Upcoming Events Seminars & Presentations
Retirement and the Estate Tax
June 09, 2000

by Lawrence R. Barusch

Many clients have substantial assets in qualified pension or profit-sharing plans ("Qualified Plans"), or Individual Retirement Accounts ("IRAs"). Some will have benefits due under a non-qualified deferred compensation plan ("Non-qualified Plan"). Large federal income taxes will eventually be due on these sums, but the ability to defer income taxation may have significant value. Coordinating the income tax considerations with federal estate and gift tax consequences is the subject of this paper.

I. Types of Plans

A. Qualified vs. Non-Qualified.

A qualified plan is an arrangement that qualifies for certain tax benefits under the Code . Usually contributions are deductible to the employer at the time of contribution, the earnings accumulate on a tax-deferred basis, and the employee is not taxed until distribution. Employers maintain qualified trusts under Code § 401(a), or (now rarely) annuities under Code § 403(a) and 404(a)(2). Non-taxing paying entities (charities, schools or universities, state government) maintain annuities under Code § 403(b). Individuals may contribute to an Individual Retirement Account under 408(a) or an Individual Retirement Annuity under 408(b). States and other tax-exempts may contribute to plans for their employees (often judges) under Code § 457.

If an arrangement does not qualify, the employer may get a current deduction with current inclusion in the employee's income. This is current compensation and generally not an estate planning issue. Alternately, the deduction and income inclusion may be deferred until the employee receives the funds. This is accomplished by having the plan be unfunded, because a mere promise to pay at a future time is not current income . In particular, any designated funds for such a plan must be available to general creditors of the employer in the event of bankruptcy. Alternately income may be deferred under Code § 83 until the right to receive income is transferable or not subject to a substantial risk of forfeiture.

B. Employer vs. Individual

Most plans are maintained by an employer. These are generally covered by the Employee Retirement Income Security Act of 1974 as amended ("ERISA") which is concerned, in part, with assuring that the employer's promise of retirement income to its employees is fulfilled. IRAs or all kinds (including annuities) are not subject to these provisions of ERISA and are generally controlled directly by individuals.

C. Defined Contribution vs. Defined Benefit

In a defined contribution plan each individual has an account balance (not necessarily a separate account) that is increased by employer or employee contributions and plan earnings and decreased by plan losses, plan expenses and distributions. The employer indicates what contribution it will make. The actual benefit depends on plan experience. At any given date the employee's potential benefit is his account balance.

In a defined benefit plan the employer promises a particular benefit (pension) based on years of service and compensation. For example the promise may be that at normal retirement age (say 65) the employee will receive annually during his life an amount computed by multiplying his average salary for the last five years before retirement (or some other average) by his years of service by a fraction (typically between 1% and 2%). Thus if the employee goes to work at age 25 under a plan where the fraction is 1.5%, at age 65 he will retire with an annual pension of 60% of his average salary. The actual benefit may be actuarially adjusted for early or late retirement, or if payable over the joint lives of the employee and the employee's spouse. The employer takes the risk whether the funds contributed provide sufficient income to meet obligations. Because the employer may not be able to make up funding deficiencies, such plans are insured by the Pension Benefit Guaranty Corporation.

D. Pension, Profit Sharing and Stock Bonus

For purposes of the Code a pension plan is one intended to provide post-retirement income and involves a firm commitment by the employer. A profit sharing plan is intended to defer income (generally at least two years) and the employer retains discretion to fund from year to year. Under current law such plans can be funded in the absence of profits. A stock bonus plan is a plan where the principal investment is stock of the employer.

E. Other labels.

1. 401(k) Plans.

The term 401(k) plan is sometimes used to refer to any employer plan with the suggestion the employee can direct how plan assets are invested. More properly it means a defined contribution plan where the employee may elect to make pre-tax contributions. Whether there is self direction is independent of whether the defined contribution plan is a 401(k) plan. Note that in defined benefit plans employers always direct the investment (they take the risk) and Individual Retirement Accounts (but not necessarily Individual Retirement Annuities) are of necessity self directed.


Most stock bonus plans choose to qualify as Employee Stock Ownership Plans, which provide certain additional benefits, currently almost exclusively to employers.

3. Special Plan Names.

A number of other terms are used for employer plans (target benefit plans, purchase money pension plans, age-weighted profit sharing plans, cash balance defined benefit plans) that relate to contributions and benefits but have no effect on estate planning (except perhaps for owner employees).

4. IRAs.

IRAs come in many flavors, including deductible IRAs under Code § 219, non-deductible IRAs see Code 408, (together, sometimes referred to as "classic IRAs") Roth IRAs under Code 408A with no current deduction, but no further income taxation, SEPs or simplified employee pension plans under Code 408(k) where the employer contributes to an IRA, SIMPLE plans under Code 408(p) which is an IRA to which a participant may contribute pre-tax earnings, an Education IRA under Code § 530 (which is a vehicle for saving for college and has little to do with retirement) and Medical Savings Accounts under Code § 220. A contributory IRA is one to which the holder contributed; a roll-over IRA is one to which distributions from an employer plan have been rolled over and a conduit IRA is a roll-over IRA when the funds are intended to be moved to another employer plan. These distinctions are only rarely significant for our purposes.

5. Stock Options and Stock Related Compensation.

Stock options are not ERISA plans at all, but are significant assets for estate planning. These may be Incentive Stock Options under Code § 422, or non-statutory stock options taxed under Treasury Regulation ("Reg.) 1.83-7. A related notion is stock purchased under Employee Stock Purchase Plans under Code § 423 (NOT an ESOP.) Phantom stock and stock appreciation rights are forms of unqualified deferred compensation.

6. Non-qualified Deferred Compensation.

Some non-qualified deferred compensation plans are also named. A Supplemental Employee Retirement Plan ("SERP") is intended to provide a percentage of retirement income to highly paid employees that cannot be provided under qualified plans because of limits on contributions under Code § 415. These may be "Top-Hat" (only top employees) or "Excess Benefit" (makes up disallowed contributions) plans for ERISA purposes. Benefits may put in the custody of a third party to assure payment, even though still subject to creditor risk ("Rabbi Trust."). A "Secular Trust" is one which is not subject to the employer's creditors but the employee's tax is deferred because of nontransferability and substantial risk of forfeiture.

II. Pre-Retirement Issues

A. Pre-retirement Survivor Annuities

Under current law, an employee's interest in a qualified plan becomes non-forfeitable not later than the time he completes seven years of service. Code § 411(a). In the case of a defined contribution plan, the account balance would be payable on death. However, in the typical defined benefit plan providing an annuity for the employee's life, the value of such an annuity on death is zero. Under Code § 401(a)(11)(A)(ii) a "preretirement survivor annuity" is usually required to be paid to the surviving spouse. This raises some matters for the estate planner:

1. Determine how much the annuity will be for planning purposes. This is not always simple.

2. Be careful the employee or spouse does not waive the annuity inadvertently (this may be a factor when using a trust), and consider carefully before intentionally waiving the annuity.

3. The annuity is payable to a SPOUSE. Consider how to advise the unmarried client who has a significant other, domestic partner or the like.

B. Early Retirement

Many clients are today considering retirement, before age 59 ½, or even age 55. Early distributions from qualified plans and IRAs are subject to a 10% penalty tax under Code § 72(t). For a discussion on how to handle this situation please see "When Can I Retire", Utah Bar Journal Vol. 13, No. 3 (February 2000) included with these materials.

III. Roll-overs and Annuities at retirement

At retirement, the client will usually have a number of options. Choosing among these options is an important part of estate planning.

A. Annuities.

In most plans the client will have the option of taking a joint and survivor annuity for herself and her spouse. One the death of the first spouse the annuity may continue at the same rate during the survivor's life or decrease (usually not below one half of the value during the joint lifetime.) The larger the survivor's annuity, the less the joint annuity will be, since these are actuarially computed benefits based on a fixed lump sum value. It may be possible to waive the spouse's interest altogether (yielding a higher annuity for the participant). In the absence of basis the entire amount of each annuity payment will be taxed when received.

1. Before choosing anything other than a joint and survivor annuity unreduced on the death of the first spouse, consider the health of both spouses. Clients sometimes choose the larger annuity without considering mortality.

2. The Supreme Court has held than retirement annuities should be calculated on a "sex-blind" basis. Women live longer than men. Therefore an unmarried man should almost never choose an employer annuity. He is likely to do better if he rolls the sum into an IRA and has the IRA buy a commercial annuity. The same will be true if one of the couple has a life expectancy that is recognized by commercial insurers to be shorter than average. It may be true for any couple. Check with a company selling commercial annuities.

3. A commercial annuity will usually guaranty a rate of return. This will provide security for the client, but typically a lower rate of return than can be expected in the long run from a well-managed diversified portfolio of reasonably conservative investments (readily available in mutual funds). For a wealthy client an annuity is generally a poor investment.

4. If the client does not plan to consume her entire estate during the lifetime of herself and her spouse, the amount passed on to the children or other heirs can generally be increased by deferring tax on retirement benefits. That is, the annuity pays out too fast, thereby increasing taxes.

5. A lump sum, or something other than an annuity, provides greater flexibility which permits more effective estate planning.

For these reasons in larger estates, the annuity will usually not be the best choice.

B. Lump Sum Distributions.

Special tax rules formerly applied for taxation of lump-sum distributions. These have been almost entirely phased out.

1. Pre-2000 rules.

Five year forward averaging (basically dividing the distribution by 5, computing the tax at the rate applied to single persons and multiplying by 5, thereby getting a lower average rate) was repealed for tax years beginning after 12/31/99. The same is true for the minimum distribution exclusion (for those under 66) which permitted half of a distribution to be excluded (up to a $10,000 exclusion) but phases out the benefit so it is inapplicable to distributions of more than $20,000.

2. Rules for those 66 or over.

If a participant born before 1936 elects the grandfather rules, a portion of the distribution (numerator is the number of years of plan participation BEFORE 1974, denominator is the total number of years of plan participation) is taxed at 20%. The number of people who can take advantage of this is steadily shrinking. The balance is taxed using 10 year averaging, but the higher pre ?86 rates apply. For larger distributions (over $1,000,000f) 10 year averaging generally provides no benefit.

The author's experience is that under current law, roll-over to an IRA is always better than current taxation. However the computations are complex and you should make your own decision. If you seek lump-sum treatment, check former Code § 402(d)(4) for what is and is not a lump sum distribution.

C. Roll-overs.

Any distribution from a qualified plan other than (1) hardship distributions, (2) those required by the minimum distribution rules or (3) substantially equal distributions made over a 10 year period, or longer or over the life or lives of the employee and her spouse may be transferred free of current income tax to an IRA. Code § 402(c). The participant may actually take the money and hold it for up to sixty days. This is a bad idea for several reasons. Under Code § 3405(c), 20% will be withheld for taxes. Although this could be refunded if there were a roll-over, the participant won't have that money to contribute to the account. Further, brokers and other IRA custodians (or those who think they may be IRA custodians) tend to make mistakes (set up accounts that are not IRAs or perhaps they may not be qualified IRA custodians). Once the sixty days has expired the IRS has NOT been willing to allow corrections of good faith errors . Under current law every qualified plan must allow participants to do a "trustee to trustee" transfer of eligible rollover distributions. Code § 401(a)(31). The trustee of the qualified plan transfers the funds directly to the IRA. There is no withholding tax and the opportunity for error is reduced. Once the funds reach the IRA, the participant may invest and distribute them as she chooses. Distributions before age 59½ may attract a 10% penalty tax (but see Section II B for managing this). Beginning at age 70½ there are mandatory minimum distribution rules discussed below.

IV. Minimum Distribution Rules

On January 17, 2001 the Internal Revenue Service issued revised proposed regulations governing minimum distributions, Proposed Regulations 1.401(a)(9)-0 to 1.401(a)(9)-8. The former rules could be used through 2001. The new rules must be used beginning January 1, 2002. These rules are complex and the reader is referred to them. What follows attempts to summarize some of the key provisions for estate-planning purposes.

A. Death Before Annuity Starting Date.

If the participant dies before he begins to take distributions from his Qualified Plan or IRA and his spouse is his designated beneficiary, then the spouse does not need to commence distribution until the participant would have attained age 70½ and then distributions are made over the spouse's life expectancy as discussed blow. If there is a non-spouse designated beneficiary, distributions may begin within one year of the participant's date of death and continue over the life of the beneficiary. Otherwise the entire amount must be distributed within five years of the participant's death. Code § 401(a)(9)(B).

B. Required Beginning Date.

Distributions must begin by April 1 of the year following the later of the year in which the participant attains age 70½ or the year in which he retires (if he lives that long). Note some qualified plans have not yet been amended and may require distributions regardless of whether the employee has retired. The plan provision controls, but it may be possible to do a trustee-to-trustee transfer to an IRA to avoid the effect of this provision.

C. Joint Lives and Joint Life Expectancy.

How much must be distributed? Each year a fraction of the balance of the account determined as of the last valuation date of the previous year must be distributed. Under the former rules the fraction depended on the ages of the participant and his spouse, whether they had elected to recalculate life expectancies and whether they were subject to the minimum distribution incidental benefit rules. Under the new rules, the fraction depends (with one exception) only on the age of the participant and is based on a uniform table. The table is based on the joint life expectancy of the participant and an assumed beneficiary ten years younger. At age 70 the fraction is 1/26.2 = 3.8%. At age 80 1/17.6 =5.7%. At age 90 1/11.1 = 9%. This permits rather slow distribution. If the spouse is the sole beneficiary and she is more than ten years younger than the participant, the distribution may be made over their joint life expectancies based on the expected return multiples of Table VI of Reg. 1.72-9. If the young spouse dies before the participant, the uniform table applies for the rest of the participant's life.

If the surviving spouse is the sole designated beneficiary she may each year use the life expectancies found in Table V of Reg. 1.72-9 to compute the minimum distribution fraction. Her life expectancy in the year of her death is used to compute minimum distributions following her death, reducing the expectancy by one each year. Thus if the spouse died in 2002 at age 85, she had a 6.9 life expectancy from the tables. The minimum distribution in 2003 would be 1/5.9 = 17%. In 2004 1/ 4.9 =20.4%.

If the designated beneficiary is not the spouse, one determines his life expectancies from the tables in the year following the calendar year of the participant's death. Each year thereafter that number is reduced by one and used as the denominator for the minimum distribution fraction.

D. Amount of Distribution.

In a typical situation, we look at the account balance at December 31 for the preceding year. The minimum distribution for the year is that balance divided by the multiple. Suppose P attains age 70 ½ in August 2001 and his balance is $1,000,000 on 12/31/00. Suppose his wife is no more than ten years younger than he is. Their 2001 multiple from the uniform table is 26.2. They must take out $38,168 by April 1, 2002 which is their 2001 distribution. By December 31, 2002 they must take their second distribution which is the balance on 12/31/01 say $1,100,000 - $38,168 (special adjustment to avoid penalizing the taxpayer for the delay) divided by 25.3 (age 71) or $41.970. Subsequent distributions must be paid by December 31 of succeeding years.

Notice we are taking out about 4%, but the IRA may be growing by more than that. In this case the multiple does not shrink below 10 for 20 years. That is, for 20 years the IRA might continue to grow. It is not unusual for IRAs to double or even quadruple during the early years of the minimum distribution period. This needs to be considered for estate planning purposes.

E. Determining the Designated Beneficiary.

Under the new rules, the designated beneficiary is not finally determined until the last day of the calendar year following the participant's death. Disclaimers are permitted, allowing significant post-mortem estate planning. Trusts will not be treated as designated beneficiaries for minimum distribution rules. Under the old rules this meant that if the trust was a designated beneficiary, the account had to be distributed over the participant's single life expectancy. Under the new rules, this makes no difference during the participant's life, unless the spouse is more than ten years younger than the participant. The rules for looking through a trust are discussed below.

If more than one beneficiary is named, the distribution is made over the shortest life expectancy. However it is possible to assign to each of several beneficiaries a separate account and distribute each account over the lifetime of the associated beneficiary. The planner must exercise care to qualify for this treatment.

F. Spousal Roll-over.

A surviving spouse may roll-over an IRA and treat it as her own. Code § 408(d)(3)(c). She can defer distributions until she reaches age 70½ (if she has not already reached that age) and take distributions over her life expectancy. Most importantly she can choose a new designated beneficiary. This could be a grandchild. She is then permitted to make distributions over the joint life expectancy of herself and the grandchild. Under the new rules the surviving spouse calculates her minimum distribution under the rules for participants discussed above. Thus the age of the new designated beneficiary is irrelevant (unless the surviving spouse marries a person at least ten years younger). If grandma is 90, and designates her grandson as the beneficiary the uniform table treats grandson as 80. However if grandma dies when grandson is twenty, he will take his distribution for the following year with a multiple of 61.9, which means he need take out only 1.6%. The IRA might continue to grow another sixty years after grandma's death, which might be 20 years after grandpa turned 70½.

G. Value of Deferral.

An approach to valuing deferral is given in the appendix. We consider here two examples. Let us assume the pre-tax rate of return is 10% and that the effective tax rate of the taxpayer would be 30%. Suppose the taxpayer dies immediately after distributions begin at age 70 ½ without a designated beneficiary. This is the worst possible case. The account may be distributed over 27 years and on these assumptions has a value nearly 50% higher than what it would have if immediately distributed when the taxpayer attained age 70 ½. A very good (but not unattainable) case would involve the participant living to age 80, with his wife of the same age surviving for ten years, with the account then being left to grandchildren no older than twenty. The account could be distributed over 82 years (following the year the participant attained age 70 ½) and would have a value of about 2 1/3 times its value if distributed when the participant attained age 70 ½. These values are after tax effects based on present value.

V. Roth IRAs

Contributions to a Roth IRA are not deductible. However permitted distributions are not subject to tax. Despite intuition, if one assumes a constant rate of return and income tax rate, a deductible contribution that accumulates on a tax deferred basis and is taxed on distribution (a classic IRA) has the same yield as a non-deductible contribution that accumulates free of income tax and is free of tax on distribution (the Roth IRA). There are some important distinctions however.

A. No Minimum Distribution Requirements.

A Roth IRA is not subject to the minimum distribution rules or incidental death benefit rules during the lifetime of the owner. Code 408A(c)(5), Reg. 1.408A-1 Q&A2. Thus significantly more deferral is available. When the owner dies, the minimum distribution rules apply.

B. Later Designation of Beneficiary

With a Roth IRA the owner can change beneficiaries during life. Reg. 1.408A-6 Q&A 14. Thus if the owner's wife dies when the owner is 85, he can designate his grandchild as beneficiary. No distributions are required during grandpa's life, and on his death distributions may be made over the life of the grandchild. Of course under the new rules it is also possible to change beneficiaries under classical IRAs effective after the participant's death.

C. Contributions after 70 1/2

Contributions may be made to a Roth IRA (subject to other limits) at any age. Code § 408A(c)(4). This permits contributions of $3,000 per year after this age. Code § 408A(c)(2).

D. Larger limits.

The $3,000 limit for a classic IRA is pre-tax. Someday tax must be paid. Thus, if the owner's tax rate is 36%, the contribution is really only $1,280. The Roth IRA contribution limit is $2,000 after tax. Thus if maximum contributions are made the final net after tax value of the Roth IRA will exceed that of the classic IRA.

E. Reduced Estate Tax.

Converting to an IRA reduces the estate tax burden. The tax incurred in contributing to a Roth IRA, particularly in converting a classic IRA to a Roth IRA reduces the (potential) gross estate of the owner, thereby reducing his estate tax. In the case of an unmarried owner, or one who does not use the marital deduction, there will be an actual reduction in estate tax with a Roth IRA as opposed to a classic IRA. The beneficiary of the classic IRA will get a Code § 691(c) deduction, as described below, for estate taxes paid on the classic IRA to be used against distributions from the IRA, but she will not get the benefit until she includes distributions in income. The Code § 691(c) deduction, allowing for time value of money, is not as great as the extra estate tax paid. If the marital deduction is used, the tax paid on converting the classic IRA to a Roth IRA reduces the estate tax due on the survivor's death. Again the beneficiary will have a 691(c) deduction when she receives distributions from the classic IRA, but this has a lesser value.

VI. Income in respect of Decedent and Credit for Estate tax paid

Contrary to what many clients wish to believe, there is no step up in basis on a qualified plan or IRA on death. All income (other than recovery of decedent's basis) is taxable to the recipient as income is respect of a decedent ("IRD") under Code § 691(a). However the recipient may take a deduction under Code § 691(c) for the estate tax paid with respect to such item.

This raises an interesting issue. Suppose D, the decedent dies, survived by his second wife S2 and child by his first wife C. D leaves $ 2,000,000 to C. He leaves the balance of his estate, also $2,000,000 in a QTIP trust. Included in his estate is his IRA worth $1,000,000. If the IRA passes to C there will be a 691(c) credit available to reduce income tax of about $475,000. This might be worth $190,000 in reducing C's tax on distributions from the IRA. However C could not do a spousal roll-over and (depending on the facts) and would have to take all distributions within 5 years of D's death. If the IRA passed to S2, she could take distributions over her lifetime and name a new designated beneficiary. The $190,000 IRD benefit would be lost, however. If there is no need to consume the funds in the IRA, it will usually be the case that the deferral is worth more than the IRD deduction.

VII. Spousal Rights

A. ERISA Rights

ERISA and the Code require most employer plans to offer pre-retirement survivor annuities (see Section II A above) and joint and survivor annuities (see III A above) Code § 401(a)(11) and 417, and ERISA Section 205. Plans that do not pay such annuities must pay all benefits on the participant's death to the surviving spouse. Code § 401(a)(11)(B)(iii)(I). These requirements do not apply (unless the plan chooses to make them apply) to couples married less than one year. Code § 417(d). They can be waived by the spouse. Code § 417(a). Federal law on this subject preempts conflicting state law.

Two results flow. First, when dealing with a couple married for more than one year, effective planning for a qualified plan cannot be done without the informed consent of the participant's spouse . Dealing with the recalcitrant spouse is beyond the scope of this presentation, but such cases usually involve bargaining.

Second, the constraints imposed by ERISA should be considered by the client considering marriage and by a married couple contemplating the possibility the survivor may remarry. The Boggs case cited in the footnote involved a first spouse (of many years) who left her interest in her husband's qualified retirement plan (an interest recognized by Louisiana law) to her husband for life and then to her children. Her husband had not retired at the time of her death. Mr. Boggs remarried and, more than a year later, died. The Supreme Court ruled that under ERISA the entire interest under the qualified plan passed to the second spouse. This presents difficult problems for the estate planner. One of the Boggs opinions suggested that there could be an accounting in the probate estate, decreasing what would otherwise pass under the will to the second spouse. Obviously this should be considered in drafting the will so that no special action is required. If the bulk of the family assets are in a Qualified Plan, this does not solve the problem.

These ERISA provisions do not apply to IRAs. This is another incentive to roll-over amounts from Qualified Retirement Plans to IRAs when the participant retires. That is, if H retires at age 65 and rolls his balance into an IRA, provision can be made in the IRA designation for the first spouse. If the amount is left in the employer plan, the first spouse dies before H is 70 ½ and H remarries, the Boggs result might apply.

B. State law rights

Under Utah law, 75-2-202 UCA the surviving spouse has the right to an elective share of the decedent's probate and non-probate property, 75-2-205(1) UCA. This includes 1/3 of the decedent's interest in qualified plans and IRAs if acquired during marriage. 75-2-708 UCA. The share is satisfied first from probate assets, but if necessary from assets passing to others outside of probate, 75-2-209. If necessary the holders of these assets are personally liable to the spouse. 75-2-210.

Under ordinary circumstances ERISA and state law will be in harmony. Any amount passing to the spouse under ERISA discharges pro tanto the obligation to pay her share.75-2-207 UCA. Note that under Utah law the spouse may have rights to an IRA, even though the IRA is not covered by ERISA.

If community property is involved, the spouse may have rights (at least to IRAs) under the laws of the controlling jurisdiction. Note that while in Utah the spouse gets 1/3, generally under community property laws the spouse gets ½. For example, H &W are married in California. H begins employment at XCO after marriage. H is transferred to Utah when his 401(k) account at XCO is worth $300,000. While in Utah an additional $200,000 is contributed to the account. On death the account is worth $700,000. It would seem W would get 1/3 of the $200,000 and earnings and ½ of the $300,000. Possibly she would have a claim to ½ (or, instead 1/3?) of the earnings on the $300,000. These issues are best dealt with by an estate plan to which both spouses agree.

VIII. Use of trusts as beneficiaries and IRA beneficiary designations.

A dozen years ago it was not uncommon for estate planners to transfer all proceeds from a Qualified Plan or an IRA to a revocable or testamentary trust in order to control future beneficial interests. Clearly this should not be done without careful consideration of income tax consequences. Withdrawing funds intended for heirs faster than the minimum distribution rules require loses the substantial benefits of income tax deferral and should be avoided. Several questions remain.

A. Retaining spousal life expectancy.

At one time if the trust (generally a living trust) was used as a designated beneficiary it's life expectancy was zero for the minimum distribution rules. This was clearly a serious disadvantage, which was reduced by the new distribution rules. However trusts may now be used for minimum distribution purposes if the requirements of Proposed Regulations 1.401(a)(9)-4 A-5 b are met. A trust beneficiary will be treated as the designated beneficiary for minimum distribution computation purposes if four requirements are met:

1. The trust is either a valid trust under state law, or would be if it were not for the fact it is unfunded.
2. The trust is irrevocable, or will be on the death of the employee.
3. The applicable beneficiary or beneficiaries of the trust are identifiable from the trust instrument.
4. The employee provides a copy of the trust instrument to the plan administrator and agrees to give the administrator notice of future trust amendments OR certifies the names of the current beneficiaries, that items 1 through 3 are true, agrees to keep the information current and agrees to provide a copy of the trust instrument on demand.

B. Retaining Spousal Roll-over

If a trust is the beneficiary of an IRA or Qualified Plan the spouse will not have the ability to roll it into a new IRA unless she either has the ability to revoke the trust or has a lifetime power to withdraw the assets. The primary advantage of the spousal roll-over is that the spouse can designate a very young beneficiary who, on her death can take distributions over his life. With a QTIP this is lost, and the minimum distribution rules will be frozen based on the surviving spouse's age at the time of her husband's death. The trust could provide that on the participant's death a younger generation beneficiary was designated, but then the marital deduction would be lost.

C. Marital Deduction

An IRA payable on death to the spouse will qualify for the marital deduction and escape estate taxation on the participant's death. Code § 2056(a). However if the participant wants to assure herself that on her spouse's death assets will pass as she desires, she will have to use a QTIP Trust. If the spouse does not have the power to revoke or withdraw, as discussed above, the roll-over option is lost. Under the minimum distribution rules, the minimum distribution may, and usually will, be less than the current income of the IRA. For the QTIP to qualify the surviving spouse must have the power to compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA assets at least annually and to distribute that amount to the spouse. Rev. Rul. 2000-2, 2000 I.R.B. 3, 305. As long as the spouse does not exercise this power, the minimum distributions can continue. The other QTIP rules must also be followed.

D. Death in Service

If an employee dies in service and his spouse is the designated beneficiary she will be able to roll-over funds to an IRA or take a lifetime annuity or perhaps have the choice. However, the employer is not required to offer annuities to trusts and many employer plans do not provide this alternative, perceiving it to be administratively burdensome. Thus if the trust is a beneficiary the plan terms (not the law) may result in requiring distribution within five years of the decedent's death. This can be a costly drawback of using a trust as a beneficiary.

IX. Disclaimers

As a matter of post-mortem estate planning, a person, particularly the surviving spouse, my want to disclaim benefits under a Qualified Plan or IRA.

A. Gift Tax

If the disclaimer is in writing, received by the plan administrator or other appropriate person within 9 months of the creation of the interest (death or retirement), made before accepting any portion of the interest and results in the interest passing to another, then it will be a qualified disclaimer and there will be no gift or estate tax consequences to the person disclaiming.

B. Permitted Alienation

Code §401(a)(13) and ERISA §206(d) prohibit assignment or alienation of benefits. This was intended as a protection to the participant and these provisions should not affect a qualified disclaimer. The IRS has so held, GCM 39858.

C. Nine Month Period

The nine month period for a spouse to disclaim an interest under a joint and survivor annuity begins to run from the annuity starting date (usually the required beginning date, see IV.A. above), since from that date the participant no longer has the power to change the designated beneficiary. GCM 39858 states "there is no evidence that Congress intended to preclude a spouse from disclaiming or renouncing benefits under a qualified plan after the participant's death." However, it may not be possible for the surviving spouse to disclaim after a participant's death more than nine months after the joint and survivor annuity starting date.

D. Terms of Plan

The terms of the plan control whether a disclaimer will be honored. If the plan does not permit disclaimers, any disclaimer will be disregarded.

E. Distribution Rules

Note that for purposes of determining the designated beneficiary it is possible to wait until the last day of the calendar year following the year of the decedent's death, but this will be too late for a qualified disclaimer for estate and gift tax purposes.


An Approach to Valuing Deferral

Let t be the effective marginal tax rate on a particular distribution or income. While tax rates vary over time due to changes in law and taxpayer circumstance, the assumption that t will remain constant will be the best long term planning prediction in many cases.

Let P be a "payment" or "principal" or a "pre-tax" amount.

The tax on the payment will be t*P. P-t*P will be what is left after paying tax. Thus an after-tax amount is obtained by computing P*(1-t).

Let I be the pre-tax "interest" or "income" rate of return. Then I*(1-t) will be the after-tax rate of return.

Pre-tax, income of I*P will be earned in a year. After one year there will be a total of P + I*P = P*(1+I). The compounded income for the second year will be I*P*(1+I) and therefore at the end of the second year we will have P*(1+I) + I*P*(1+I) = P*(1+I)^2. (The carat stands for an exponent.) After N years we will have P*(1+I)^N, the familiar formula for compound interest.

CASE I: The retirement plan or deductible classic IRA

If a pre-tax payment is made into a retirement plan, allowed to generate income at the pretax rate and fully distributed and taxed after N years, we will have (future value):

(1) FV = P*(1+I)^N*(1-t).


If we pay tax on the payment and allow it to accumulate tax-free for N years, as in a Roth IRA, we will have:

(2) FV = P*(1-t)*(1+I)^N.

Observe that (1) and (2) are the same. That is, assuming a uniform rate of return and tax rate a Roth IRA produces the same benefits as a classic IRA. Further, the benefit from a retirement plan can be represented by (2) as well as (1).

CASE III: Fully taxed

If a payment is received, tax is paid, and the return for N years is subject to tax we have:

(3) FV = P*(1-t)*(1+I*(1-t))^N.

Comparing (2) and (3) we see the benefit of a retirement plan is that our future value grows at the pre-tax rate of return, instead of the after tax-rate.


As a rough rule of thumb an investment earning a (pre-tax) rate of return of 10% doubles after seven years, while an investment earning a (post-tax) rate of return of 7% doubles every ten years. If we obtain the after tax rate for twenty years our money will quadruple. However, if we obtain the pre-tax rate for twenty years, our money will grow nearly 8- fold. It is in that sense that money in an IRA with a life of 20 years is worth about twice what it would be worth outside the IRA. If we had 40 years, money in an IRA would be worth 4 times would it would be worth outside an IRA.

To obtain the values on deferral in Part IV Section F, I assumed that money in the retirement plan would generate income at the pre-tax rate, but that outside the retirement plan it would generate income at the after tax rate. I therefore discounted the required minimum distribution at year N by (1+I (1-t))^-N. In the first case (twenty-seven years) the present value was 148.87%. In the second case (eighty-two years) the present value was 232.91%.