Over the last two decades, IRAs, 401(k)s, 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 plan to employer plan (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, 401(k)s and other retirement accounts constitute a significant portion of the net worth of most Americans. If you are not 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, retirement accounts pass to the beneficiary named on the account.

Federal law requires that qualified pension and profit sharing plan participants (but not IRA, SEP, or 403(b) owners) name their surviving spouse as their 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 common practice for spouses to name each other as beneficiary of such accounts. As beneficiary, several options are available to the surviving spouse.

The survivor may:

1. Take a distribution of the entire account and then roll it over into his or her IRA.
2. Leave the money in the deceased spouse's account which the survivor may access as needed.
3. Take a lump sum distribution of the account and elect "10-year averaging".
4. "Disclaim" the interest.

What is appropriate will depend on a number of factors including the size of the deceased participant's retirement accounts, his or her age at the time of death, the survivor's age, and the survivor's need for income. The rules pertaining to retirement account distributions are extremely complex. Although the discussion that follows is difficult, it is of critical importance.

HISTORY

Contributions to retirement plans are typically deductible by the employer (or employee) when made. The growth of the contributions is tax deferred until distributed. Recipients of retirement plan distributions are taxed upon the receipt of the distribution at ordinary income tax rates.

The granting of a deduction at the time of the initial contribution, and the deferral of tax on the investment growth of plan assets until their ultimate distribution are in effect tax subsidies by the federal government. In exchange for this subsidy, the Internal Revenue Code requires that retirement plan assets be used during the participant's retirement years.

A participant's entire interest in the plan need not be distributed at age 70 1/2; it must only begin to be distributed at that age and continue annually over the participant's lifetime (or over the joint lifetimes of the participant and the participant's designated beneficiary) in what are called "required minimum distributions" or "RMDs."

CHOOSING A BENEFICIARY

Except in divorce, a participant cannot transfer ownership of his or her retirement plan interests during his or her lifetime, and the beneficiary designation is the mechanism for transferring ownership at death. Generally, it is advisable for the participant to name his or her spouse as the primary beneficiary of retirement benefits. Naming the surviving spouse as primary beneficiary provides the greatest flexibility and allows for the longest and least complex method of deferring income tax in the event of the premature death of the participant. Surviving spouses are given preferred treatment in that only a surviving spouse can "roll over" the deceased spouse's interest in a retirement plan. In other words, upon the death of the participant, the surviving spouse (assuming he or she is the named beneficiary) can take a distribution of the deceased spouse's interest in the plan and within sixty days of the distribution deposit the distribution in the surviving spouse's own IRA. Under this scenario, the surviving spouse can continue to defer income tax on the retirement monies until he or she attains age 70 1/2.

Certain limitations apply in naming a retirement plan beneficiary. Federal law requires that qualified plan participants name their surviving spouse as the primary beneficiary of their interest in the plan. A beneficiary other than the surviving spouse can be named only with the written consent of the spouse. This requirement does not apply to IRAs, SEP plans, 403(b) plans and certain profit sharing plans.

The participant's revocable living trust is the appropriate contingent beneficiary in the event that the participant's spouse (the primary beneficiary) fails to survive the participant. Retirement benefits paid to the revocable living trust will be distributed to the beneficiaries named in the trust. Thus, for example, benefits allocated to a deceased child would automatically be distributed to the children of the deceased child (i.e., grandchild) under the terms of the trust.

ADVANCED PLANNING CAVEAT:

A revocable trust should not be named contingent beneficiary where retirement accounts are substantial and there is a wide age difference among trust beneficiaries. The final regulations at Reg. Section 1.401(a)(9)-4, A-5(c) do not permit separate accounts to be established if a trust is the named beneficiary. In such cases, a customized beneficiary designation form should be used to create separate accounts for each trust beneficiary using each separate beneficiary's age to calculate that beneficiaries RMDs.

THE STRETCH PHILOSOPHY

For a variety of reasons, it may be very attractive to postpone retirement plan distributions as long as legally possible. First, as a matter of sound income tax planning, it makes sense to recognize taxable income later rather than sooner. Secondly, individuals with large retirement plan assets often have significant alternate sources of income and consequently do not depend on their retirement plans as their primary source of income in retirement. Amazingly, with a little advance planning, the income tax burden of retirement plan distributions can be postponed and spread over the lives of the participant's children and even grandchildren.

In addition to the tax savings, spreading retirement plan distributions over the lives of the participant's children or grandchildren can also provide the trust beneficiaries with a safety net of lifetime income. Affluent parents are often concerned that their children will lose their substantial inheritance through mismanagement, divorce or economic calamity. These same parents are often unwilling to hold their children's inheritance in trust beyond the age of 35 or 40 in the belief that holding assets in trust too long will discourage self-determination and self-reliance. Spreading retirement benefits over children's lifetimes, however, makes such good economic sense that their postponement can be explained to the children not on the basis of the parent's mistrust of their children but on the basis that both parent and children will be economically enriched by the delay.

ROLLOVER

A "roll over" is a distribution of a participant's entire interest in the retirement account (IRA, etc.) that is deposited into a new IRA within sixty days of distribution. Rollovers are tax-free. Only a surviving spouse can roll over a deceased participant's interest. Once rolled, the surviving spouse becomes the owner of the rollover account and therefore is entitled to name a beneficiary of his or her choosing. Of the options available, it is almost always best for a surviving spouse to roll a deceased spouse's IRA, 401(k), or company retirement plan into the survivor's own IRA. Rolling over allows the surviving spouse the greatest investment and distribution flexibility. By rolling over, the surviving spouse is in complete control of the investment house, investment advisor, and investment mix of the new IRA. With his or her own IRA, the survivor will also have a greater ability to defer distributions both during his or her life, and to the survivor's beneficiaries after the survivor's death. The flexibility of the survivor's own IRA is in marked contrast to the option of leaving the deceased spouse's account in his or her former employer's retirement plan. Such plans often offer limited investment options, minimal financial planning advice, and restrictive distribution options. The only time a survivor should not roll a deceased spouse's account into the survivor's IRA is if the survivor is younger than age 59 1/2 and is in immediate need of the funds.

REQUIRED MINIMUM DISTRIBUTIONS: RMD's

Retirement distributions may not be deferred indefinitely. You must begin taking annual "required minimum distributions" ("RMDs") when you reach age 70 1/2. You may take your first RMD by April 1 following the calendar year you attain the age of 70 1/2 (the "required beginning date" or "RED"). 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 1/2 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 Divisor 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

ROLLING OVER VERSUS NOT ROLLING OVER

Distributions at death before required beginning date.

If a married participant dies before attaining age 70 1/2, his or her surviving spouse may elect to either roll the deceased participant's interest to his or her own IRA or leave the plan intact. If the survivor chooses the rollover option, the survivor's RMDs are based on the survivor's age. Thus, if the deceased participant was older than the surviving spouse, rolling over the deceased participant's account will allow the survivor to postpone RMDs until the survivor's 70-1/2 year rather than decedent's.

If the survivor decides not to roll over, the survivor must begin taking distributions in the year the participant would have attained age 70 1/2. RMDs - where there has been no rollover and where death occurred before the RED - 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 the survivor's single 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 the survivor chooses to roll over, the survivor will begin taking RMDs based on the Uniform Table. At the survivor's death, the survivor's new beneficiaries (for example, the survivor's children) may take the balance of the survivor's interest over their life expectancies. By contrast, if the survivor does not roll over, any benefits remaining in the deceased participant's account at the survivor's death must be paid to the contingent beneficiaries named by deceased participant over the survivor's remaining life expectancy (which is likely to be substantially shorter than that of the survivor's 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 1/2 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 1/2. She must either take the entire account within 5 years, or over her single life expectancy. Her life expectancy is figured on a table with shorter lives than the Uniform Table, which uses joint lives. Any balance remaining after Mary's death must be paid out to the children over Mary's remaining life expectancy, not the children's.

Not rolling over might be advantageous if the survivor is substantially younger than 59 1/2 and needs immediate access to the deceased spouse's retirement accounts.

If the survivor rolls over, and takes distributions from the new IRA before the survivor is 59 1/2, the distributions would be subject to a 10% excise tax, in addition to the regular income tax. If the survivor leaves the deceased spouse's account intact, withdrawals are considered to be paid on account of the deceased spouse's death - one of the exceptions to the pre-59 1/2 premature distribution 10% excise tax.

For example, if the survivor is 52-years-old at spouse's death and elects to roll over the deceased spouse's retirement plan, the survivor could not take a distribution from the rollover IRA without a 10% penalty until the survivor attains age 59 1/2 (a 7 1/2 year wait). By contrast, if the survivor leaves the deceased 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 1/2 distributions).

If the surviving spouse is not the designated beneficiary, the deceased 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 the year of the participant's death. If the deceased participant 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 October 31 of the year following the year of death.

Distribution on death after RMDs have begun.

The rules for distributions after RMDs have begun (meaning that the deceased participant was at least 70 1/2 at the time of his or her death) are very similar to those for pre-RMD death described above. First, the surviving spouse may roll the deceased spouse's interest over into his or her own IRA. Once rolled, RMDs are based on the survivor's age, not the deceased spouse's. Consequently, if the survivor is younger than 70 1/2, RMDs will cease until the survivor's required beginning date (except that the survivor must take the deceased spouse's RMD for the year of his death). When RMDs do begin, the survivor is eligible to use the Uniform Table. At the survivor's death, the survivor's beneficiaries will be able to take the balance of surviving spouse's account over their life expectancy.

If the survivor does not roll over, distributions during the survivor's life and after the survivor's death must be based on the deceased spouse's life expectancy (rather than the longer Uniform Table during the survivor's life and the survivor's children's life expectancy after the survivor's 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 the survivor and the survivor's children, the survivor may be able to discontinue RMDs altogether after the spouse's death if the survivor is not yet 70 1/2.

POST-DEATH PLANNING

Whether the participant died before or after his required beginning date, the beneficiary of his retirement accounts is not officially determined until September 30th of the year following the year of his death. This delay allows for significant post mortem distribution planning. In effect, time is allowed to "clean up" a messy beneficiary designation. For example, if the participant 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 distributions in the year following the year of death!

With proper post mortem planning, however, the share of an older beneficiary or a charity can be distributed before September 30th 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 beneficiaries. Also, an older beneficiary can also "disclaim " (essentially give) his or her interest to younger beneficiaries 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 the year of 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 October 31 of the year following the year of death.

TEN YEAR AVERAGING

If the participant was age 50 by lanuary 1, 1986 the survivor should calculate "10-year averaging" on a lump sum distribution of the participant's entire account. Although somewhat radical, this approach can sometimes produce surprising results. Note that 10 year averaging is available only for employer-sponsored qualified retirement plans and not for IRA, SEP, or 403(b) distributions.

CONCLUSION AND COURSE OF ACTION

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 a surviving spouse is substantially younger than 59 1/2, he or she should roll the deceased spouse's accounts into the survivor's own IRA. The survivor should name his or her revocable trust as beneficiary of all retirement accounts, or create separate accounts for his or her beneficiaries (see the Advance Planning Caveat above). Spreading RMDs over children's lifetimes not only provides maximum income tax deferral, but also provides financial safety for children and perhaps grandchildren.

Obviously, the rules governing retirement plan distribution are incredibly complex. Competent legal and financial advisors employing software programs that illustrate the impact of various planning options should be consulted. Choosing a retirement plan beneficiary is an ominous undertaking. Given that such elections are irrevocable (after death), they cannot be made without a great deal of thought and the input of competent counsel.

Based on the foregoing, the following course of action should be taken by participants approaching retirement age:

1. Check current plan beneficiary designations to ensure that they comport with your wishes.
2. Check retirement plan documents to ensure that the distribution strategy chosen is permissible under the plan.
3. Consolidate and merge various plans of like kind (e.g. all IRAs) for simplicity and to ensure that none are overlooked causing the 50% penalty to be imposed.
4. Consider the financial needs of the surviving spouse to determine whether he or she should be named as primary beneficiary.
5. Participants who were age 50 by January 1, 1986 should calculate 10-year averaging on a lump sum distribution. Although somewhat radical, this approach can sometimes produce surprising results. Note that 10 year averaging is available only on employer-sponsored retirement plans and not IRA distributions.
6. Except where the Advanced Planning Caveat applies, name a revocable trust as the contingent beneficiary, or, if the participant's spouse is well provided for, as primary retirement plan beneficiary.
7. If a trust is named as beneficiary, the life expectancy of the oldest trust beneficiary is used in calculating RMDs.
8. Stretch out retirement plan distributions as long as legally possible to defer income tax as long as possible.
9. Convert company retirement plans to IRAs prior to age 70 1/2 since IRAs provide greater investment and payout flexibility and are a better vehicle for stretching plan distributions as long as possible. Employer plans shouldn't be converted to IRAs if 10 year averaging is desired;
10. Divide large IRAs into separate IRAs to accomplish varied objectives. For example: name second spouse as designated beneficiary on 1/2 and children from first marriage on the other 1/2.
11. Consider conversion to a Roth IRA and avoid the RMD rules entirely.

MICHIGAN INCOME TAX

Michigan has a flat income tax rate of 4.1% (2002). However, retirement plan distributions are given very favorable income tax treatment. Lump sum distributions are entirely exempt from Michigan income tax. The first $36,090 (2001) of annual retirement plan distributions for single taxpayers and $72,180 (2001) for married filers are tax exempt.