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Practical Issues Involving Retirement Distributions

Retirement assets often represent a substantial portion of a taxpayer's wealth. The retirement assets may be accumulated in a 401(k) plan, 403(b) arrangement, in another type of qualified plan or an IRA. Regardless of the retirement type arrangement that is involved, the tax consequences of making the right move at the right time can be financially beneficial for the taxpayer and his/her family. Conversely, making the wrong move at the wrong time can be financially hazardous to both the taxpayer and his/her family.

The problem with retirement distribution planning is a simple one. It may just be too complicated to deal with. The taxpayer may rely upon an advisor who may be well versed in a particular discipline but may not know how to integrate retirement assets with an overall estate plan.

The IRS has many rules that involve retirement distributions. In addition, each year the IRS issues many pronouncements and rulings that involve retirement assets. The problem is that the average practitioner is overwhelmed with these rules and generally cannot devote a substantial period of time in mastering them.

Distribution planning may be important to the client but it may be too difficult an assignment for the professional advisor.

In order to deal with retirement distribution planning, the advisor must take retirement planning courses, do extensive reading on the subject and have practical experience in dealing with retirement distribution issues.

The advisor must acquire a common body of knowledge that is multifaceted. The advisor must be aware of both the IRS rules as well as state laws. State laws can be crucial to a taxpayer's financial well being. If a taxpayer has a substantial amount of retirement assets in a qualified plan, then the retirement assets generally are protected from creditors. If the taxpayer transfers the qualified plan retirement assets into an IRA, then the IRA may or may not be protected against creditors. A number of states protect IRAs from creditors but several states do not. Most states do not protect Roth IRAs from creditors. The advisor should check the state law before he/she recommends the transfer of the qualified plan retirement assets to an IRA.

Taxpayer's often think that retirement assets are disposed of under a will. A will does not govern who receives retirement type assets. It is controlled by a beneficiary designation form and not a will. The exception to that rule is when the retirement asset is payable to his/her estate. In that case the executor of the estate controls the proceeds of the retirement assets and will administer the retirement asset proceeds according to the provisions of the will.

In most instances, a retirement asset should be payable to an individual rather than an estate since an estate does not have a life expectancy. If an estate receives a retirement asset, then generally income tax liabilities are accelerated

Retirement assets are payable to the beneficiary of the plan participant or IRA owner. Generally the beneficiary form determines who obtains the retirement assets upon the death of the plan participant or IRA owner.

The beneficiary form is governed by state law and not federal law. However, spouses are given certain rights involving retirement assets under federal law when certain qualified plans are involved. In addition, certain 403(b) arrangements provide for spousal rights as well.

A state law may provide for spousal rights to IRAs. The parties by contract may also provide for spousal rights to an IRA as well.

An occasion, the wrong beneficiary appears on a beneficiary designation form. This may happen if a taxpayer mistakenly leaves a former wife as the beneficiary of his retirement account and dies without correcting the error. The taxpayer may have forgotten to change the beneficiary form after his/her divorce. Obviously, litigation will take place over the issue as to who receives the retirement asset death benefits upon the subsequent death of the taxpayer.

Many taxpayers do not know where his/her beneficiary forms are. The beneficiary forms may be misplaced or lost. On occasion, the taxpayer never filled out a beneficiary form. If a beneficiary form was never filled out, then the IRA will be payable to the IRA owner's estate upon the IRA owner's death. This defect will result in a substantial income tax problem for the estate since an estate has no life expectancy. It is possible that the IRA application may state that if there is no beneficiary form on file with the IRA institution that the beneficiary is automatically the surviving spouse.

On occasion, both the taxpayer and the financial institution cannot locate the beneficiary form. In that case, then upon the death of the IRA owner, the IRA death benefits will be paid to the IRA owner's estate unless the spousal default option described above is applicable. Once again, this omission may result in a substantial income tax problem for the estate.

In order to avoid this problem of lost beneficiary forms, it is best for a taxpayer to retain an acknowledged duplicate copy of all his/her beneficiary forms. The taxpayer should periodically request the financial institution to verify who the existing IRA beneficiaries are. Many times the taxpayer thinks that the spouse is the beneficiary and finds out that the children and wife are the beneficiaries of the IRA. If the taxpayer wishes to provide for both his wife and children, then he should establish several IRAs. For example IRA #1 can be payable to his wife as beneficiary and IRA #2 can be payable to his children as beneficiaries.

If a taxpayer has one IRA for the benefit of three children, then he should state in the beneficiary form what happens if a child predeceases the IRA owner. This can be done by attaching a letter to the beneficiary form. The taxpayer should obtain both acknowledged copies of the beneficiary form and the attached letter to the beneficiary form from the financial institution.

The letter might state that if any child predeceases the IRA owner, then in that event such child's share shall be payable to the issue of the predeceased child. In addition, it should state that if the issue of a predeceased child is a minor that the share of the predeceased child shall be paid to a custodian under the Uniform Transfers to Minors Act or similar act until the maximum age permissible by law and that the custodian shall be designated by the executor or administrator of my estate, as the case may be, to the extent permitted by law. The attached letter might also state that if a child predeceases the IRA owner leaving no surviving issue, then in that event said predeceased child's share shall be payable to the IRA owner's surviving children, per stirpes.

On occasion, an IRA owner lists one child as the primary beneficiary and the second child as the contingent beneficiary. This may be done unintentionally because the taxpayer may not examine the beneficiary form in detail. The beneficiary form may not be clear or it may not have sufficient room in the body of the form to list all the primary beneficiaries or all the contingent beneficiaries. Obviously, the taxpayer should amend the form to accomplish the result that is desired.

Remember that a beneficiary form is the equivalent of a will when it comes to determining who receives the IRA death benefits. It must be prepared carefully since it is difficult to successfully challenge a beneficiary designation.

If taxpayer would like to have an IRA payable to a minor, then the taxpayer generally should use a special trust on behalf of the minor as the beneficiary of the IRA account. Alternatively, he may select as a beneficiary for the minor a Custodian under the Uniform Transfers to Minors Act or similar act.

The advantages of using the trust approach is that the IRA death benefits can be stretched out over an extended period of time, perhaps as much as 70 years. In the Custodian approach, the minor controls the IRA at either age 18 or 21 depending on state law. A minor should not be selected as the direct beneficiary for legal reasons. In many jurisdictions, the probate court will be involved in the administration of an IRA that is directly payable to a minor.

If a taxpayer has substantial retirement type assets, then he/she should have the professional advisor analyze the estate tax liquidity situation. If an estate may not have sufficient liquidity, then the taxpayer's family may have a significant problem. Generally it is best that the taxpayer's professional advisor perform an in-depth estate planning analysis in order to protect, to the extent possible, the retirement assets from being dissipated upon the taxpayer's death. In the estate planning analysis, several issues should be considered by the professional advisor. These issues should include the following:
1. Projecting the amount of the estate tax liability;
2. Projecting the income tax liabilities on the retirement assets;
3. Projecting the source of payments of the estate tax liability; and
4. Integrating the retirement assets into the estate plan.

The professional advisor generally is trained in projecting income tax and estate tax liabilities. However, integrating the retirement assets into the estate plan is a complex assignment for the advisor. The advisor should coordinate the estate plan with the client's attorney. One of the basic issues to examine is the source of payment of the estate tax liability of the estate. In addition, the legal instruments of the taxpayer must be coordinated.

In terms of coordinating the legal instruments such as the will and any trusts, several precautions must be taken. Many wills state that estate taxes shall be paid from the residuary estate. This provision may not be appropriate if substantial retirement assets are part of the gross estate since the retirement assets may trigger substantial estate tax liabilities. The probate estate may lack liquidity and may not have sufficient assets to pay the estate tax liabilities. Retirement assets that are payable to a beneficiary other than the decedent's estate are considered to be nonprobate assets. In that case, the taxpayer's will generally should apportion estate taxes to all assets that are included in the gross estate (probate and nonprobate assets). Estate taxes should be allocated to the recipients of probate assets and nonprobate assets proportionately. The will should provide that estate taxes be apportioned based upon the apportionment statutes under the state law. If a state does not have an apportionment statute, then the apportionment clause under the will should be drafted accordingly. The fact that a retirement asset bears an estate tax liability does not mean that the beneficiary must liquidate the retirement asset in order to pay the estate taxes. The beneficiary may use personal assets to pay the estate taxes that are allocable to the retirement asset.

For example, if Carl designates his daughter, Gloria as the beneficiary of his $1,000,000 IRA and the IRA is subject to an estate tax liability of $400,000 then Gloria need not liquidate the IRA in order to pay the $400,000 estate tax liability to the executor/personal representative of Carl's estate. Instead Gloria may use her personal assets to the extent available to pay the $400,000 estate tax liability. Gloria may use a combination of the IRA assets and/or personal assets to pay the $400,000 estate tax liability if she wishes.

If the estate has sufficient liquidity to pay the estate taxes, then the taxpayer may wish to provide in his will that the estate taxes shall be paid from his/her residuary estate. The taxpayer may have other reasons for not doing so. This is a key provision that should be discussed with the taxpayer.

If it appears that the taxpayer's estate may lack liquidity to pay the estate taxes, then the taxpayer's will should provide that estate taxes be apportioned to both probate and nonprobate assets.

However, if after his death the beneficiary of a nonprobate asset refuses to contribute his/her share of the estate tax liability or dissipates the nonprobate assets, then extensive litigation problems will ensue. A possible solution to this anticipated problem is to use a trust (protective trust) as the beneficiary of the retirement asset(s). A trust can be established that satisfies the IRS life expectancy rules and through proper drafting can be used to ensure that the trustee pays the appropriate estate taxes that are allocable to the particular retirement asset(s).

Another important issue regarding retirement assets involves the failure of an IRA owner to receive a required minimum distribution from an IRA. If an IRA owner on or after attaining his required beginning date fails to timely receive a required minimum distribution, then the IRA owner faces a 50% penalty on the insufficient distribution.

If the IRA owner's beneficiary fails to timely receive a required minimum distribution, then the beneficiary faces a 50% penalty on the insufficient distribution. The 50% penalty rules also apply to qualified plans and 403(b) arrangements when insufficient distributions are involved.

The IRS may waive the 50% penalty if the insufficient distribution was due to reasonable error and reasonable steps are being taken to remedy the situation. According to the IRS, the 50% penalty must first be paid to the IRS and a request for refund of the penalty must then be made to the IRS. If the IRS finds that the error was a good faith error and has been or is being corrected, then the 50% penalty may be refunded.

Seymour Goldberg, the author of this article, is a CPA and attorney, a member of the IRS Northeast Area Pension Liaison Group, and has participated as a member of the AICPA Pension Compliance Task Force. Mr. Goldberg is the author of Goldberg Reports, an online pension distribution planning information service (

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