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DISTRIBUTION PLANNING - THE KEY TO MAKING THE MOST OF YOUR IRAS

The individual retirement account, or "IRA", plays an important role in the long-term investment plans of millions of Americans. Given the ability of the IRA to protect personal contributions from annual taxation and maintain the tax-deferred status of retirement plan rollovers, it is not surprising that many Americans rely on it for all or a substantial portion of their retirement income. But preparing for one's "golden years" requires careful planning, and the use of the IRA as an asset accumulation device is no exception in this regard. Without a well-thought-out distribution strategy, taxes can significantly reduce IRA withdrawals and thereby interfere with long-term investment goals.

Prudent beneficiary designation is at the heart of most effective IRA distribution strategies. Anyone can be designated as the beneficiary of an IRA. But careful selection of a beneficiary can go a long way toward minimizing the impact of taxation and/or penalties on distributions. Following are several of the most common approaches to beneficiary selection. Bear in mind that whether any one of these techniques is suitable for a particular individual will depend on that individual's retirement needs.

Selecting a Spouse as Beneficiary1

Naming a spouse as one's IRA beneficiary offers several advantages. First, the IRA owner can use the spouse's age to calculate a joint life expectancy factor regardless of age differences. This can be very helpful, particularly if the spouse is substantially younger than the IRA owner, because a greater life expectancy reduces the amount of the annual required minimum distribution2 (RMD) during the IRA owner's lifetime and thus allows the IRA accumulation to continue to grow. Second, the spouse has a broad range of options if the owner dies before the required beginning date3 (RBD), including the "spousal rollover," which allows the surviving spouse to take the deceased owner's IRA and roll it into a new "spousal IRA" in his or her own name, to designate new beneficiaries, and to change the distribution option to meet current family needs. Third, the surviving spouse can continue receiving distributions if the owner dies after the RBD or use the "spousal rollover" option described above. Finally, naming a spouse as one's IRA beneficiary makes the entire IRA balance qualify for the spousal marital deduction, thereby deferring estate taxes until the surviving spouse's own death.

Children as Beneficiaries

Another distribution option is to name a child as one's IRA beneficiary. This is often referred to as the "multi-generational approach" and is particularly helpful in situations where the owner and spouse have no need to draw from their retirement assets or when there is a second marriage. By selecting a child as his or her IRA beneficiary, an owner can not only provide that child/beneficiary with a steady income source, but he or she can also stretch his or her IRA distributions over a much longer period of time to achieve tax deferred growth. This is because the multi-generational approach necessitates setting the parent's life expectancy at zero and using the child's high life expectancy for purposes of determining the RMD.

An IRA owner can take advantage of the multi-generational approach in one of two ways. First he or she can name the child as beneficiary of the IRA from the outset. Second, he or she can name the spouse as beneficiary on the assumption that if the owner predeceases the spouse, the spouse will create a spousal rollover IRA naming a child or children as beneficiaries. An IRA owner can also name all of his or her children as beneficiaries, but must use the oldest child's age to calculate the life expectancy figures. However, it is also possible to divide an IRA into separate accounts and designate individual children as beneficiaries of each of those accounts. This allows each child to use his or her own life expectancy.

The Trust as an IRA Distribution Vehicle

Using a trust is often a useful alternative to using an individual as a beneficiary. Following are a few ways of utilizing trusts to take maximum advantage of IRA distributions:

(1) Using a Trust as IRA Beneficiary: Individuals whose assets are largely tied up in IRAs and retirement plans may want to consider using a revocable trust (that becomes irrevocable upon the account holder's death) as their IRA beneficiary. This approach requires the use of a trust company or professional investment manager as IRA trustee and thus offers many advantages not otherwise available to IRA owners. Such advantages include professional management services; protection from irresponsible use of IRA funds by beneficiaries; and protection from creditors.

(2) Using a Trust with a Spouse as IRA Beneficiary: IRA assets can under certain circumstances be used to establish a qualified terminable interest trust or "QTIP" (the QTIP is most often used in situations where one spouse wants to provide for a surviving spouse but does not want to give the surviving spouse outright access to his or her assets). The primary advantage to this method is that it allows estate taxes to be deferred until the death of the second spouse while giving the owner control over final disposition of the property.

(3) Using a Trust with a Child as IRA Beneficiary: This approach is helpful when the IRA owner wants to use the multi-generational technique described above but is uncomfortable with the idea of giving his or her children free access to the funds. In this kind of situation, the IRA owner can leave management duties to a trustee. The trustee is also responsible for annual disbursements of the RMD. The child/beneficiary is thus unable to invade the IRA and is also afforded a measure of protection from creditors.

Note that with each of the approaches outlined above, the trust must take distribution of the IRA within five years of the IRA owner's death if the IRA owner dies before reaching age 70. Also keep in mind that the trust must satisfy several legal requirements in order to be valid. Most important, the trust must be irrevocable on the later of the RBD or the date the trust is named as beneficiary; the trust must meet state law requirements; the beneficiaries must be clearly identifiable from the trust document; and a copy of the trust must be provided to the IRA trustee or qualified plan trustee.

Designating a Charity as Beneficiary

IRA owners who have charitable impulses but also wish to obtain a tax advantage for their heirs can sometimes kill two birds with one stone by gifting their IRA to charity. The reason for this is that IRAs and other retirement assets do not receive a step-up in basis to the value at the death of the owner. Therefore, an IRA owner can steer these assets to charity (where they will not be taxed) and ensure that other assets, namely those which are subject to an increased basis at death, go to his or her heirs. Methods of giving an IRA to charity include making an outright bequest to a charity and using a charitable trust as a beneficiary.

The Eternal IRA

The eternal or continual IRA is a relatively new tool that makes it possible for children, grandchildren, or great-grandchildren to inherit an IRA. Typically, the beneficiary's actual life expectancy is used to determine a new and longer annual payment schedule upon the eternal IRA owner's death. This new payment schedule makes it possible to keep more of the IRA income-tax-deferred for a longer period of time.

A Word About Estate and Income Taxes

IRA beneficiaries of course have to pay income tax on the annual income they receive from their IRA distributions. But this additional income tax can be partially offset by a special deduction available to beneficiaries receiving income in respect of a decedent (IRD) from an IRA. This deduction applies to the portion of the federal estate tax attributable to the IRA and is available to all IRA beneficiaries, regardless of whom actually paid the estate tax.

Estate taxes also pose a problem since they often reduce the amount of an IRA passed to a beneficiary. However, one can avoid such reductions by specifying in his or her will that non-IRA assets are to be used to cover estate taxes. One way to create a source of such non-IRA assets is to purchase a single-life or second-to-die life insurance policy. Individuals who are more than 70 can use part or all of their RMDs to pay the premiums on such a policy.

IRA distribution planning based on careful beneficiary selection can significantly minimize the effects of taxation on distributions. When properly tailored to individual retirement goals and family circumstances, each of the distribution planning approaches outlined above offers the prudent IRA owner an effective means of making the most of his or her IRAs.

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Footnotes:

1  An IRA that was acquired during marriage will likely be considered community property.  Be aware that if this is the case and you wish to name someone other than your spouse as sole beneficiary of your IRA, you will need to obtain written consent and acknowledgement from your spouse that he/she has no claim to your IRA assets.

2 After age 70 1/2, an IRA owner is required by law to remove a certain minimum amount from his or her IRA(s) every year.  This minimum amount is known as the "required minimum distribution" (RMD) and is calculated by dividing the fair market value of the IRA by a life expectancy factor.  The lower life expectancy, the higher the RMD and the greater the diminution of the IRA accumulation.  Conversely, a higher life expectancy translates into a lower RMD and a smaller diminution of the IRA.

3 The "required beginning date" (RBD) is the date after which an IRA owner is required by law to remove a certain minimum amount of his or her IRA annually.  This is no later than April 1 of the calendar year following the year iin which the person reaches age 70 1/2.

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