of the participant are as follows. If the participant dies before the RBD, and if the DB has been properly specified, the life expectancy of the DB will then be used for the calculation of minimum distributions. As noted above, if he did not properly name a DB, the entire account must be paid (to his heirs or to the improperly named beneficiary) within five years of his death.

If the participant dies after his RBD, that is, once mandatory distributions have begun, the distributions must continue using the schedule that the decedent had used, unless he had designated his spouse as his DB.

If the DB is the spouse, then the IRA can be (but need not be) treated as the spouse’s own IRA, and her RBD can be substituted for the purposes of calculating minimum distributions. An account which is already in a payout status can be suspended on the participant’s death, if it passes to his spouse as DB and if she elects to wait until her own RBD to resume taking distributions. Only the spouse is permitted to make this election.

If more than one person is named as DB, then the calculation is based on the age of the oldest of the group. If multiple beneficiaries of varying ages are named, and if the longest possible “stretch periods” are desired, one option is to separate the IRA into multiple accounts, and to make separate beneficiary designations for each. A charity could be named as one of the DBs by using this approach, without invoking the five-year distribution rule mentioned above.

It is necessary to review the rules of the custodian of the account well before the irrevocable designations are made. Some custodians impose requirements on accounts which are even more limiting than those imposed by the statutes and regulations. Verifying a custodian’s advice on the rules which apply and on the schedule of distributions with an attorney familiar with retirement accounts is often necessary, since the custodian will often have only limited understanding of these complex rules.

IRAs and Medicaid planning

The tax-deferred but tax-imminent nature of IRAs held by older clients should be taken into account when counseling clients with limited assets on Medicaid planning issues.

In Michigan, the Family Independence Agency considers IRAs to be fully available assets, without regard to the participant’s age or the payout status of the accounts. For the occasional client who is in need of Medicaid assistance for nursing care before age 59½, this creates a Catch-22: the FIA demands that the funds be used for nursing care, but the Federal government will impose a 10% penalty on that withdrawal. The regulations (new in 1998) which provide an exception for extraordinary medical expenses will help to ameliorate that situation.

For the client over age 59½, the funds may be withdrawn from an IRA in any amount at any time, without penalty, and thus they are also fully available assets. An IRA which has been “annuitized” is typically not considered available, but the regular payments do of course count as income.

Of interest is that fact that many states do not characterize IRAs as countable assets for Medicaid planning purposes. There are some situations in which a client whose family members live in other states may consider relocating if most of her assets are part of an IRA and if she would fare better under that state’s eligibility rules.

Because IRA funds, once withdrawn, are subject to income tax, a spenddown plan should typically look to other assets to pay for home improvements, car purchases, etc. The IRA cannot be simply transferred to another person, so any plan to give money to family members, as is done under the “half a loaf” strategy, should use other funds for this purpose. Using the IRA would require that the money first be taken from the IRA as income, with the participant then paying the taxes on the distribution and giving the remaining funds to family members.

In general, a strategy which creates recognized income should be coupled with a deduction which will offset that income. For that reason, the Medicaid plan will use other funds for spending on protected assets or for transfers, and keep the IRA intact until the time that personal funds need to be used to pay for nursing care. Using the IRA funds at that point to pay for nursing care will allow the recognition of income to be offset by the medical expense deduction, assuming that a doctor certifies that nursing home care is medically needed for the client, and of course subject to the 7.5% floor for the medical expenses deduction.