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Cascading IRA Beneficiaries IRA owners and beneficiaries have many estate planning options to reduce or postpone taxes. This article examines a cascading beneficiary plan, a flexible strategy based on a combination of a “stretch” IRA and disclaimers.
James Lange, Esq., CPA
For more information about this article, contact Mr. Lange at (800) 387-1129 or jim@rothira-advisor.com. Author’s note: This author especially thanks attorneys Camille Brubach and Geraldine Skupien for their assistance with the article.
Executive Summary
Most taxpayers would dramatically im-prove their family's finances by using savings and investment strategies that defer taxes. Capitalizing on this idea provides the basis for successfully accumulating and distributing retirement assets and lays the foundation for optimal estate planning for owners of IRAs and Secs. 403(b) and 401(k) plans, etc. (collectively, “IRAs”). This article examines a cascading beneficiary plan, which offers a particularly flexible strategy based on combining “stretch” IRAs and disclaimers.
“Stretching” an IRA Spousal Beneficiary If a surviving spouse is an IRA beneficiary, it is generally best for the surviving spouse to roll the IRA into his or her own IRA. The surviving spouse will not be required to take required minimum distributions (RMDs) until April 1 of the year following the year the surviving spouse turns 701/2. The surviving spouse's RMDs from the IRA will be based on the joint life expectancy of the surviving spouse and someone who is deemed to be 10 years younger than the surviving spouse.1 For example, if the surviving spouse is 71 years old, he or she has a life expectancy of 16.3 years and his or her beneficiary (deemed to be 61) would have a life expectancy of 16.3 years under the Single Life Table in Regs. Sec. 1.401(a)(9)-9.2 The RMD for the surviving spouse's rollover is based on a joint life expectancy of 26.5 years, found under the surviving spouse’s age in the Uniform Lifetime Table in Regs. Sec. 401(a)(9)-9, Q&A-2. For the following year, the RMD would be based on a distribution period of 25.6 years. If the surviving spouse did not roll over the IRA or elect to be treated as its owner, and the IRA owner died before distributions began, the RMD will be based on the surviving spouse's single life expectancy, resulting in a shorter distribution period and a larger RMD.
Young Surviving Spouse There are exceptions to the general recommendation that a beneficiary spouse roll an IRA over into his or her own IRA. For example, it is not prudent to roll over the inherited IRA if the surviving spouse is younger than 591/2 and needs income from the IRA, because withdrawals from the rollover IRA would be subject to the Sec. 72(t) 10% penalty for pre-age 591/2 distributions. If, however, the IRA remains as the decedent’s IRA, the surviving spouse can take distributions without the 10% penalty under Sec. 72(t)(2)(A)(ii).3 Alternatively, a young surviving spouse could roll over a portion of the IRA into his or her own IRA, and treat the rest of it as an inherited IRA not subject to a penalty for withdrawals either before or after age 591/2.
Nonspousal Beneficiary Under Regs. Sec. 1.401(a)(9)-5, Q&A-5(c), a nonspousal beneficiary’s RMD is based on the beneficiary's life expectancy as of December 31 of the year following the year the IRA owner died. For example, if the beneficiary is the IRA owner's 45-year-old child, he or she would have a deemed life expectancy of 38.8 years under the Single Life Table. The RMD for the inherited IRA would be calculated by dividing the balance in the account as of December 31 of the year the IRA owner died by the beneficiary’s life expectancy. For a $1 million balance, the RMD will be $1 million divided by 38.8 or $25,773. As the beneficiary ages, the life expectancy is reduced by one year (i.e., the next year's factor would be 37.8, then 36.8, etc.).4 The RMDs for Roth IRA beneficiaries follow the same rules, but the distributions are income tax free. Naming a younger beneficiary means a higher life expectancy and a lower RMD. Thus, a younger beneficiary who inherits an IRA will have a greater potential for long-term tax deferral than an older beneficiary.
Restricted Retirement Plans Many plans, particularly Sec. 401(k) plans, have restrictive conditions that preclude effective planning for nonspousal beneficiaries. For example, plans often provide that a nonspouse beneficiary must withdraw the entire plan balance in the year following the participant's death and pay income tax on the proceeds. Participants with the ability to roll over their restrictive account into an IRA can avoid this potential income tax disaster.
If, instead, B had rolled over the Sec. 401(k) into an IRA before his death, the trustee (and subsequently the grandchild) would have been able to stretch the RMD on the inherited IRA over the next 77.7 years, the deemed life expectancy of a five-year-old. In this case, the trustee would be required to accept and pay taxes on $12,870 in the year following B’s death ($1,000,000/77.7). The next year, the RMD would be the balance at the end of the year divided by 76.7, etc. Clients with such restrictive plans have an enormous incentive to roll over the funds into an IRA for reasons that have nothing to do with investments.
Cascading Beneficiary Plans Disclaimers A beneficiary is not required to accept an inherited IRA. For example, if an IRA owner names his or her spouse as primary beneficiary, and their children equally as contingent beneficiaries, and the spouse chooses not to accept the inherited IRA, he or she could “disclaim” all or part of his or her interest. Under Regs. Sec. 1.401(a)(9)-4, Q&A-4(a), a disclaimer must satisfy Sec. 2518 requirements by September 30 of the calendar year following the IRA owner’s death to allow other beneficiaries to take that share. Under Regs. Sec. 1.401(a)(9)-8, Q&A-2(a)(2), each designated beneficiary child could take his or her RMDs based on his or her own individual life expectancy if the inherited IRA is divided into separate accounts by December 31 of the year following the IRA owner's death. Under most state disclaimer laws, the surviving spouse has nine months to decide whether to accept, disclaim or partially accept and partially disclaim his or her interest. The disclaimer does not allow the primary beneficiary to change beneficiaries after the IRA owner dies. For example, if only one of the three children were named as the contingent beneficiary, the spouse could only disclaim to that child, not to the unnamed children. The individual who disclaims the inheritance simply steps aside; the next person in line (i.e., the contingent beneficiary or beneficiaries) inherits the IRA, and if that next person is a younger beneficiary, then the IRA can be “stretched.”
Financial Considerations After the death of the first spouse, the surviving spouse needs to regroup financially with the help of his or her professional advisers and children. The surviving spouse must consider his or her present and future financial situation, current tax laws, family needs and perhaps, most importantly, the current amount of the exemption equivalent, to determine whether to make a full, partial or no disclaimer. A cascading plan’s disclaimer strategy preserves the safety net for the IRA’s natural heir (i.e., the surviving spouse). This is a win-win situation for the surviving spouse, giving him or her both the time to make decisions and ultimate control over distributions. Traditional families (i.e., not having the complications of second marriages and stepchildren) would be wise to consider incorporating the cascading beneficiary plan, with disclaimer options, into their estate plans. They can do this by revising their IRA and qualified plan beneficiary designations.
How It Works To take full advantage of the cascading beneficiary plan, an IRA owner could name primary and contingent beneficiaries to his or her IRA in the following order: (1) spouse, (2) a unified credit shelter trust (or “B” trust) that is deemed a qualifying beneficiary under Regs. Sec. 1.401(a)(9)-4, Q&A-5, (3) a child (or children) and (4) a well-drafted qualifying trust for a grandchild (or grandchildren). If there is a risk of estate taxes at the death of the second spouse, that spouse can use the deceased spouse's credit shelter amount by disclaiming to the B trust. The B trust can be used to protect against potential estate tax at the surviving spouse’s death, because money disclaimed to the B trust will not be subject to the estate tax on the surviving spouse’s estate. The surviving spouse could also avoid estate taxes at the second death by disclaiming at least some of the inherited IRA directly to his or her children, skipping the B trust completely. Under Sec. 2518(a), that portion also would not be included in the surviving spouse's taxable estate. To preserve the surviving spouse’s options, the original IRA participant should name his or her spouse as the primary beneficiary. The contingent beneficiary could be a B trust (incorporated within a cascading beneficiary plan). The B trust contains provisions for the surviving spouse to disclaim some or all of his or her interest from the trust directly to the children. The administrator would then separate the account into separate inherited IRAs and each child would calculate the RMDs based on his or her own life expectancy. Further, the plan language allows an adult child to disclaim his or her interest in the amount disclaimed by his parent (i.e., the surviving spouse) to a trust for the benefit of the child’s child (or children). Then, the grandchild (or grandchildren) would be deemed the IRA’s primary beneficiary and could use his or her own life expectancy for RMD purposes (the ultimate stretch).
The Perfect Plan In a perfect cascade, the surviving spouse would:
At that point, the adult child could:
If the surviving spouse chooses to roll the entire IRA into his or her own IRA, the surviving spouse must begin taking RMDs by April 1 of the year after the surviving spouse turns 701/2, based on the joint life expectancy of himself or herself and a beneficiary deemed to be 10 years younger. Also, the surviving spouse will be able to name his or her own primary and contingent beneficiaries. At the surviving spouse's death, the remaining IRA is included in his or her estate for estate tax purposes. Under Regs. Sec. 1.401(a)(9)-5, Q&A-5, the RMD for the ultimate beneficiary of the inherited IRA is based on his or her own life expectancy5 as of December 31 following the year of the death of the deceased spouse of the deceased IRA owner; see Exhibit 1. If the spouse disclaims to a B trust and retains the rights as income beneficiary, he or she can receive a steady income and the right to receive discretionary principal distributions for health, maintenance and support. Those assets will not be included in his or her estate at death, possibly saving estate tax. From an RMD or income tax perspective, however, the B trust is the worst alternative, because the spouse is treated as a beneficiary under Regs. Sec. 1.401(a)(9)-4, Q&A-5(a). Thus, as provided in Regs. Sec. 1.401(a)(9)-5, Q&A-5(c)(2), RMDs are based on the surviving spouse's single life expectancy, rather than on a joint life expectancy. After the surviving spouse dies, the B trust’s remainder interest holder (usually an adult child) must continue to take RMDs based on his or her deceased parent's remaining single life expectancy, not his or her own longer life expectancy. As a practical matter, clients like the security of the B trust option. Even though many advisers often draft B trusts as an IRA’s contingent beneficiary on the first spouse’s death, in practice they would often be wiser to attempt to find better alternatives for the disposition of the IRA. Qualified terminable interest property (QTIP) trusts are equally disadvantageous from the RMD perspective, for both the surviving spouse and end beneficiaries.6
The Cascade The “cascade” begins when a financially secure spouse chooses to disclaim either all or a portion of his or her interest as primary beneficiary to the B trust as a contingent beneficiary, then simultaneously disclaims some or all of his or her income interest in the trust to the remainder interest holder (i.e., a child). The long-term advantage of the lower RMDs then moves to the foreground. The child (or a grandchild, assuming the child disclaims to the grandchild) can then take lower RMDs based on his or her own longer life expectancy. The cascading beneficiary plan protects the surviving spouse, allows the greatest flexibility to stretch the IRA and allows decisions to be made after the IRA owner's death. However, the flexibility is a double-edged sword; by giving the surviving spouse that much power, the planner risks the surviving spouse making inappropriately conservative decisions (e.g., failing to disclaim) and leaving the family with less-than-optimal results. For example, if the only asset in a cascading beneficiary plan is the deceased spouse's $3 million IRA, it would probably be prudent for a 75-year-old surviving spouse to disclaim $1 million to the children and retain $2 million in his or her own IRA rollover. If the surviving spouse chooses not to disclaim, there could be significant income tax acceleration and estate taxes at the second death. Many surviving spouses might choose not to disclaim because it seems complicated. They know that keeping the money is easy and best for them and may rationalize or legitimately feel that their needs take precedence over their children's needs. Thus, one criticism of the cascading beneficiary plan is that it overprotects the surviving spouse and puts off the difficult decisions of whether and how much to disclaim. Many beneficiaries will fail to disclaim even when it may be prudent to do so. Another problem occurs when the surviving spouse is not competent to make a disclaimer decision at the time of the IRA owner's death. That contingency is best addressed by having a well-drafted durable power of attorney, specifically allowing an IRA beneficiary (usually a child) to disclaim as agent for the parent. It is ideal to involve an attorney that does sophisticated IRA beneficiary designations, so that all the cascading options are available.
Conclusion CPAs can provide a valuable service by checking a client's IRA and other retirement plan beneficiary designations to see if they allow for stretching and to look for disclaimer opportunities. In terms of making a recommendation, the safest course is to fully explain the advantages and disadvantages of the cascading beneficiary plan and let the client make an informed choice. Most clients with traditional marriages and the same children will often wisely choose the cascading beneficiary plan. |
