Tax Planning for Retirees

Spouses and Other Beneficiaries: Part 1

Spouse’s IRA Ownership Election Significantly Impacts Retirement Plan Rollovers. – A retiree’s surviving spouse may roll over a distribution from the retiree’s qualified retirement plan into an IRA in which the spouse is the beneficiary – or alternatively into an IRA the spouse “owns.” Depending on the spouse’s choice, the timing and amounts of required minimum distributions from the IRA and the application of the 10 percent penalty tax on early distributions will likely differ. (Ltr. Rul. 200450057.) See Chapters 5 and 8 of the treatise for discussions of your spouse’s election to own your IRA.

Spousal Rollover to IRA Permitted after Another Beneficiary’s Proper Disclaimer. – The tax law treats a retiree’s surviving spouse as the direct recipient of qualified retirement plan benefits received because another beneficiary properly disclaimed them (i.e., legally renounced them). Thus, the spouse may generally roll the benefits over tax-free to his or her own IRA. (Ltr. Rul. 200505030.) Further, the disclaimer is not invalid merely because the disclaimant received the retiree’s final required minimum distribution. Rev. Rul. 2005-36, 2005-26 I.R.B. 1368. See Chapter 2 of the treatise for an explanation of tax-free rollovers from qualified retirement plans.

Rollovers to IRAs Allowed for Some Indirect Distributions to Surviving Spouses. – A surviving spouse may generally roll over IRA distributions or qualified retirement plan distributions passing to the spouse indirectly through a trust or estate – if the spouse has the unconditional power to obtain the distributed funds. For example, a surviving spouse may generally roll over a qualified plan distribution passing through the deceased spouse’s estate where (i) the surviving spouse is the executor of the estate and (ii) the distribution must pass to the surviving spouse as the only beneficiary. (Ltr. Rul. 200444032.)

Similarly, a surviving spouse may generally roll over an IRA or Roth IRA distribution passing through the decedent’s trust where (i) the surviving spouse is the trustee and (ii) the trust actually distributes the funds to the surviving spouse or his or her IRA. (Ltr. Rul. 200424011; Ltr. Rul. 200742032.) See Chapters 2, 5, and 6 of the treatise for explanations of tax-free rollovers from qualified retirement plans, IRAs, and Roth IRAs.

IRA Ownership Election by Surviving Spouse May Lengthen Children’s Tax Deferral. – A retiree’s surviving spouse and children may all be current beneficiaries of a “qualified” trust that is in turn the beneficiary of the retiree’s IRA. If so, the IRA may generally make required  minimum distributions over a period no longer than the life expectancy of the oldest beneficiary (Normally the spouse).

However, the IRS has ruled such an IRA may spread minimum distributions to the children over the longer life expectancy of the oldest child – if the surviving spouse transfers his or her share to a separate IRA that the spouse elects to treat as his or her own. To achieve this longer tax deferral for the children, the surviving spouse must make the transfer and ownership election before September 30 of the year following the decedent’s death. (Ltr. Ruls. 200449042 and 200449041.) See Chapter 8 of the treatise for an explanation of minimum distribution requirements and Chapter 5 for spousal ownership elections.

QDRO Distributions Taxed to Spouse Regardless of Community Property Laws. A distribution from a retiree’s qualified retirement plan to the retiree’s spouse or former spouse under a court’s “qualified domestic relations order” (a QDRO) is generally taxable to the spouse. The Tax Court has held that community property laws of a state do not change this result – i.e., do not make the distribution taxable to the retiree to the extent the spouse received it under the QDRO. Seidel v. Commissioner, T.C. Memo 2005-67 (2005). See Chapter 2 of the treatise for a discussion of QDROS under qualified retirement plans.

Indirect Plan Distributions for a Spouse Not Taxable to the Spouse. A taxpayer’s spouse or former spouse is not required to pay tax on an amount paid to him or her pursuant to a court’s domestic relations order requiring the taxpayer to withdraw funds from a qualified retirement plan and pay the funds over to him or her. Rather, the plan distribution is taxable to the withdrawing taxpayer since such an indirect payment to a spouse cannot qualify as a payment under a “qualified domestic relations order” (a QDRO). Amarasinghe v. Commissioner, T.C. Memo 2007- 333 (2007). See Chapter 2 of the treatise for a discussion of QDROS under qualified retirement plans.

Optional Spousal Annuity in Lieu of Required Joint and Survivor Spousal Annuity. – Many if not most qualified retirement plans are required to provide a retiree with an annuity payable for the retiree’s lifetime and, after the retiree’s death, to his or her spouse for the spouse’s lifetime (a “J&S annuity”). The amount of the annuity payment to the surviving spouse must be in the range of 50 percent to 100 percent of the amount of the payments to the retiree during his or her lifetime. The exact percentage is determined by the terms of the plan.

In the past, a retiree could generally waive the J&S annuity during the 90-day period ending on the annuity starting date and instead choose another payment option. After 2006, the Pension Protection Act allows 180 days for the waiver. Nevertheless, as in the past, the waiver is generally not effective without the consent of the retiree’s spouse.

After 2007, qualified plans must generally offer an optional survivor’s annuity as an alternative to a J&S annuity. As with the J&S annuity, the optional annuity is payable for the retiree’s lifetime and, after the retiree’s death, to his or her spouse for the spouse’s lifetime. However, the amounts of the annuity payments are different for the optional annuity.

If the J&S annuity provides the surviving spouse with annuity payments that are less than 75 percent of the payments to the retiree, the optional annuity must provide for payments to the surviving spouse equal to 75 percent of the payments to the retiree. If the J&S annuity provides the surviving spouse with payments that are 75 percent or more of the payments to the retiree, the optional annuity must provide for payments to the surviving spouse equal to 50 percent of the payments to the retiree.

Under either the J&S annuity or the optional annuity, the present value (discounted value) of the expected future annuity payments to the retiree and surviving spouse must equal the present value of a lifetime annuity otherwise payable to the retiree alone. The idea is that it should cost approximately the same amount to purchase any of these annuities from a commercial issuer of annuities. Thus, an increase in the surviving spouse’s payments under the optional annuity will necessarily reduce the amount of the payments to the retiree during his or her lifetime, and conversely, a decrease in the surviving spouse’s payments will increase the retiree’s payments.

See Chapter 2 of the treatise for a more complete discussion of spousal annuity requirements. (Pension Protection Act of 2006, Pub. L. No. 109-280, § 1004(a), (c); I.R.C. § 417(a), (g).)

Rollovers by Nonspouse Beneficiaries from Decedents’ Retirement Plans to IRAs. – The tax law has long allowed surviving spouses to roll over certain distributions tax-free from their deceased spouses’ retirement plans to their own IRAs. Such rollovers may allow surviving spouses to utilize methods of distribution not available for distributions from retirement plans.

Similarly, after 2006, a “designated beneficiary” who is not the decedent’s spouse may authorize a tax-free trustee-to-trustee rollover from the decedent’s consenting “eligible retirement plan” to a newly established IRA. For this purpose, a designated beneficiary (1) is generally an individual specifically designated as a beneficiary by the governing instrument of the plan and (2) under certain circumstances may include a beneficiary trust. Eligible retirement plans are qualified retirement plans, section 403(b) tax-sheltered annuities (TSAs), or eligible state and local government plans – provided their terms allow such rollovers.

The nonspouse beneficiary continues as a beneficiary (and not the owner) of the recipient IRA. Thus, the tax law treats the IRA as an inherited IRA (that the beneficiary must establish in the name of the decedent). However, for a decedent dying after 2005, a nonspouse beneficiary may be able to use the rollover to lengthen the required minimum distribution period, and thus extend the tax deferral period for plan funds. More specifically, the beneficiary may be able to lengthen the distribution period from a five-year period under the plan to an IRA period extending over the beneficiary’s life expectancy. To qualify, the plan must make its first annual minimum distribution, and also consummate the rollover, before the end of the first full calendar year following the decedent’s death

See Chapters 2, 4, 5, and 8 of the treatise for more complete discussions of the taxation of IRA and retirement plan distributions and the applicable required minimum distribution rules. (Pension Protection Act of 2006, Pub. L. No. 109-280, § 829(a), (b); I.R.C. §§ 402(c)(11), 403(a)(4) (b), 403(b)(8)(b), 457(e)(16))(B); Notice 2007-7, 2007-1 C.B. 395.)

No Implied Election to Avoid Penalty for Failure to Make Required Distributions. – If a retiree dies before his or her required beginning date, a plan or IRA that does not require use of the five- year distribution rule must make minimum distributions to a designated beneficiary over the his or her life expectancy, unless the beneficiary elects the five-year rule. If  the beneficiary does not explicitly elect the five-year rule, the life expectancy rule will apply even if the plan or IRA fails to make timely distributions. However, the beneficiary must pay a 50 percent penalty tax on required distributions not timely made. (Ltr. Rul. 200811028.)

Spouse or Former Spouse Taxed on QDRO Benefits. – A retiree is not liable for income tax or gift tax on benefits paid to his or her spouse or former spouse under a QDRO. Rather the spouse will pay income tax on the benefits. Neither the terms of a QDRO nor state community property laws can change this result. However, distributions actually received by a retiree are taxable to the retiree even if a court order requires the retiree to pay the distributed amounts over to his or her spouse. (Mitchell v. Commissioner, 131 T.C. No. 15 (2008); Seidel v. Commissioner, T.C. Memo 2005-67 (2005); Amarasinghe v. Commissioner. T.C. Memo 2007-333 (2007), aff’d, 282 Fed. Appx. 228 (4th Cir. 2008).) See Chapters 2 and 4 of the treatise for an explanation of QDROs.

» Spouses and Other Beneficiaries: Part 2