Careful consideration should be given to the timing and the tax consequences of distributions from qualified retirement plans, tax sheltered annuities, and IRAs following your death.
There are different distribution rules depending on whether minimum required distributions from IRAs and defined contribution plans had commenced by your date of death and depending on whether your beneficiary was your spouse.
Death Prior to Required Beginning Date
The basic requirement is that, if you die prior to beginning distributions from the plan, your entire retirement benefit must be distributed in one of two ways:
- If there is no designated beneficiary, distribution must be made by the end of the fifth calendar year following the year of your death (known as the five-year rule). No distribution is required for any year before the fifth year, but full distribution must be made by the end of the fifth year.
- Scheduled over the single life expectancy of your designated beneficiary, with distributions beginning either:
- by December 31 of the year following the year of your death; or
- if your spouse is your sole beneficiary, by December 31 of the year in which you would have reached age 70½, if later (see Spousal Beneficiaries, below).
The life expectancy rule applies if there is a designated beneficiary. If there is no designated beneficiary, the five-year rule applies.
Death After Required Beginning Date
If you die after beginning minimum distributions, your entire interest may be distributed over the single life expectancy of your beneficiary, unless your beneficiary elects to use the five-year rule. If you did not designate a beneficiary, the account must be withdrawn over your remaining life expectancy.
Spousal Beneficiaries
There are special rules that apply to spouses whether death occurred before or after the required beginning date. For spouse beneficiaries, your surviving spouse has the choice of 1) rolling over your plan assets into an IRA in his/her own name or into his/her qualified plan, or 2) if the inherited asset is your IRA, your surviving spouse can elect to treat it as his/her own IRA if he or she is the sole beneficiary of the IRA.
Your surviving spouse would then use the life expectancy table used by IRA owners. This table contains larger distribution periods than the table used by beneficiaries; hence smaller minimum distributions are required. Minimum distributions would then begin from an IRA upon your surviving spouse's attainment of age 701/2. If the amounts are rolled over into a qualified plan, no distribution is required until the later of age 70½ or retirement age.
If your spouse is your sole beneficiary, he or she may also remain as a beneficiary on your account. This may be beneficial under certain circumstances. For example, if your spouse beneficiary is older than you, and remains a beneficiary on your account, he or she would not need to begin required minimum distribution until you would have attained age 70½, even if your spouse beneficiary were already over 70½.
In addition, if your spouse beneficiary is under age 59½, he or she may choose to remain a beneficiary on your account in order to take withdrawals from the account. By remaining a beneficiary, withdrawals are not subject to the 10% early withdrawal penalty. If your spouse beneficiary instead chose to roll over the IRA to his or her own IRA, any withdrawals made before age 59½ would be subject to the 10% early withdrawal penalty.
These post-death distribution rules also apply to Roth IRAs.
Although qualified plan funds are generally exempt from creditors' claims, these funds may still be available to the IRS to collect unpaid income taxes.
Beneficiary Designations and Distributions
Beneficiaries of qualified plans may be designated either through standard plan provisions or by election of the participant. Trusts may also be designated as beneficiaries and are often used as part of sophisticated estate plans. It is possible for minimum distributions to be based on the life expectancies of trust beneficiaries. Estates may be designated as beneficiaries but this is often a disadvantage, as heirs may be forced to use the five-year rule for payouts.
Beneficiary designations should be coordinated to accomplish your goals and minimize the tax impact of assets passing to your heirs. The advantages of tax deferral and passing assets outside of probate can be substantial. Until 2009, amounts left to grandchildren were subject to a generation-skipping tax that applied to amounts in excess of $3.5 million. In 2010, this tax disappears. According to current rules, it is scheduled to re-activate in 2011.
There are several techniques with regard to beneficiary designations that allow retirement plan assets to remain tax-deferred for a longer period of time, and thus potentially grow to a larger amount. One such way is for one spouse to name the other as sole beneficiary of his or her retirement plan savings accounts.
At death of the owner/spouse, rights to any remaining retirement plan savings pass to the surviving spouse. If the surviving spouse rolls these retirement plan savings into an IRA in his or her own name or into his or her qualified plan, or treats the inherited IRA as his or her own, he or she can then name a new, younger, beneficiary for the assets. No distribution is required from an IRA until the surviving spouse reaches age 70½. If the amounts were rolled over into a qualified plan, no distribution is required until the later of age 70½ or retirement age. When the surviving spouse dies, the younger beneficiary inherits the assets. He or she may be able to withdraw these assets in payment amounts that are based on his or her life expectancy, and because of the younger age, these payments are generally smaller—in effect, stretched out.
The payout period can also be lengthened, for example, by designating a child as beneficiary of an IRA (or qualified plan). When the plan participant or IRA owner dies, the younger beneficiary may continue minimum distributions using the beneficiary's actual life expectancy.
