Written by P. Mark Accettura

Over the last two decades, IRAs, 401ks, simplified employee pensions (“SEPs”), and other account-based retirement plans have gained widespread acceptance and popularity. For the most part, they have come to replace traditional employer-provided monthly pension benefit plans. Such account balance plans can easily be transferred from employer to employer (or to an IRA), and are therefore better suited to our mobile workforce. The move to account based plans has also shifted the responsibility for retirement savings from the employer to the employee.

The result of the last twenty years of employee-based retirement savings is that IRAs, 401k and other retirement accounts constitute a significant portion of the net worth of most Americans. If neither you nor your late spouse is eligible for a pension benefit from a previous employer, you might find that, other than social security, your retirement accounts are the sole source of your retirement income. Therefore, how you manage, invest, and take distribution from your retirement accounts will be critical to your personal financial security.

At death, your late spouse’s retirement accounts pass to the named beneficiary on each account. Federal law requires that qualified pension and profit sharing plan participants (but not IRA, SEP, or 403b owners) name their surviving spouse as the primary beneficiary. A beneficiary other than the surviving spouse can be named in such plans only with the written consent of the spouse. Although IRAs, SEP plans, and 403(b) plans do not require that one’s spouse be named as primary beneficiary, it is nonetheless likely that your late spouse named you as beneficiary. As beneficiary, several options are available to you.

You may:

1. Take a distribution of the entire account and then roll it over into your own IRA.
2. Leave the money in your late spouse’s account and access the account as needed.
3. Take a lump sum distribution of the account and elect “10-year averaging”.
4. “Disclaim” the interest.

What is appropriate for you will depend on a number of factors including the size of your late spouse’s retirement accounts, your late spouse’s age at the time of his death, your age, and your need for income. The rules pertaining to retirement account distributions are extremely complex.

Although the discussion that follows is likely beyond the comprehension of most readers, it is too important to leave out of this book. You will need the advice of a competent tax attorney, financial advisor or CPA to assist you in the subject matter of this chapter. Please be patient, and learn what you can.

THE STRETCH PHILOSOPHY

Except in the case of Roth IRAs, distributions from retirement accounts are taxable to you as ordinary income. Generally, sound tax advice dictates that you accelerate your deductions and defer taxable income.

As you develop your financial plan (Chapter Five), you should blend taxable and non-taxable sources of income to allow you to live the lifestyle to which you became accustomed when your spouse was living, while at the same time minimizing income tax. If you have significant alternate sources of income, you may not need to take immediate distributions from your retirement accounts.

With a little planning, you can postpone retirement distributions until you are 70 ½ (see Required Minimum Distributions below). With artful planning, you can “stretch” retirement distributions over your life as well as your children’s lives. Of the four options described above, the best potential for postponing distributions can be achieved by electing Option 1 and rolling your late spouse’s retirement accounts over into your own IRA.

ROLLOVER

A “roll over” is a distribution of your spouse’s entire interest in the retirement account (IRA, etc.), that within sixty days is deposited into your own IRA. Rollovers are tax-free. Only a surviving spouse can roll over a deceased participant’s interest.

Once rolled, you become the owner of the rollover account and therefore are entitled to name a beneficiary of your own choosing. Of the options available, it is almost always best to roll your late spouse’s IRA, 401k, or company retirement plan into your own IRA. Rolling over allows you the greatest investment and distribution flexibility.

By rolling over, you are in complete control of the investment house, investment advisor, and investment mix of your new IRA. With your own IRA, you will have a greater ability to defer distributions both during your life, and to your beneficiaries after your death. The flexibility of your own IRA is in marked contrast to leaving your spouse’s account in his former employer’s retirement plan.

Such plans often offer limited investment options, minimal financial planning advice and restrictive distribution options. The only time you should not roll your spouse’s account over is if you are younger than age 59 ½ and need immediate access to the funds.

Retirement distributions may not be deferred indefinitely. You must begin taking annual “required minimum distributions” (“RMDs”) when you reach age 70 ½. You may take your first RMD by April 1st following the calendar year you attain the age of 70 ½ (the “required beginning date” or “RBD”). Future RMDs must be taken by December 31 of the year in question. Thus, if you wait to take your first distribution until the latest possible time (April 1 of the following year), you will be required to take a double distribution in the second year. To avoid a double RMD, it is advisable to take your first year RMD by December 31 of the year you reach age 70 ½ rather than waiting until April 1 of the following year.

Example: Mary attains 70 1/2 during 2001 and takes her first RMD March 31, 2002. Mary must take her 2002 RMD by December 31, 2002, resulting in a double RMD distribution in 2002.

RMDs are determined by dividing your retirement plan account balance (as of the previous December 31) by the Applicable Devisor from the Uniform Table below that corresponds to your age. If you have more than one IRA, 403(b), 401(k) or qualified plan, all such plans must be aggregated for purposes of meeting the RMD requirement. Required Minimum Distributions are just that, minimums. You may always take more than the minimum. Roth IRAs are exempt from the RMD rules.

Example: On December 31, 2001, Mary has $703,285 in her IRA. She is 73 years old. Her RMD for 2002 is $703,285 -=- 24.7 = $28,473.08

The Uniform Table

Distributions at death before required beginning date

If your spouse died before attaining age 70 ½, and you are named as his beneficiary, you may elect to either roll your spouse’s interest to your own IRA or leave the plan intact. If you choose the rollover option, your RMDs are based on your age. Thus, if your late spouse was older than you, rolling over his account will allow you to postpone RMDs until your 70-½ year rather than his. If you decide not to roll over, you must begin taking distributions in the year your late spouse would have attained age 70 ½.

RMDs must be taken under one of the following two methods:

1. Under the “5-year rule” (nothing required to be distributed in the first four years following death, but the entire account must be distributed by December 31st of the fifth year after death); or
2. Annual distributions over your life expectancy (which is faster than the Uniform Table which calculates minimum distributions on the basis of the joint lives of two individuals 10 years apart in age).

If you choose to roll over, you will begin taking RMDs based on the Uniform Table. At your death, your new beneficiaries (for example, your children) may take the balance of your interest over their life expectancies. By contrast, if you do not roll over, any benefits remaining in your late spouse’s account at your death must be paid to the contingent beneficiaries named by your late spouse over your remaining life expectancy (which is likely to be substantially shorter than that of your beneficiaries).

Example: Jim, age 68 and Mary, age 62, are married with two children. Jim has an IRA worth $1,000,000. Jim dies. Mary can:

1. Rollover the entire account into her name. If she rolls over, she does not have to start RMDs until she reaches the age of 70 ½ and she can use the Uniform Table. After her death, the children can take the remaining balance over each of their life expectancies, not Mary’s
2. Not rollover the account. If the account is not rolled over, Mary must take the RMD the year Jim would have turned 70 ½. She must either take the entire account within 5 years, or over her life expectancy. Her life expectancy is figured on a table with shorter lives then the Uniform Table, which uses joint lives. Any balance remaining after Mary’s death must be paid out to the children over Mary’s life expectancy, not the children’s.

Not rolling over might be advantageous if you are substantially younger than 59 ½ and need immediate access to your late spouse’s retirement accounts. If you roll over, and take distributions from your IRA before you are 59 ½, the distributions would be subject to a 10% excise tax, in addition to the regular income tax. If you leave your spouse’s account intact, withdrawals are considered to be paid on account of your spouse’s death, an exception to the pre-59 ½ premature distribution 10% excise tax.

For example, if you are 52-years-old at your spouse’s death and were to roll over your deceased spouse’s retirement plan, you could not take a distribution from the rollover IRA without a 10% penalty until you attained 59 ½ (a 7 ½ year wait).

By contrast, if you leave your spouse’s account intact, withdrawals may be taken without penalty (they would, however, be subject to income tax), since the distributions are on account of the death of the participant (an exception to the 10% penalty on pre-59 ½ distributions).

If you are not the designated beneficiary, your spouse’s entire account balance must be distributed to the named beneficiary in accordance with either the five-year rule described above, or over the life expectancy of the beneficiary. Under the life expectancy method, distributions must commence no later than the end of the calendar year following your spouse’s death.

If your spouse named multiple beneficiaries or a trust, life expectancy is determined based on the life expectancy of the oldest beneficiary or the oldest trust beneficiary. If a trust is named as beneficiary, it is extremely important that a copy of the trust (or a certification of trust that complies with IRS Regulations) be supplied to the Plan Administrator (IRA Custodian) prior to December 31 of the year following death.

Distribution on death after RMDs have begun

The rules for distributions after RMDs have begun (meaning that your spouse was at least 70 ½ at the time of his or her death) are very similar to those for pre-RMD death described above. First, you may roll your spouse’s interest over into your own IRA. Once rolled, RMDs are based on your age, not your late spouse’s.

Consequently, if you are younger than 70 ½, RMDs will cease until your required beginning date (except that you must take your spouse’s RMD for the year of his death). When RMDs do begin, you are eligible to use the Uniform Table. At your death, your beneficiaries will be able to take the balance of your account over their life expectancy.

If you do not roll over, distributions during your life and after your death must be based on your life expectancy (rather than the longer Uniform Table during life and your children’s life expectancy after your death).

Thus, the case for rolling over is even more compelling where death occurs after RMDs have begun. In addition to the extended deferral available to you and your children, you may be able to discontinue RMDs altogether after your spouse’s death if you are not yet 70 ½.

POST-DEATH PLANNING

Whether your spouse died before or after his required beginning date, the beneficiary of his retirement accounts is not officially determined until December 31 of the year following his death. This delay allows for significant post mortem distribution planning. In other wards, there is time to “clean up” a messy beneficiary designation.

For example, if your late spouse named multiple beneficiaries under his retirement account or named his trust as beneficiary, the age of the oldest named beneficiary (or trust beneficiary) must be used for purposes of calculating RMDs.

If one of the multiple beneficiaries is a charity, all beneficiaries must take their distribution in the year of death!

With proper post mortem planning, however, the share of an older beneficiary or a charity can be distributed before December 31 following death (i.e., the “clean up” deadline). In so doing, only the life expectancy of the oldest remaining beneficiaries is counted, lowering RMDs for the remaining beneificiaries.

Also, an older beneficiary (such as you) can “disclaim” (essentially give) his or her interest to younger beneficiaries (your children) during the clean-up period, eliminating the older beneficiary from the calculation.

Finally, separate accounts may be created for each beneficiary by the end of the year after death. With separate accounts, each beneficiary’s RMD is calculated separately based on the age of each such beneficiary.

If a trust is named as beneficiary, a copy of the trust (or a certification of trust that complies with IRS Regulations) must be supplied to the Plan Administrator (IRA Custodian) prior to December 31 of the year following death.

TEN YEAR AVERAGING

If your spouse was age 50 by January 1, 1986 you should calculate “10-year averaging” on a lump sum distribution or your spouse’s entire account. Although somewhat radical, this approach can sometimes produce surprising results. Note that 10 year averaging is available only for employer-sponsored retirement plans and not for IRA, SEP, or 403(b) distributions.

CONCLUSION AND COURSE OF ACTION

Your late spouse’s retirement accounts are likely an integral part of your financial security. You should control all aspects of such accounts including investment matters and the timing of distributions. The fact that the accumulations in these accounts are fully taxable for income tax purposes (and estate tax for that matter) dictates that you plan to defer distributions as long into the future as legally possible.

Unless you are substantially younger than 59 ½, you should roll your deceased spouse’s accounts into your own IRA. You should name your revocable trust as beneficiary of all retirement accounts, or create separate accounts for your beneficiaries. Spreading RMDs over children’s lifetimes not only provides maximum income tax deferral, but also provides financial safety for your children and perhaps your grandchildren.