If you have investments with tax-deferral features, such as conventional Individual Retirement Accounts, 401(k) Plans, Defined Benefit Retirement Plans, or other qualified plans, from which your withdrawals are in whole or in part subject to income taxes, please carefully review the following information. For purposes of the following discussion, the term "IRA" refers to a conventional IRA account and the term "Plan" refers to all kinds of tax-deferred benefit plans. "Roth" IRA accounts have no tax-deferral features, and timely distributions from such accounts are not subject to income tax. Accordingly, the following instructions do not apply to Roth IRA accounts.
In order to preserve the tax-deferral features of an IRA or Plan, your ownership interest must remain in your personal name during your lifetime, and should not be transferred to your Trust. If you have not withdrawn all funds from the investment by the time of your death, you must make certain that a death beneficiary has been appointed, to whom the funds will be paid after your death. If no death beneficiary is appointed, those funds will probably become payable to your "estate," in which case they will have to pass through probate and all deferred income taxes on the funds will become due and payable in the year of your death.
When making a decision about the proper death beneficiary appointment, you must think about not only who you want to receive the funds, but also about the income and estate tax consequences of the manner in which the funds are passed to the beneficiary or beneficiaries.
Spouse as Primary Beneficiary. If you are married, you will almost always want to name your spouse as Primary Beneficiary of the IRA or Plan, because your spouse should be able to elect certain "roll over" options that will permit a continuation of the tax-deferral benefits after your demise.
In some cases the surviving spouse may not want to "roll over" the deceased spouse's IRA or Plan. If the survivor has not yet attained the age of 59-1/2 years, and doesn't have a lot of other assets, consider the possibility that the survivor may need to make withdrawals of principal before attaining age 59-1/2. Withdrawals of principal from the rolled-over IRA will not only be subject to payment of the deferred income taxes, but will also be subject to a 10 percent early withdrawal penalty. In that case it might be better to not roll over all of the deceased spouse's account, and take direct distributions. The income tax will be payable on the funds from the deceased spouse's IRA or Plan (but would have had to be paid eventually by someone), but the 10 percent early withdrawal penalty will not apply regardless of the survivor's age.
Exception to the "Spouse as Primary Beneficiary" Rule. In an estate tax planning form of Living Trust, a separate trust estate is established at the death of the first spouse, to hold assets from the deceased spouse's taxable estate in a special manner that will provide income and security to the surviving spouse without those trust assets "belonging" to the surviving spouse for estate tax purposes. Such a trust is sometimes called a "bypass" or "shelter" or "Family" trust. With this type of planning, property having a value up to the Federal Estate Tax exclusion amount in effect for the year in which each spouse dies ($2,000,000 this year and going up to $3,500,000 in 2009) can pass tax-free at the death of each spouse.
If a significant portion of either spouse's estate value consists of tax-deferred investments held in an IRA or Plan, difficult choices must be made. Naming the surviving spouse as Primary Beneficiary under the IRA or Plan can, under certain circumstances, result in unnecessary Federal Estate Tax having to be paid at the death of the surviving spouse. In these situations, one must weigh the benefit of deferring payment of the income tax by leaving the IRA and Plan proceeds to the surviving spouse against the "cost" of the additional Federal Estate Taxes that will become payable at the survivor's death because those IRA and Plan proceeds were paid to the survivor. After analysis, it sometimes appears that there would be an overall savings to the estate by leaving all or a part of the IRA or Plan proceeds to the bypass trust (thereby "triggering" the deferred income taxes but reducing the final Federal Estate Tax bill).
This planning dilemma is presented only if both of the following circumstances exist:
If both circumstances exist in your estate, you need to consult with a competent attorney, financial planner or tax advisor before making any decision about beneficiary designations.
If you have designated the surviving spouse as Primary Beneficiary under your IRA or Plan, you should also designate a Contingent Beneficiary, to whom the proceeds will be paid if your spouse does not survive you.
Non-Tax Considerations. Remember that the various planning strategies discussed above all relate to when the deferred income tax must be paid, and not whether it must be paid. Someday, someone is going to have to pay that deferred income tax. Tax planners tend to think in terms of postponing the time of payment of tax as long as possible, but there are sometimes personal reasons why it is better to designate the trust as death beneficiary, with the trust electing to receive and distribute the funds immediately or within the five-year default period, instead of following a strategy that stretches out the income tax payment.
There are no clear-cut answers concerning the "right" decisions, but the following general observations may be helpful:
You should carefully review the above information about beneficiary designations on tax-deferred investments and consult with a competent attorney, financial planner or tax advisor before making a decision about naming death beneficiaries.