For well-to-do families, Individual Retirement Accounts or “IRAs” often remain largely intact upon the IRA owner’s death. Why? Most owners don’t touch IRA funds, until they absolutely have to (after turning age 70 l/2), to retain the benefits of tax-free earnings for as long as they can. Prudent beneficiary designations can provide continued tax deferral on IRA funds, even after an IRA owner dies.

Taxation of IRA Distributions

IRA funds are generally subject to income and estate tax. There is no income tax applied to that portion of the IRA on which income taxes had been paid at the time of the contribution. Special tax rules permit longer payout periods for distributions (and tax payments) for beneficiaries who are spouses, other individuals, and beneficiaries of certain irrevocable trusts. Corporations, partnerships, living trusts or the estate itself are not eligible for deferred distribution and taxes, and IRA assets must be distributed to them by the December 31st of the fifth year, after the year of the IRA owner’s death.

Here’s How It Works

Until new rules were enacted in 2006, non-spousal beneficiaries were not allowed to receive tax deferred distributions. Instead, payments made to a designated beneficiary had to be paid in annual installments, over the life expectancy of the beneficiary. So, for example, if Dad dies at age 68, leaving his IRA to his daughter who is 38, with a life expectancy of about 45 years, she had to take a minimum distribution of 1/45th of the amount in the IRA each year, beginning in the year of her Dad’s death. She could take more, but not less.

Beginning in 2006, the rules changed so that a non-spouse beneficiary could roll over qualified plan proceeds into a special type of “Decedent IRA” set up for the beneficiary in a trustee to trustee transfer.

Special Rule for Spouses

Several special breaks are available to spouses:

• If an IRA owner dies before he is required to take distributions, and the surviving spouse is the sole beneficiary, she does not have to begin IRA withdrawals until the year after the IRA owner would have turned 70 ½.
• A surviving spouse can “roll over” IRA benefits to another IRA in her own name.
• If the IRA owner dies while taking distributions, the actual joint life expectancy of the IRA owner and surviving spouse can be used to measure required distributions.

Other Points to Consider

Recent changes in the law in this area have clarified the law and made it easier to do planning that provides the longest tax deferral. For example:

• Creation of separate accounts for required distributions may be established if, e.g., half is left to a charity and half is left to a child, and different permitted deferral periods apply.
• The “designated beneficiary” can be finalized until September 30th of the year following the IRA owner’s death.
• If a surviving spouse rolls over the decedent’s IRA into a new account, he/she may name new beneficiaries (e.g. children) whose life expectancies can be used to calculate continued deferral.

Practice Pointer

New private letter rulings issued in 2007 and 2008, as well as a revamping of IRA rules in 2006 and 2002 make it essential to consult with a tax advisor. This is especially true if you have sophisticated estate planning needs and/or qualified plan assets are a substantial part of your estate’s assets.