Note: These regulations were updated ago about a year after this article. Please see the estate planning article in the June 2002 Grandkid’s Watch for an update on the final regulations.
An important estate planning decision faces many of you. Make it carefully and the odds are greatly reduced that between estate taxes and income taxes the IRS will get 60% of your IRA.
You might recall that early in 2001 the IRS revised the rules for required minimum distributions for retirement account owners who are over age 70 1/2. (See my March 2001 issue.) Required payouts are reduced for most IRA owners. Also reduced are distributions for heirs inheriting IRAs, making it easier for an IRA to last several generations. Perhaps best of all, the rules allow everyone a fresh start. Even if you have been taking required minimum distributions for years, you can adjust you r estate planning strategy and use the new rules to recalculate your required payouts.
In the past, to minimize required payouts you had to carefully select a beneficary and determine the calculation method for the distributions. Then everyone had to die in the right order.
Under the new rules, most IRA owners determine required distributions using a joint life expectancy table that assumes the beneficiary is 10 years younger than the owner. (That table is linked with this article on the web site.) That’s a longer life expectancy than most people qualified for under the old rules. The new table also never requires the account to be depleted. The old life expectancy tables can be used when the beneficiary is your spouse more than 10 years younger than you.
You are allowed to switch to the new rules for 2001, even if you have been taking required distributions for years. Everyone has to use the new rules in 2002. I can’t think of any reason not to begin using the new rules. The advantage of switching is that the new rules lower the required minimum distributions. You always can take out more than required if you need to, so there is no penalty for using the new rules.
When converting to the new rules, here are some key points and estate planning strategies to consider.
- You can change the beneficiary at any time without changing required distributions. Even better, the heirs who actually inherit the IRA really don’t have to be determined until Dec. 31 of the year after the owner dies.
- Your estate planning strategy should be to name one or more primary beneficiaries. Then name alternate or contingent beneficiaries. After your death, if the primary beneficiaries (probably your spouse or children) don’t need all the assets, they can disclaim all or part of that inheritance. Then the rest could go to the alternate beneficiaries (your children or grandchildren).For example, suppose your wife is the primary beneficiary of your $500,000 IRA. Based on other income and assets, she decides to keep only $200,000 of the IRA. She disclaims the rest of the inheritance to your adult children. The two of them decide they need only $100,000 each and disclaim the rest. That goes to your grandchild, who starts out with a $100,000 IRA.The grandchild takes required minimum distributions over his life expectancy. All or most of the distributions will be taxed at his or her low rate, and earnings from the IRA likely will exceed the required distributions. That allows the IRA to grow indefinitely.
- A spouse still gets special privileges as beneficiary. A spouse who inherits an IRA gets to roll it into a new IRA in his or her name, then start the required distributions and designated beneficiaries from scratch.
- Be sure your heirs will get good advice. An IRA now can be broken up into separate IRAs, each with its own required distribution schedule based on the new owner’s life expectancy. This can happen when you name several joint beneficiaries or some heirs disclaim all or part of the inheritance as in the example above. Each can set up a separate IRA.
- Remember that your will doesn’t count here. Only beneficiaries named on the form kept by the IRA sponsor count. Name many possible beneficiaries on this form so that heirs have maximum flexibility. Name several layers of beneficiaries: primary, contingent, and remote.
- Don’t name your estate as beneficiary. This still results in accelerated distributions and income taxes shortly after your death.
- Don’t name a trust as IRA beneficiary unless you have very good advice. Some trusts work well with IRAs; some don’t. There’s less reason to name a trust since the new rules provide so much flexibility in splitting one inherited IRA into many.
- Don’t forget to state in your will who pays estate taxes. Often, if you don’t say anything, other beneficiaries pay the taxes from the IRA. That might mean that your children get the IRA but your spouse’s share of the other assets is used to pay estate taxes from the IRA.
- The new rules also apply to 401(k) plans and other qualified retirement plans, but there are differences. Keogh plans and 401(k)s cannot stretch payments to a non-spouse beneficiary. That is one reason it is best to roll over retirement plan assets to an IRA at retirement.
- The new distribution rules also apply to inherited Roth IRAs. Payouts from the Roth still can be tax-free, and the new rules allow the maximum amount of money to stay in the Roth IRA and compound tax free until needed.