©1999, Peter James Lingane

Presented to the San Francisco Chapter, IAFP, February 9, 1999

Introduction

My remarks will highlight some of the strategic decisions that you will be helping your clients make as they manage their retirement distributions.

Bill and Sue are forty five years old and have come to you for help. Both work, they have two children and they own a modest home in a California suburb. By the time that Bill and Sue retire twenty years from now, you forecast [end note 1] that their assets will include a half million dollar home, an investment portfolio worth $300,000 and $700,000 in pension plan assets.

"Should We Roll Our Pensions Over to an IRA?"

§401(k), §403(b), SIMPLE and SEP-IRA plan assets, and lump sum distributions from defined benefit plans, can be rolled over to a traditional IRA at retirement [2]. §457 deferred compensation plan assets cannot. Rollovers simplify a client’s financial life by consolidating accounts, by making possible a cohesive investment strategy and by bringing everything under a common set of pension rules.

However, there are reasons not to rollover a pension account to an IRA.

• ERISA grants special protection against creditors that does not exist with an IRA in California. ERISA also grants special spousal rights; that why spouse’s notarized signature is required when rolling an ERISA plan over to an IRA.
• One can only rollover the tax deferred portion only. You receive a separate (non taxable) check for tax paid contributions. Since tax paid contributions are no longer tax sheltered after a rollover, these assets will earn a lower after tax investment return.
• Some 403(b) plans allow participants to delay distribution of pre 1987 accruals until age 75. Therefore, rolling a "tax sheltered annuity" over to an IRA might accelerate distributions.
• The employer plan may offer special investments, such as closely held employer stock or GICs, which are not available outside the employer plan. The employer may also subsidize management fees.
• Rolled over funds cannot be rolled back into another employer plan unless they are segregated from other funds in a "conduit IRA."
• The employer plan might include employer securities which would qualify for special income tax treatment if distributed as a lump sum.

A distribution could qualify for lump sum treatment and still be subject to the 10% penalty on premature withdrawals. If an account contains employer securities and other assets, one cannot take a lump sum distribution of the securities and roll over the other assets. See IRS Pub. 575 for details.

"Whom Should We Name as Beneficiaries"

The choice of beneficiary must mesh with the overall estate plan. The choice of beneficiary also affects the size of the IRA distributions and this in turn affects how long the investments remain tax advantaged.

The after tax investment return of a tax advantaged account is greater than the after tax return of a taxable account, assuming the same investment strategy. It therefore makes financial sense to delay IRA distributions as long as possible and to use the taxable rather than the IRA portfolio for necessary living expenses. Distributions from a traditional IRA can be delayed until about age seventy [3]. Failure to take timely distributions triggers a 50% penalty.

Once distributions begin, the only remaining way to delay distributions is to make the required distributions as small as possible [4]. Since the size of each distribution is calculated by dividing the prior year ending account balance by a life expectancy factor, the goal is to make this divisor as small as possible.

The initial life expectancy factor is either the owner’s life expectancy, as determined from a table reproduced in IRS Pub. 590, or the joint life expectancy of the owner and primary beneficiary, again determined from an IRS table [5]. If the goal is smaller required distributions, choose the joint life expectancy option since a joint life expectancy is always larger than the life expectancy based on a single individual. This is why premiums for a second to die policy are less than the premiums for a single life policy.

If there is more than one primary beneficiary, the life expectancy factor is based on the age of the oldest beneficiary [6]; that is, use the shortest life expectancy.

The life expectancy factor is large if a young person is the primary beneficiary. When there is more than ten years difference in the ages of the owner and the primary beneficiary, and if the primary beneficiary is not the spouse, the special "Minimum Distribution Incidental Benefit (MDIB)" life expectancy table is required. This table limits the age differential to ten years.

According to the IRS tables, someone aged seventy has a single life expectancy of 16.0 years, a 20.2 year joint life expectancy assuming a spouse of equal age and a 26.2 year MDIB divisor.

The same formula, the balance at the end of the first year [7] divided by a life expectancy factor, determines how much is to be withdrawn in the second year. The prior year ending balance appears on the annual Form 5498 which you and the IRS receive from the IRA custodian in the Spring.

There are several ways in which the life expectancy factors can be determined after the first year. The easiest approach is to elect the term certain method. If the initial factor is 20.6 years, the term certain factor for the second distribution is one less or 19.6 years and the factor which determines the third distribution is two less or 18.6 years.

The second advantage of the term certain method is its predictability. If the owner or designated beneficiary dies after the owner’s required beginning date, distributions continue to the beneficiaries over the remaining term using the methodology in place at time of the owner’s death.

The term certain method tends to understate future life expectancies. For example, again using IRA tables, if the joint life expectancy were 20.6 years at age seventy, the true life expectancy would be 19.8 years a year later and 18.9 years a further year later. To the extent that the term certain method understates true life expectancies, it overstates the required minimum distributions.

Another approach to determining future life expectancy factors is to base the factor on the true life expectancy. Since "refiguring" produces larger factors, this method results in smaller required distributions and provides more tax deferral.

The IRA owner may refigure their life expectancy. The owner may also refigure the life expectancy of the primary beneficiary if the beneficiary is his or her spouse. The life expectancy of a non spouse beneficiary must be determined using the term certain method and may not be refigured.

Refiguring both lives is less predictable than the term certain method. Distributions occur over the actual life of the second to die, which can be great if everyone lives a long time but which has unfortunate consequences if death is premature [8].

The "hybrid" method [9] blends the term certain and refigure both lives methods. It is frequently the best choice for a married couple. A husband and wife would elect the term certain method for the spouse who is likely to die first and the refigure method for the spouse who is likely to be the second to die. Irregardless of which spouse dies first, distributions are over a period which is at least as long as the term certain single life expectancy of the one spouse and which could be as long as the actual life of the second spouse [10].

The hybrid method eliminates the risk of a short distribution interval while generally providing a slower rate of distribution than the term certain method.

The surviving spouse has the option, but is not required, to claim an inherited IRA as his or her own. Renaming the IRA as your own includes the right to name new beneficiaries [11]. Renaming the IRA as your own can be an important planning opportunity because it allows the surviving spouse to name younger beneficiaries and to restart the life expectancy factor calculation using her life expectancy and the life expectancy of the new beneficiaries [12].

The surviving spouse bases timing issues on his or her age, not on the decedent’s age. For example, a younger spouse can delay further distributions from the decedent’s IRA until she reaches age seventy.

Timing issues might discourage the surviving spouse from renaming the decedent’s IRA as his or her own. For example, an older spouse might have to take distributions from the decedent’s IRA even though the descendent spouse would not have been required to do so had he or she lived. If the surviving spouse is less than age 59½ and takes a distribution from a renamed IRA, he or she might be assessed a premature withdrawal penalty even though the decedent could have made the withdrawal without penalty.

The right of the surviving spouse to rename the decedent’s IRA as her own can produce an attractive outcome. Suppose that Sue elects to rename Bill’s IRA as her own and names their children as the new beneficiaries. Subsequent distributions are based on the joint life expectancy of Sue and the eldest child and the MDIB rule applies because of the age differential. After Sue’s death, the MDIB rules no longer apply and the children have the option of taking distributions gradually over their life expectancy.

An IRA owner may change beneficiaries at any time. Thus, after Bill’s death, Sue can also name the children as the new beneficiaries of her own IRA.

If the change in beneficiaries occurs after the required beginning date, and if the new beneficiary has a shorter life expectancy than that of the prior beneficiary or if the new beneficiary is the owner’s estate or certain trusts, future life expectancy factors are calculated as if the new beneficiary had been the beneficiary on the required beginning data. That is, naming an older individual or an estate as the beneficiary can accelerate distributions.

Distributions from Sue’s personal IRA are not accelerated when she names her children as new beneficiaries because the children have longer life expectancies than the former beneficiary.

Choices become irreversible as of the required beginning date, or the date of death, whichever is earlier.

"Should We Convert to a Roth IRA?"

Distributions are never required from a Roth IRA before death. Since the surviving spouse has the opportunity to rename the descendant’s Roth IRA as his or her own, current law allows a married couple to delay distributions from a Roth IRA until the second death.

The Roth IRA can always be distributed gradually after the second death over the life expectancies of the designated beneficiaries. A similar result is possible with the traditional IRA if the owner dies before their spouse or before the required beginning date.

Three questions help clients decide whether they are Roth conversion candidates.

• Will you be able to take advantage of the extra tax deferral that the Roth IRA allows after age seventy or will economic necessity force distributions? Conversion is usually not attractive unless there are surplus assets.
• Are there heirs to whom the Roth IRA will pass? A Roth conversion offers the opportunity for continued tax deferral after the second death and this benefit is not important to someone without heirs.
• Are there taxable assets which could be liquidated to pay the conversion tax? Converting is an opportunity to tax shelter additional money. Extra tax sheltering can only happen if the conversion tax is paid from non IRA assets.

Deciding whether or how much to convert can require considerable analysis [13]. After a thorough analysis, the planner suggests a partial conversion. Bill and Sue leave the planner’s office promising to consider this recommendation.

"How Do We Fund the By-Pass Trust?"

Unfortunately, Bill does not survive the trip home.

Bill and Sue had created a living trust and their home and taxable investments are owned by the trustee of the living trust. The living trust was designed to avoid estate tax at the first death and to shelter as much as possible from estate tax at the second death. That is, a "by-pass" trust (or credit shelter trust or B trust) is created at the first death with the intention of funding this trust to the applicable exclusion amount [14], which is $1 million at the time of Bill’s death.

Sue returns to the planner’s office a few months after Bill’s death for advice on funding the by-pass trust. Since the couple’s assets were $1.5 million at the time of Bill’s death and since the asses were all community property, Sue expects to be told to place half of everything, or $750,000, inside the by-pass trust.

However, of the $1.5 million, only $800,000 is owned by the trust. The balance is in IRAs which belong to Sue or which pass to Sue directly by operation of the beneficiary designation. Consequently, the maximum that can be stuffed inside the by-pass trust is half of $800,000, substantially less than Sue had anticipated.

This underfunding of the by-pass trust could create a larger estate tax liability at the second death. The extra tax at the second death could be substantial since estate tax rates are about 50%.

Sue is sorely disappointed. "I sure wish my financial planner had been at Peter’s seminar. He would have learned how a carefully crafted beneficiary designations would have let me use IRA assets to fund the by-pass trust!"

Simply put [15], Bill and Sue should have asked their attorney to draft an IRA beneficiary designation naming the spouse as primary beneficiary and, if he or she is deceased, naming the children as contingent beneficiaries. The language would specify that if the surviving spouse chose to refuse part of the IRA, the disclaimed portion would pass to the by-pass trust rather than to the children.

Suppose that such a beneficiary designation had been in place at the time of Bill’s death. Sue would have had the option of saying, "I don’t want all of Bill’s IRA. I’ll take my community property share and disclaim the rest." This disclaimer would cause an additional $175,000 to flow to the by-pass trust [16].

Suppose that Bill lives until his late eighties. When Sue inventories their assets after Bill’s death, she discovers that she and Bill own IRAs worth $800,000, a home worth $1.4 million and a taxable investment portfolio worth $700,000.

Of these assets, $2.1 million worth are owned by the trust. Bill’s community half interest is more than applicable exclusion amount and the Trustee should have no difficulty funding the trust [17]. A disclaimer is not needed in this instance.

If Bill and Sue had elected a partial conversion to a Roth IRA, the Roth IRA would be worth $1.3 million at Bill’s death in his late eighties and the only asset owned would be their $1.4 million personal residence. Bill’s community property half interest in their home is not sufficient to fully fund the by-pass trust. A carefully crafted disclaimer [18] allows an additional $325,000 to flow to the by-pass trust.

"Should Sue Take Smaller Distributions from the Renamed IRA?"

The surviving spouse has the option of renaming a decedent spouse’s IRA as her own, of naming new beneficiaries and, if the beneficiaries are younger, of slowing distributions.

Sue might end up with two traditional IRAs, each worth about $400,000, when Bill dies in his late eighties. The distributions from her personal IRA [19] would be based on the hybrid method in place on her required beginning date and the distributions from the renamed IRA would be based on the joint life expectancy of herself and her children as limited by the MDIB rules.

When calculating the required minimum distribution in the years after Bill’s death, Sue performs separate calculations for each IRA using the prior year ending balance and the life expectancy factor appropriate to that IRA. Sue must take a total distribution equal to the sum of the individual required distributions but Sue need not take a pro rata share from each IRA. She may take any amount from either IRA, so long as the sum of the distributions equals or exceeds the sum of the required distributions [20].

In deciding how to take the distributions, Sue should remember that her personal IRA is going to be fully distributed within a few years [21] of her death whereas the children will have the opportunity to distribute the renamed IRA gradually over their life expectancy. From the children’ point of view, money in the renamed IRA is more valuable than money in the personal IRA because there is a longer opportunity for tax advantaged investing after Sue’ death.

It is therefore to the children’s advantage for Sue to take larger distributions from her personal IRA and smaller or no distributions from the renamed IRA.

"How Does Tax Advantaged Deferral Benefit Our Children?"

A few years later, Sue dies. The nominal values of her estate and of the by-pass trust total $2.9 million. This includes a traditional IRA worth $400,000, a home worth $1.6 million and a taxable portfolio worth $900,000.

The heirs won’t receive this full amount. They will have to pay estate taxes and they are going to have to pay income tax on the "income in respect of a decedent (IRD)" contained within the traditional IRA.

After income tax, the traditional IRA might be worth a quarter of a million dollars rather than its nominal value of $400,000. So, the economic value of all assets at the second death is about $2.75 million before estate tax [22].

If Bill and Sue had made a partial Roth conversion, the nominal values of the estate and of the by-pass trust would total $2.75 million before estate tax. These assets are their $1.6 million home, a $1.1 million Roth IRA and a small taxable portfolio. This nominal value is also the economic value because there is no unpaid income tax with a Roth IRA.

Bill and Sue might leave an estate containing a traditional IRA with a nominal value of $2.9 million or, if they make a partial conversion, an estate containing a Roth IRA with a nominal value of $2.75 million. Since these economic values are essentially identical, there is no financial benefit to the second to die to have converted to a Roth IRA in this instance [23].

This discussion has assumed that Bill and Sue’s heirs choose to withdraw the traditional and Roth IRA shortly after the second death. The relative benefit from the Roth conversion is quite different if the heirs choose to take IRA distributions gradually over their lifetimes.

We will ignore the possibility that the traditional IRA might have to be distributed more rapidly than the Roth IRA and assume that both IRAs are distributed over the term certain life expectancies of the beneficiaries [24].

Even without calculations, it is clear that the $1.1 million Roth IRA is going to generate a larger after death benefit [25] than is the $400,000 traditional IRA, simply because the Roth IRA is bigger. A larger IRA at the second death, and hence the possibility for more post death deferral, is a common result of a Roth conversion.

The Usual Financial Strategy of a Married Couple

A husband and wife are probably going to name each other as the primary beneficiary of their traditional or Roth IRAs. The beneficiary designation should provide the surviving spouse the opportunity to disclaim a portion of the IRA at the first death and to thereby control the funding of the by-pass trust.

A husband and wife have several options for calculating the life expectancy factors which control the size of their required distributions. The hybrid method should probably be given first consideration.

The surviving spouse should probably rename the decedent’s IRA as his or her own, should probably name new beneficiaries and should probably set up a new distribution methodology. The surviving spouse should manage distributions to maximize the size of the renamed IRA at the second death.

Those with heirs and resources in excess of their needs should consider converting to a Roth IRA in the years between retirement and their required beginning date.

Power of Attorney: Authority to Change IRA Beneficiaries.

Bill and Sue appreciate that they need to execute a power of attorney so that someone can manage their financial affairs if they become incapacitated. Bill and Sue check off "retirement plan transactions" intending to give their agents power to manage their IRAs. The powers that Bill and Sue grant their agents are specified in Probate Code §4462 [26] and include the power to change beneficiaries.

Before executing a power of attorney, everyone should discuss with their attorney language limiting their agent’s authority to change pension beneficiaries.

The power of attorney could be incorporated into the beneficiary designation.

Designated Beneficiary Trusts

Until recently, naming a by-pass trust to receive IRAs disclaimed by the surviving spouse accelerated distributions if the IRA owner died before the required beginning date or if the owner was refiguring his life expectancy. Distributions are still accelerated when you name your estate as beneficiary but the rules changed in December 1998 as regards the by-pass trust.

If four specific conditions are met [27], the by-pass trust qualifies as a designated beneficiary trust and distributions will be based on the life expectancy of the oldest trust beneficiary, the surviving spouse in this example. The conditions are not onerous but the attorney and trustee need to understand the rules.

Who Owns IRA Distributions to a By-Pass Trust?

The language of a by-pass trust frequently provides that the surviving spouse is to receive all the income from the trust and as much of the principal as he or she needs. The remainder beneficiaries receive whatever is left over at the second death. There is therefore a tension between the rights of the surviving spouse and those of the remainder beneficiaries.

One of the purposes [28] of the by-pass trust is to shelter the decedent’s assets from further estate taxation. The trustee of the by-pass trust has a fiduciary duty to see to it that there are no unnecessary distributions to the surviving spouse since unnecessary distributions put the money back into the estate tax queue and change the ultimate beneficiaries when the deceased and surviving spouses have different heirs.

The trustee chooses investments in light of his or her responsibility to both the surviving spouse and to the remaindermen. It is not appropriate for trust investments to generate more income than is needed by the surviving spouse.

The trustee has to determine whether specific proceeds are income and thus need to be distributed to the surviving spouse, or principal and thus need to be retained within the trust for eventual distribution to the remainder beneficiaries. The process of making these allocations is called "fiduciary accounting" [29] and there is California legislation to assist the trustee in making these allocations.

The Revised Uniform Principal and Income Act [30] does not address pension distributions. It is thus unclear [31] whether IRA distributions to a by-pass trust are to be allocated to the income or principal account.

Bill and Sue have the opportunity to decide these issues when their attorney prepares their trust document. The document could say that Bill and Sue want the IRA distributions to be retained within the trust or that the distributions should be distributed to the surviving spouse. Or the document could give the Trustee power to decide how the distributions are to be treated, not withstanding the Revised Uniform Principal and Income Act.

IRA distributions to a "designated beneficiary" by-pass trust are taxable income. If the trustee of the by-pass trust allocates IRA distributions to the surviving spouse, the surviving spouse will pay the income tax at their marginal tax rate. If the distributions are retained in the trust, the trust will pay the income tax at the highest marginal rate [32]. If the IRA distributions flow to the surviving spouse, there is probably less income tax now but possibly more estate tax later.

Distributions from a Roth IRA are not taxable and the Roth IRA is therefore a better choice than a traditional IRA for funding the by-pass trust. If the trustee classifies the distributions as principal when initially received by the by-pass trust, the distributions remain within the by-pass trust without adverse income tax consequences.

Non Pro Rata Allocation of Community Property

It is not always possible to fund the by-pass trust to the full applicable exclusion amount. A carefully crafted beneficiary designation may allow the surviving spouse to increase the funding of the by-pass trust by disclaiming part of the decedent’s IRA.

Disclaimers are effective if the by-pass trust is a "designated beneficiary trust" and if the trustee has the authority to allocate IRA distributions to the principal account. It may not be possible to disclaim the surviving spouse’s community property share of the decedent’s IRA without income and gift tax consequences.

All in all, Bill and Sue have a workable but not entirely satisfactory estate plan.

Let us suppose that Bill and Sue had executed an agreement that said that they owned their home, their investment portfolio and their IRAs as community property. While they each owned one half of the aggregate value, the agreement went on to say that they did not want to apportion ownership on an item by item basis. Instead, Bill and Sue wanted the IRAs to belong to the surviving spouse with everything else belonging to the decedent spouse [33].

Such a community property agreement could have significant benefits when funding the by-pass trust. If Bill were to die in his mid sixties, the agreement would allocate ownership of the $700,000 in IRAs to Sue while their home and the bulk of their investment portfolio would be allocated to Bill. This allocation would mean that the decedent’s share of the living trust assets would be sufficient to put $750,000 of non IRA assets into the by-pass trust.

Bill’s estate tax return would have different numbers in different places but the tax base [34] on which the estate tax is calculated and the estate tax liability would not be changed substantially.

This community property agreement was designed to save estate taxes. There is a risk that the IRS may challenge the non pro rata allocation of community assets at the first death as an income taxable exchange [35]. Since California has modified the Probate Code [36] so that an agreement like that between Bill and Sue is now sanctioned by state law, the Service is less likely to raise income tax issues. But be aware that the non pro rata division of community property is new to California, that there are no directly applicable court cases, that your attorney may not have thought the issues through and that the IRS has said nothing.

Simultaneous Death Clauses are common in wills and trust documents. They should likewise appear in IRA beneficiary disignations.

1. The assumptions underlying this forecast may be found at http://www.lingane.com/consider.htm. Valuations at the second death are before income tax whereas they were after tax in the prior work. The partial Roth conversion described herein represents 20% per year over five years and is suboptimal.

2. Retirement planners should have the following close at hand.

• IRS Publication 571 "Tax Sheltered Annuities"
• IRS Publication 575 "Pensions and Annuities"
• IRS Publication 590 "Individual Retirement Accounts"
• "Professional’s Guide to the IRA Distribution Rules" by Seymour Goldberg, 3rd Ed. (October 1997) Foundation for Accounting Education; ISBN: 9993318027.
• "Retirement Distributions: Planning Options" by Mary Kay Foss, CPA. This course is presented by the California CPA Education Foundation.

Call (800) 829-FORM for free copies of the IRS publications. The IRS publications are also available at http://irs.ustreas.gov and on the CD-ROM of federal tax products.

Your clients may benefit from reading "J. K. Lasser's How to Pay Less Tax on Your Retirement Savings" by Seymour Goldberg, 2nd Ed. (December 1997); ISBN: 0028619994.

3. The "required beginning date" is April 1 of the year in which one turns seventy one if one’s birthday falls between January and June and April 1 of the year one turns seventy two if one’s birthday is in the second half of the year. The required beginning date from a qualified employer plan but not IRAs is deferred to the April 1st after the retirement year if later than the year the participant attains age 70½. As explained in Publication 590, the first and second distributions are taken in the same calendar year if one delays the initial distribution from December 31 to April 1.

If the owner dies before the required beginning date, the decedent’s entire interest must be distributed by December 31 of the fifth year after death; or must be distributed over a period not longer than the life expectancy of the designated beneficiary, beginning no later than December 31 of the first year after death. The choice must be made by December 31 of the first year after the owner’s death. Special rules apply when the designated beneficiary is the decedent’s spouse.

4. The exception is in the year of death, when a death bed withdrawal or a death bed conversion to a Roth IRA may have a large financial payoff.

5. When using these tables to calculate the initial required distribution, use the ages of owner and beneficiary as of the calendar year in which the owner turns 70½.

6. Consider multiple IRA accounts with a single primary beneficiary as an alternative to a single account with multiple beneficiaries. This allows the minimum distribution from each account to be based on the age of the beneficiary of that account rather than on the age of the oldest of the beneficiaries.

7. If the initial distribution has been delayed until April 1, the first year ending balance must be corrected by the amount of the initial distribution. That is, the size of the second distribution is not affected by the calendar year in which the initial distribution is received.

8. Assume that Bill dies prematurely and that Sue, his designated beneficiary, dies a few years later. The life expectancy factor in the year after Bill’s death is based on Sue’s singe life expectancy since a refigured life expectancy is zero after death. If Bill dies at age seventy five, Sue uses a 11.9 factor when determining distributions in the year after Bill’s death. The factor would have been 15.7 had Bill survived.

If Sue dies at age 76, the refigured factor is zero in the year following her death and Bill and Sue’s heirs must withdraw the entire IRA balance by December 31st of the year after Sue’s death.

9. Hand calculations of the hybrid method are not practical. The software I use was provided by Brentmark to participants in the California CPA Education Foundation’s "Estate Planning, Employee Benefits and IRAs" by Michael Jones, CPA and Jerry Kasner, JD, CPA.

10. The usual recommendation is to refigure the owner’s life. This means there is no change in life expectancy at the death of the spouse. As we will see, the surviving spouse will probably rename the decedent’s IRA as her own rather than base future distributions on his or her single life expectancy.

11. The surviving spouse can combine any basis in the inherited IRA with the basis in their other IRAs. Someone other than the surviving spouse must account separately for the basis in the inherited IRA. The determination of taxable income when there is basis in an IRA is discussed in the reference in footnote 1.

12. Consider dividing the IRA so that there is only one primary beneficiary. This will slow distributions for younger beneficiaries after the second death and will avoid conflicts about how to manage the IRA.

13. See the reference in footnote 1.

14. This is an approximation. Funding depends on such factors as the funeral and administrative expenses, income and estate taxes, prior gifts, the amount of separate property and post death appreciation.

15. This is an uncertain area when the IRA is community property, as it generally is in California. Disclaiming more than half of the decedent’s IRA could be construed as a gift to the by-pass trust of the surviving spouse’s community interest in the decedent’s IRA, meaning that the surviving spouse might have to file a gift tax return and pay income tax on the gifted IRA.

16. Distributions to the by-pass trust must begin in the year after death whereas it might be possible to delay distributions if the surviving spouse were the beneficiary. Quicker distributions reduce estate tax benefits.

17. Since no one would have paid one half of the full valuation for Bill’s community half interest in their home, the home is listed on the estate tax return at a discounted value. "Federal Estate Tax: Hot Issues and Battlegrounds of Form 706" by Keith Schiller, JD, California CPA Education Foundation, 1998. A fractional interest discount does not apply to joint tenancy property, see Estate of Young v. Comr., 110 TC 24.

This discount has no effect on the estate tax liability at the first death but it does mean that the basis in the home will be less when the home is eventually sold. If the Trustee allocates the home to the surviving spouse, a lower basis may not be not important because of the $250,000 §121 exclusion should the home be sold or because of the stepped up basis on the death of the surviving spouse. But, should the Trustee allocate the home to the by-pass trust, the §121 exclusion and the stepped up basis at death will not apply and a valuation discount at the first death will result in increased income tax when the home is sold.

18. Tt is imperative that the surviving spouse understands that disclaimers need to be done carefully. For example, disclaiming a specific dollar amount causes the surviving spouse to have to report the disclaimed portion on her income tax return. Disclaimers must be done within nine months of death and the surviving spouse cannot have benefited from the disclaimed funds. This means that there can be no withdrawals from the decedent’s IRA and the IRA cannot be renamed as his or her own. Paraphrasing David Gaw, the most important rule in post death administration is to do nothing until you talk with your adviser.

19. The Internal Revenue Code uses "inherited IRA" when the beneficiary cannot or chooses not to rename the decedent’s IRA as his or her own. "Personal IRA" and "renamed IRA" are not mentioned in the Code but my meaning should be clear from the context.

20. One may not similarly aggregate distributions from IRAs and tax sheltered annuities.

21. If Bill dies in his late eighties and if Sue’s life expectancy is being recalculated, the entire balance in Sue’s personal IRA must be distributed by December 31 of the year after Sue’s death.

22. There are sufficient non IRA assets to pay the estate tax but liquidity issues have been neglected. It is important that there be assets (life insurance?) to pay the estate tax without having to liquidate the IRA.

23. The conversion amount was chosen to achieve this result. Had Bill and Sue converted less, there might have been a $250,000 financial benefit as of the second death as discussed in the reference in footnote 1.

24. Distributing a traditional IRA over the life expectancies of Bill and Sue’s children is only possible if Bill and Sue die before age seventy or if, as in this example, the surviving spouse renames the decedent’s IRA as their own and takes disproportionately smaller distributions from the renamed IRA.

25. Bill and Sue’s heirs receive, net of estate and income taxes, about $2.5 million if Bill and Sue do not convert and $3.0 million if there is a partial conversion. Estate taxes assume current rates and a million dollar applicable exclusion amount for both Bill and Sue. Post death benefits assume 35% income tax rate, the §691(c) deduction, 30 year life expectancy and 8% IRA growth rate after the second death and were discounted to the date of the second death at 5.2% after tax.

26. From http://www.leginfo.ca.gov/calaw.html. California Probate Code 4462. In a statutory form power of attorney, the language granting power with respect to retirement plan transactions empowers the agent to do all of the following: (a) Select payment options under any retirement plan in which the principal participates, including plans for self-employed individuals. (b) Designate beneficiaries under those plans and change existing designations. (c) Make voluntary contributions to those plans. (d) Exercise the investment powers available under any self-directed retirement plan. (e) Make rollovers of plan benefits into other retirement plans. (f) If authorized by the plan, borrow from, sell assets to, and purchase assets from the plan. (g) Waive the right of the principal to be a beneficiary of a joint or survivor annuity if the principal is a spouse who is not employed.

27. IRS Prop Reg. 1.401(a)(9)-1. Answer to question D-5. . . . as of the later of the date on which the trust is named as a beneficiary of the employee, or the employee's required beginning date, and as of all subsequent periods during which the trust is named as a beneficiary, the following requirements are met:

(1) The trust is a valid trust under state law, or would be but for the fact that there is no corpus.

(2) The trust is irrevocable or will, by its terms, become irrevocable upon the death of the employee.

(3) The beneficiaries of the trust who are beneficiaries with respect to the trust's interest in the employee's benefit are identifiable from the trust instrument within the meaning of D-2 of this section.

(4) The documentation described in D-7 of this section has been provided to the plan administrator. [Essentially, the trustee must provide a copy of the trust or a list of beneficiaries plus a certification that conditions (1), (2) and (3) have been met. See the proposed regulation for details. - PJL]

28. Other priorities are to provide for the surviving spouse and to control who receives what is left over at the second death. Controlling the remainder beneficiaries is especially important in complex families.

29. "Fiduciary Accounting for Estates and Trusts" by David Ostrove, JD, CPA. This course is offered by the California CPA Education Foundation

30. California Probate Code 16300-16315.

31. When the trustee receives an IRA distribution as of the date of death, this distribution probably belongs to the remaindermen and the income taxes should probably be charged to the principal account.

Allocating an IRA distribution which includes post death appreciation is analogous to the distinction that must be made between IRD and post death appreciation when claiming the §691(c) deduction. In the later case, it is commonly assumed that the IRD is distributed before post death appreciation so as to take the deduction as quickly as possible. However, Jerry Kasner, JD and Michael Jones, CPA argue that post death appreciation is distributed first, "Estate Planning, Employee Benefits and IRAs" California CPA Education Foundation, 1998, p. 31. This is also how IRA distributions to a QTIP trust are treated in Rev. Rul. 89-89.

Once a decision has been made as to what portion of an IRA distribution is post death appreciation, one needs to allocate the distributed appreciation to the principal or to income account. One could argue that the allocation should be based on fiduciary accounting principles with distributed dividends being allocated to the income account and distributed capital growth being allocated to the principal account.

32. For 1998, trusts pay 39.6% federal tax on taxable income over $8,350 plus 9.3% California tax on taxable income over $33,673 (same bracket as single individuals.)

33. This approach was suggested by Steven E. Trytten, JD in "Estate Planning for Retirement Plan Assets" 1997 Annual Meeting of the California Tax Bars, San Francisco, November 1997. I am indebted to Fred Meissner, EA for bringing this article to my attention.

34. A non pro rata community property agreement may eliminate fractional interest discounts, which might change the tax base and estate tax.

35. A similar attribution of taxable income could arise in the non pro rata funding of the by-pass trust but there are no income tax consequences when the non pro rata allocation is authorized by state law, as it is in California, or by the trust language. Trytten, op. cit.

(b) Notwithstanding subdivision (a), a husband and wife may agree in writing to divide their community property on the basis of a non pro rata division of the aggregate value of the community property or on the basis of a division of each individual item or asset of community property, or partly on each basis. Nothing in this subdivision shall be construed to require this written agreement in order to permit or recognize a non pro rata division of community property.

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