Large IRAs and Portability Under the 2010 Tax Act

Owners of large IRAs prior to the 2010 Tax Act generally had to decide between the income tax benefits of leaving the IRA to his or her spouse and the potential estate tax benefits of leaving some or all of the IRA to a credit shelter trust or a trust for children or grandchildren. Now, portability may allow owners of large IRAs to name the spouse as the beneficiary of the IRA while still preserving the owner’s unused estate tax exempt amount to be transferred to the surviving spouse.

Rules for IRAs with the Surviving Spouse as Beneficiary

When an inpidual 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 inpidual 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.

As we know, portability is only in effect for 2011 and 2012. In the event that portability is not extended or made permanent, the other methods to preserve the first spouse’s exemption will have to be revisited. For the next two years, however, IRA owners without sufficient non retirement assets to fully utilize their estate tax exempt amounts should consider whether it would be desirable to name the spouse as beneficiary in light of the availability of portability.