When an individual with an IRA dies, leaving the surviving spouse as the beneficiary, the survivor has three options, all of which could have positive income tax results:
1. Roll the IRA into his or her own IRA, which allows the survivor to wait until he or she reaches the age of 70 ½ before having to take minimum distributions.
2. Keep the IRA as an “inherited IRA,” which allows the survivor to wait until the deceased spouse would have reached 70 ½ before taking distributions.
3. Convert the IRA to a Roth IRA, which has no required distributions during the lifetime of the survivor.
The problem with these options is that, if the survivor is the named beneficiary of the IRA, and the deceased spouse does not have sufficient assets to maximize his or her estate tax exemption, the exemption of the first spouse to die could be wasted.
Maximizing the exemption before the 2010 Tax Act
In order to avoid wasting the exemption, many couples were either naming another individual as a beneficiary of their IRAs, or they were leaving all or a portion of their IRAs to a credit-shelter trust in order to preserve the exemption of the first spouse to die.
A number of disadvantages and complexities arise when leaving an IRA to a trust, such as:
1. If you are only leaving a portion of the IRA to a trust, preparing a formula beneficiary designation is complicated and may not be accepted by the IRA custodian.
2. The IRA benefits will have to be paid over the life expectancy of the oldest beneficiary of the trust, which is usually the spouse. If the payments are distributed to the spouse, they will be included in the spouse’s estate. If they are distributed to other beneficiaries, the spouse will not benefit from the IRA. If they are accumulated, the compressed income tax rates applicable to trusts will apply.
Another option would be to name the family trust as the primary beneficiary, allowing the survivor to disclaim the proceeds to a disclaimer trust at the first spouse’s death. However, the spouse would have to decide whether to give up the potential estate tax benefits of fully funding the credit shelter trust and disclaiming the IRA and giving up the income tax benefits of the spousal rollover. Additionally, the spouse would not be able to have any power of appointment over the disclaimer trust.
After the 2010 Tax Act
Now, with the 2010 Tax Act allowing for a $5 million exemption per person, the unused portion of which can be transferred to the surviving spouse, the problems set forth above may be largely solved. The IRA owner can name the spouse as the beneficiary, with all the income tax benefits which come with that option. Any amount of unused estate tax exemption will be transferred to the survivor to use upon his or her own death. Not only will this preserve the estate tax benefits which were only previously preserved by the methods outlined above, but the planning will also be simplified for owners of large IRAs who do not have sufficient other assets to fully fund a credit shelter trust.