Intergenerational transfer is the major estate planning opportunity of the Roth IRA. You will need help from your attorney and the cooperation of your IRA custodian to achieve the potential benefits. Retirement planning involves big bucks and evolving rules. If in doubt, seek competent advice.

Roth Might Mean Rethinking Your Estate Plan

by Peter James Lingane

Your planning strategy should define primary and contingent beneficiaries and the method for calculating required distributions from traditional IRAs. Review the references for the precise definitions of the distribution rules and for further discussion of the following principles.

Typically, married couples will name each other as the primary beneficiary and will elect the "hybrid" method for calculating required minimum distributions. This method involves refiguring the owner’s life expectancy but uses the term certain method for the owner’s spouse. The hybrid method tends to maximize wealth transfer possibilities.

Your strategy should allow the surviving spouse to use IRA assets to fund the by-pass trust. This can be achieved by allowing the surviving spouse to disclaim the decedent’s IRA. The disclaimed portion passes to the decedent’s by-pass trust.

If the surviving spouse does not disclaim the decedent’s IRA, he or she has the option to rename the deceased spouse’s IRA as their own. The option to treat a deceased spouse’s IRA as your own applies to both traditional and Roth IRAs. The children are often be named as the new beneficiaries.

The decision to rename should be made in the year of death. Delay is allowed by IRS rules but delay could trigger a full distribution, as is illustrated by Table 2, column C of Blackman and Boling, AAII Journal, August 1998.

No further planning is needed if the renamed account is a Roth IRA. No minimum distributions are required and beneficiaries are entitled to distribute the Roth IRA over their lifetimes following the second death.

Additional planning is needed when the renamed IRA is a traditional IRA. The surviving spouse will generally base required distributions from the renamed IRA on his or her life expectancy and the life expectancy of the oldest beneficiary. This allows the beneficiaries the option to continue distributions of whatever balance remains in the renamed traditional IRA over their lifetimes.

It’s best if the life expectancy of the surviving spouse is not refigured. Refiguring makes no difference before the death of the surviving spouse because of the MDIB requirement but would accelerate the post death payout, albeit slightly.

The surviving spouse probably also owns a personal traditional IRA and he or she is likely to name children as the new beneficiaries. Distributions to the children after the second death won’t be based on the children’s life expectancies, as they would for a Roth or renamed traditional IRA, but will use the distribution scheme in place when the surviving spouse reaches age seventy. The usual result is that the personal traditional IRA is going to be distributed soon after the second death and probably won’t provide attractive deferral opportunities for the heirs.

If the distribution scheme for the renamed traditional IRA probably benefits the children more than the scheme for the personal traditional IRA, it is wise to consolidate the personal IRA into the renamed IRA. The surviving spouse accomplishes this consolidation by taking minimum distributions calculated for both accounts exclusively from the personal IRA rather than pro rata from each IRA.

Prop. Reg. 1.401(a)(9)-1(e), Q&A G-4, prohibits the slowing of post death distributions by the more direct strategy of rolling the personal account into the renamed account.

Your strategy should also address what happens if a beneficiary is deceased or dies shortly after you do. And you need to determine who is going to manage your IRA in the event that you are unable to make decisions. (Continued management of the IRA, should the owner become incompetent, can also be handled with a power of attorney.)

A beneficiary designation is a legal contract which supplements the written agreement between you and your IRA custodian. It is an integral part of you estate plan and guides the distribution of an asset which could be worth hundreds of thousands of dollars. Understand the fine print and seek competent advice just as you would when drafting other, important estate planning documents.

Drafting a customized beneficiary designation is only the first step; you must also convince your IRA custodian to accept and understand what you are trying to do. Bill and Sue approached several fund companies armed with a beneficiary designation naming the survivor as the primary beneficiary with the right to disclaim to a by-pass trust and naming their children as secondary beneficiaries.

What they found was ignorance and carelessness, much like that described in Lynn Asinof’s March 29 Wall Street Journal report "Oops ... How a Variety of Basic Foul-Ups are Bedeviling the Beneficiaries of IRAs."

V and FT misinterpreted the customized form and treated Bill and Sue’s living trust as the primary beneficiary. C wrote that the customized form "indicated no changes to the beneficiaries that we have on file." F initially refused to consider a customized form but relented on learning that Bill and Sue’s accounts exceeded $200,000.

Even when a representative was willing to accept the form as drafted, Bill and Sue wondered whether the representative was authorized to execute this contract.

The lesson that I draw from these anecdotal experiences is that a customized beneficiary designation brings practical complications. It may be better to search out an IRA custodian whose standard beneficiary options are flexible enough to accomplish your estate planning objectives.

One possibility is to name the by-pass trust as the secondary beneficiary and to put the children third in line. Sequential disclaimers control where the money goes; you may need to add enabling language to the by-pass trust. Another choice is to check out Vanguard’s recently revamped "Beneficiary Designation/Change Form for Retirement Accounts."

Bill and Sue were able to use the Vanguard form to name each other as primary beneficiary, to name their children as secondary beneficiaries and a by-pass trust as the alternate beneficiary should the surviving spouse disclaim. The Vanguard form considers the possibilities of simultaneous death and the premature death of one of the children. The accompanying brochure is clearly written.

If Bill and Sue decide against converting to Roth, Sue (the

second to die) should find herself, late in life, owning a home, a million dollar investment portfolio and a traditional IRA with a nominal value of about $410,000. See the summary at the bottom of this page.

Her children would pay estate tax of about $440,000 and income tax of about $90,000 if they elected to receive the IRA immediately. The value of the children’s inheritance would be $2.48 million assuming immediate distribution of the IRA.

If the children wished to distribute the IRA over their lifetimes, and if the distribution rules allowed them to do so, the effective value of the inheritance is $2.61 million because of the continued deferral after Sue’s death. The post death deferral benefit is thus about $130,000 net of income taxes.

(The net present value calculation is performed by scheduling required minimum distributions over thirty years, paying income tax at a 33% combined federal and state rate, after consideration of the 691(c) deduction, and after discounting the future income stream back to the date of death. Both the IRA and after tax distributions return 8% annually and future income is discounted at the equivalent 5.4% after tax return.)

If Sue knew that her children planned to spend her IRA, she might choose to cash-in her IRA and pay the income tax before death. As shown by the table’s second column, the children receive about $2.50 million under this scenario. The small increase is the 691(c) effect.

Sue achieves exactly the same 691(c) benefit by converting her traditional IRA. Reminder: conversion is not possible in a year when income exceeds the $100,000 conversion limit.

A deathbed conversion provides two additional benefits. First, conversion insures that the children will be able to distribute the IRA over their lifetimes, at least under current law. Beneficiaries of a traditional IRA might not be able to fully achieve the deferral benefit indicated.

Second, conversion increases the post death deferral benefit. Compare the $220,000 benefit shown in the "deathbed conversion" column with the $130,000 benefit in the no conversion column.

The majority of the increase is because conversion increases the amount of money being sheltered within the IRA.

To illustrate, the $410,000 traditional IRA is really worth only $275,000. This is what Sue nets if she cashs the IRA in and pays the income tax. $275,000 is the amount of money that Sue has invested tax deferred in the traditional IRA.

The IRA is worth $410,000 after conversion to Roth. Paying the tax from non IRA assets is equivalent to investing more money in the IRA and this extra investment is reflected by the increased economic worth of the Roth IRA.

If we factor the $130,000 deferral benefit of the traditional IRA by the ratio of economic worths, we calculate that the deferral benefit of the converted IRA should be $194,000 based solely on its larger economic worth. That is,

$130,000 x (410 / 275) = $194,000

Bill and Sue gain about $100,000 in living benefits from a partial Roth conversion. As shown by the prior table, the children receive about $2.60 million (before deferral benefits) whereas they receive about $2.50 million from a deathbed conversion.

These living benefits are the compounded result of income tax rate differentials and of increased effective investment return after conversion to the Roth IRA.

If post death deferral benefits are considered, net present values at the second death increase to $2.71 and $3.28 million and the conversion incentive swells to $570,000.

What’s going on here? Why are the deferral benefits so much larger when the conversion is made before age seventy as compared to when the conversion is made at death?

It’s size that matters most in determining deferral benefits, specifically the economic worth of your IRAs at the second death. Conversion might not make a big difference in living benefits, as measured by the total value of your assets at the second death, but it causes a big increase in the size of your IRA relative to everything else. The effect of owning of a larger IRA at the second death is larger deferral benefits.

To illustrate, Sue owns a home, a $410,000 IRA and an investment portfolio if conversion is delayed to her deathbed whereas Sue owns a home, a $1.3 million Roth IRA and little else if she and Bill partially convert when they retire.

The Roth IRA grows so large and eventually dominates there assets because Bill and Sue never have to take distributions.

Modest changes in economic status have a big influence on the forecast benefits. Suppose that Bill and Sue were to inherit some money. This is not improbable given that many of our parents live in half million dollar homes. If their improved economic situation prompts them to a full conversion when newly retired, living and post death deferral might increase to $4 million each. Deferral benefits would increase if a life insurance trust was created to pay estate tax.

The estate tax burden implicit in these calculations assumes that Bill and Sue shelter the maximum amount from estate tax at the second death. Their attorney achieved this result by adding language to their wills or other legal documents to fund a special trust at the first death. The surviving spouse is allowed to spend the money in the trust if he or she needs to but is denied unfettered access to the corpus.

Because the surviving spouse can only spend corpus under limited conditions, the assets in this special trust are not part of the taxable estate of the surviving spouse. These assets "by-pass" estate tax at the second death.

The by-pass trust can be funded to the "applicable exclusion amount" without having to pay estate tax at the first death. The applicable exclusion amount is currently $650,000 and is assumed to have increased to a million dollars before any of the deaths discussed in this article.

Bill and Sue own everything jointly, except their IRAs, and everything is community property in states where this is a consideration. If you need a million dollars to fund the decedent’s by-pass trust, and if everything is owned jointly, it might seem like an easy matter to fund the by-pass trust so long as Bill and Sue’s combined assets exceed $2 million.

Not necessarily. For example, assets held in joint tenancy with right of survivorship pass directly to the surviving joint tenant and pension assets pass directly to the named beneficiaries. These assets are not available to fund the by-pass trust.

A disclaimer is a legal device that allows a beneficiary to control the funding of the by-pass trust. For example, a home might be owned such that with the decedent’s share of the home passes directly to the surviving spouse. But, if surviving spouse says "No, thank you.", the ownership contract could be written in such a way that the disclaimed asset passes to the by-pass trust.

Disclaimers also work with IRAs. Ordinarily, the disclaimed portion passes to the secondary beneficiaries but your attorney can write the beneficiary designation such that any disclaimed portion passes to the by-pass trust. Your attorney might also make the by-pass trust the secondary beneficiary and name your children or other residuary heirs as tertiary beneficiaries.

Designing and exercising disclaimers is best left to professionals. The disclaimer must be made within certain time limits, for example, and needs to follow a certain format to avoid income and gift taxes. It is not possible to disclaim an asset after withdrawing funds or exercising any other ownership prerogatives.

You should not fund a by-pass trust with IRA assets, assuming you have an alternative, since naming a trust as beneficiary is probably going to accelerate distributions.

IRA distributions to a trust begin in the calendar year after death whereas the spouse as beneficiary could delay distributions until their age seventy, or until death if the IRA is a Roth IRA.

Assuming a "designated beneficiary trust," the IRA will be distributed over the life expectancy of the oldest beneficiary, usually the surviving spouse. Without the trust, it is often possible to arrange for the IRA to be distributed over the children’s lifetimes.

Accelerated distributions makes the IRA less valuable to your heirs and this decrease might exceed the estate tax savings. You could be better off under funding the by-pass trust.

If IRA assets are to be used to fund the by-pass trust, it is better to fund with a Roth rather than with a traditional IRA. The reason has to do with income taxes.

Suppose that the by-pass trust is funded with a traditional IRA. Distributions are income taxable when received by the trust and so, over a period of time, what started out as a million dollar trust shrinks by 40-50%. (Trust income is taxed at high rates.) Whereas the intention had been to shelter a million dollars from estate tax at the second death, the amount sheltered could be a lot less when the funding asset has a built-in income tax liability.

For further discussion of the role of the Roth IRA in estate planning,, see "Strategic Planning for Retirement Distributions" on-line at www.lingane.com/tax/designtn.htm.

For information on the Roth IRA, consult

"Should You Convert to a Roth IRA?" by Peter James Lingane, AAII Journal, November 1997 or www.aaii.com/promo/rothira.shtml.

"An Introduction to Roth IRAs" by Natalie Choate, www.rothira.com/choate.htm.

"A Practitioner’s Guide to Roth Conversions" by Peter James Lingane, January 1998. Available at www.lingane.com/tax/roth/guide.htm.

"Planning Considerations with the New Roth IRA," Clark M. Blackman II and Ellen J. Boling, AAII Journal, October 1998.

For Roth conversion procedures and penalties, consult IRS Reg. 1.408A (TD 8816, February 3, 1999), available at www.rothira.com/rothregsf.htm.

For information on IRA distribution rules, consult

"Beneficiary Designations and Required Minimum Distributions, Parts I, II and III" Clark M. Blackman II and Ellen J. Boling, AAII Journal, April, June and August 1998.

"Beneficiary Distributions: What to Do with a Spouse’s IRA," David J. Drucker, AAII Journal, January 1999.

IRS Pub. 590 "Individual Retirement Arrangements." This is available free by calling (800) 829-FORM.

J. K. Lasser’s "How to Pay Less Tax on Your Retirement Savings," 2nd Edition by Seymour Goldberg, MacMillian, 1997.

"Pension Distributions: Planning Strategies, Cases and Rulings," Seymour Goldberg, NY CPA Society, 1998.

For information on designated beneficiary trusts, consult the amendments to IRS Prop. Reg. 1.401(9)(a)-1, Q&A D-5 as published in the Federal Register, Dec. 30, 1997. See also Blackman and Boling, AAII Journal, June 1998.