The following case study suggests a likely retirement and estate plan to optimize assets for a professional couple with substantial balances in their retirement accounts. While it does not provide all the background reasoning behind every choice and suggestion, it does outline the decision-making process and offers realistic solutions with real benefits.

The information in the case study is ideally supported by reading the article "Retirement Planning for IRA Owners and 401(k) Participants".

Case Study

Edward J. Engineer ("Eddie"), age 68, is a retired engineer who worked for Westinghouse Corporation for 35 years. Eddie is married to Emily, age 65. Eddie and Emily live in a modest house located in Pittsburgh, PA. Though Eddie made a reasonable salary at Westinghouse, it was difficult to save money. Taking care of the mortgage and maintenance on the house, buying groceries, and raising their children took most of his paycheck. They also paid for their children's college education. On the other hand, Eddie did make regular contributions to his retirement plan, and also to an IRA.  Now, the kids are educated and out of the house and recently money worries have eased up. Over the last five years, Eddie's 401(k) plan and IRA have mushroomed to $1 million. Despite having $1 million in retirement assets, Eddie and Emily still live modestly. Eddie drives a 10-year-old car that he does not plan on replacing soon. Emily still clips coupons. Now Eddie and Emily are facing enormous taxes on their retirement assets both during their lifetimes and at their deaths.

Eddie and Emily have wills, but Eddie was never really comfortable with the planning for his 401(k) and IRA. For instance, he remembers signing the beneficiary designations for his retirement plans in a pro-forma way-wife then kids-and now with the bulk of his assets in the retirement plans he wonders if that was the best solution. Their biggest concern is to provide for their mutual financial security. Providing an inheritance for the children is a secondary issue, but they would certainly prefer to see their kids inherit money than have it go to pay taxes.

Eddie had been receiving Jim Lange's retirement and estate planning e-mail newsletters. He took advantage of Jim's web site offer to purchase a videotape of his highly acclaimed seminar, Maximizing IRA and Retirement Plan Assets. He had also read some of the articles that Jim had available on his web site. Eddie was confident that his financial picture was not so bleak.  With appropriate retirement and estate planning, individuals who have significant assets in IRAs and/or retirement plans can protect themselves and their families from excessive taxes and secure a better future.

Eddie decided it was time to schedule a consultation with Jim Lange. In preparation for the meeting, Eddie and Emily filled out a form outlining their assets. Eddie also brought along a copy of their 1998 tax return. Emily was a little reluctant but she accompanied Eddie to the consultation where they explained their financial picture and important goals. The Engineers have an approximate net worth of $1.5 million, including life insurance. A detailed list of the Engineers' assets is included at the end of the newsletter. 

At the end of their consultation, Eddie and Emily had a clear understanding of Jim's recommendations for managing their retirement assets, and they felt that Jim understood their objectives and values. They liked the fact that Jim did not sell any investments, life insurance or other financial products. The Engineers engaged Jim to help them formulate, personalize and execute the best possible retirement and estate plan. What follows is a summary of Eddie and Emily's retirement and estate plan.

Eddie and Emily's Retirement Issues

• Eddie is rapidly approaching age 70 ½-the age at which he must begin taking his required minimum distributions from his IRA and his 401(k) plan. Soon he will have to choose among the methods for calculating the amount of his required minimum distribution.
  
• Eddie and Emily must determine the beneficiary designation for Eddie's large 401(k) plan and IRA, and Emily's small IRA.
  
• Eddie and Emily need to weigh the pros and cons of a Roth IRA conversion. If they choose to convert their IRAs into Roth IRAs, what is the optimal amount to convert?  When should the conversion take place?  Which assets should they use to pay the taxes on the conversion?
  
• Should they be considering additional strategies for reducing estate taxes?

Calculating the Minimum Distribution

Before seeing Jim, Eddie was unaware he had a critical decision to make, before he turns 70 and ½, about how his minimum distribution is calculated. This election will have significant consequences for the rest of his life, the rest of Emily's life and even the lives of his children. If Eddie does not explicitly state which formula he wishes to use for calculating his minimum distribution then Westinghouse will make the choice for him, which will be disadvantageous for Eddie and his family.

Assuming Eddie is going to name Emily his beneficiary, he has to evaluate four different methods for calculating his minimum distribution based on different methods for expressing his and Emily's life expectancy:

1. Term certain for himself and his wife.

2. Term certain for himself and recalculation for his wife.

3. Recalculation for himself and term certain for his wife.

4. Recalculation for himself and his wife.

Eddie's problem is that his Westinghouse 401(k) retirement plan does not allow a choice. The Westinghouse plan calculates the minimum distribution based on term certain for participants and their spouses. Jim demonstrated that using term certain for both lives would accelerate income taxes and result in a rapid erosion of the retirement plan assets. Eddie learned that Jim's difficulty with the Westinghouse retirement plan was typical of many retirement plans, i.e., restrictions that reduce the participant's options during retirement and after death. Though Eddie was reluctant to let go, he decided to roll his entire Westinghouse retirement plan into an IRA that he could direct. Jim did not direct Eddie's investment choices because that is not part of his expertise. Jim's concerns were the unfavorable distribution limitations with the Westinghouse plan.

After understanding the underlying reasoning Eddie followed Jim's advice to use the recalculation method for his life expectancy and to use term certain for Emily. This hybrid approach produces smaller minimum distributions than the term certain method for both Eddie and Emily. If Eddie predeceases Emily, Emily will be able to roll Eddie's retirement assets into her own IRA. If Eddie dies before Emily reaches age 70 and ½, Emily could then begin her own distribution schedule naming their children as beneficiaries, reducing the required distribution amounts even more. In the event that Emily predeceased Eddie, Eddie could continue using Emily's life expectancy because they selected the term certain method for calculating Emily's life expectancy.

Converting to a Roth IRA

From viewing Jim's video, Eddie thought the Roth IRA conversion seemed like a good idea, but he didn't know if the conversion would be good for him. Eddie liked the idea of tax-free growth. In addition, Eddie was concerned that, as he aged, the amounts of his required minimum distributions would exceed his needs.  If the minimum distributions, which are taxable for federal income tax purposes, provide him with more income than he needs, he will prematurely pay federal income tax. Eddie and Emily did not want to withdraw more money from his retirement plan than they needed for their spending purposes. Eddie also knew that by reducing his required minimum distribution, he would not only reduce his taxes on the IRA distributions, but he would also reduce the taxability of his social security income after the conversion. Eddie did not, however, like the idea of writing a check to Uncle Sam now. Eddie wanted expert advice on this tricky issue.

Jim proposed the idea of converting only a portion of Eddie's IRA into a Roth IRA. The primary goal of the conversion being to provide income tax free growth for Eddie and his heirs. The secondary goal is to reduce Eddie and Emily's minimum distribution both during their lives and after they are both gone. On the other hand, converting the entire IRA balance was out of the question because it would push them into a much higher income tax bracket, with a prohibitive amount of taxes. What was the optimal amount to convert and when should the conversion take place?

Fortunately, Jim's firm has created custom software to help with that exact question. Eddie requested that Jim prepare a quantitative analysis of the benefits of various levels of a Roth IRA conversion. The analysis would provide the best basis for Eddie and Emily's decision-making process. Initially Jim's computations proved to Eddie that he could reduce his minimum distributions and stay in the 15% income tax bracket by converting a partial amount, $28,000, of his IRA into a Roth IRA. Implementing this plan would provide an income-tax free source of growth for Eddie and Emily and eventually their children and potentially their grandchildren.

Converting a larger amount would subject Eddie to tax in the 28% bracket in the year that he converted to the Roth. It was a tough decision. However, after reviewing Jim's projections, Eddie and Emily understood that once his required minimum distributions started, they would be taxed at the 28% bracket anyway. Paying a 28% tax now on the seed (the tax on the conversion) to avoid a 28% tax in the future on the harvest (all the Roth IRA distributions for years to come) would significantly increase Eddie and Emily's wealth while reducing their taxes. With Jim's guidance, Eddie and Emily agreed that converting an amount that would keep them in the 28% bracket would not only increase their beneficiaries' wealth, but it would also significantly improve their financial picture.

Though Eddie still didn't like the idea of paying the income tax on the Roth IRA conversion, he converted an amount large enough to push his income to the top of the 28% bracket. The amounts of the conversions came to $88,000 for 2000 and $94,000 for the year 2001. Emily didn't like Jim's idea of taking out a home equity loan to pay the taxes on the conversion. Jim, Eddie and Emily agreed that the Engineers would use their unappreciated after-tax assets to pay the tax on the conversion.

Estate Planningı

Jim was quick to stress that the beneficiary designation of the IRA or 401(k) - not the will or the living trust - determines the disposition of these funds upon death. With the majority of their assets in Eddie's retirement accounts, focusing on the design of Eddie's retirement plan beneficiary designations was the single most important portion of Eddie and Ethel's estate plan.  

Though Jim helped Eddie and Emily revise their revocable living trusts, it was the sophisticated beneficiary designations for Eddie's retirement accounts that provided the most value to the Engineers. Jim took this opportunity to explain to Eddie and Emily the keystone of an estate planning technique that seemed tailor-made for their situation-"disclaimers" and "double disclaimers." When applied in conjunction with the creation of trusts and sophisticated beneficiary designations of retirement plans, the disclaimer technique provides clients with a very flexible estate plan.

ıA discussion of taxation at the state level is beyond the limited scope of this case study; thus, all references to taxes refer to taxes at the federal level.

Disclaimers and Double Disclaimers

Jim recommended structuring Eddie's retirement plan beneficiary designations so that a bypass trust or unified credit shelter trust will be designated as the contingent beneficiary of Eddie's retirement accounts, with Emily designated as the primary beneficiary. This structure provides Emily with the option of receiving the full amount of Eddie's retirement accounts via a spousal rollover, or she can voluntarily elect to disclaim part of his retirement assets into the bypass trust or unified credit shelter trust if, for tax purposes, it is advantageous to do so.

Jim likes to use the "double disclaimer" approach to estate planning for clients like Eddie and Emily-married couples who trust each other and "share the same children."  Under the double disclaimer approach, Eddie names Emily as the primary beneficiary and the bypass trust or unified credit shelter trust as the contingent beneficiary both for Eddie's IRAs and 401(k) plan, and all after-tax assets passing under the terms of Eddie's will and/or revocable trust. Jim feels the disclaimer technique is appropriate for couples like the Engineers because of its flexibility-Emily will be able to choose which assets, if any, will be used to fund the trust.

Conventional trusts fix the terms of the will and IRA beneficiary designations based on projections about who will die first, when they will die, the family's needs, and the amount of after-tax and IRA funds available to fund the unified credit shelter trust. The disclaimer approach allows the surviving spouse to evaluate all their lifestyle and financial issues at the time of the first death. The flexibility can be used to further the goals of protecting or overprotecting the surviving spouse, but it still saves estate taxes at the second death. Additionally, you don't have to update your retirement and estate plan with every fluctuation in the market or nearly as often as you would with more traditional planning. The whole point of the bypass trust is that the assets disclaimed into the trust after Eddie's death are not included in Emily's estate upon her death. As a result the children will save huge amounts in estate taxes.

The Trust is Familiar

Eddie and Emily recognized the concept of an unified credit shelter trust although they had heard it referred to by the following different terms: the credit exemption equivalent trust, the B trust, the family trust, the marital trust, the by-pass trust, and the residuary bypass trust. What they did not know was that the trust could be funded with both after-tax assets and pre-tax assets. Thus, in the event that Eddie predeceases Emily, Emily will be able to fund a bypass trust with Eddie's retirement plan assets but only if Eddie changes beneficiary designations on his retirement plans according to Jim's sophisticated advice. On Jim's recommendation Eddie decides to name his wife Emily as the primary beneficiary of his retirement plans and he creates a trust to be known as "The Eddie Engineer Family Plan Benefits Trust " (PBT) to be the contingent beneficiary of the IRA and 401(k).

Plan Benefits Trust

Jim and his associates often recommend naming the spouse as the primary beneficiary and the PBT as the contingent beneficiary of an IRA or other retirement plan whenever an individual's gross estate is comprised largely of IRA and/or qualified (or pre-tax) plan assets (such as Eddie's retirement accounts). In this situation, where retirement assets comprise the bulk of the estate, it is likely that that the after tax-assets controlled by the will or revocable living trust will be insufficient to fully fund a traditional trust, specified in a conventional will or living trust, up to the allowance of the federal estate tax exclusion amount. This will certainly be true for Eddie. Without the pre-tax assets to fund a trust up to the federal estate tax exclusion limit (currently at $675K) Eddie effectively gives up this tax-free exemption. Wasting Eddie's exemption will not have a direct effect on Emily since there will be no federal estate taxes levied at Eddie's death because of the unlimited marital deduction. Using Eddie's exemption to fund the PBT, however, provides huge tax advantages for the children upon Emily's death. Consider the following:

• If Eddie leaves everything to Emily without naming a trust as contingent beneficiary on his retirement assets, Emily will have approximately $1.5 million (including the proceeds of Eddie's life insurance) in her name upon Eddie's death.
  

• At Emily's death, since her total assets will exceed her once-in-a-lifetime exclusion amount, there will be estate taxes on the amount in Emily's estate that exceeds $675,000.
  

• Even assuming zero growth in the estate or assuming the growth would equal the increase in the unified credit shelter trust amount, the federal estate tax upon Emily's death would be over $350,000. With proper planning, most of the estate tax can be eliminated.

When set up with the appropriate beneficiary designations, i.e., with Emily as primary beneficiary and the Plan Benefits Trust (PBT) as the contingent beneficiary the plan:

• Provides Emily with the flexibility to determine after Eddie dies whether or not it is to her and/or her family's advantage to fully or partially fund the Plan Benefits Trust with the IRA or other qualified plan assets (i.e., the retirement funds).
  

• Allows Emily to fund the trust by using all or a portion of Eddie's $675,000 once-in-a-lifetime exclusion amount with Eddie's retirement assets. Unlike a revocable trust, the PBT will not be funded until Eddie dies. Please note that the PBT is a stand-alone trust and is not a trust created in Eddie's will or living trust.
  

• Gives Emily a full nine months to assess her financial needs and to make important decisions after Eddie dies. This is a significant and critical strategic advantage. She knows her actual financial situation upon Eddie's death and is able to plan appropriately for her existing circumstances. She will have the benefit of consulting with her children and Jim to help her make decisions as to whether or not, and how much to disclaim into the trust.

Since the $675,000 exclusion is a moving target, the trust is drafted by means of a formula, not a fixed amount. The formula is designed to take advantage of the expanding "applicable exclusion amount" for federal estate tax purposes. Emily is given the option of "disclaiming" up to $675,000 for 2000 (or the respective increased amount for future years up to a maximum of $1 million in 2006) into Eddie's PBT and/or the by-pass residuary trust in Eddie's will or revocable trust. 

Carve Outs

Eddie and Emily's main goal is to provide for themselves throughout their lives. However, the idea of providing for their children at the IRS's expense was very appealing. Emily especially liked the idea of a "carve out"-naming their children as the primary beneficiaries on a portion of Eddie's IRAs. Designating a "carve out" will also reduce Eddie's required minimum distributions during his life. Jim explained that Eddie could use a portion of his IRA to create a separate IRA account naming his children as the primary beneficiaries. For that account the minimum distribution calculation would be based upon the joint life expectancy of Eddie and the oldest child of the beneficiaries. However, by law, the oldest child is deemed to be no more than 10 years younger than Eddie despite their actual age difference. After Eddie's death, the IRA that named the children as primary beneficiaries will pass directly to the children, who will then be able to take minimum distributions based on the children's life expectancy. Therefore, the assets will continue to grow income tax deferred in the case of the regular IRA, and income tax free in the case of the Roth IRA for many years after Eddie's death.

In addition, both Eddie and Emily agreed that with $1 million of retirement assets in his own name, Eddie will not need the income from Emily's IRA if Emily dies first. Emily liked the idea of leaving some money to the grandchildren at her death. Jim recommended that she name a trust, for the benefit of all grandchildren alive at her death, as the beneficiary of her IRA. A carve out directly removes or carves out the retirement assets from the estate of the surviving spouse eliminating the necessity for a PBT. Eddie and Emily's goal in naming the grandchildren as the primary beneficiary of Emily's IRA is to provide for their education. However, they hope that other funds will be available to pay for the grandchildren's education leaving the IRA to grow tax-deferred for much of their grandchildren's lives.

What Happens if Emily Predeceases Eddie?

In the unlikely event that Emily predeceases Eddie, she will not have enough money in her own name to fully fund a unified credit shelter trust or PBT no matter what her will and/or revocable trust or IRA beneficiary designations say. Therefore, it became necessary to discuss transferring assets into Emily's name. The Engineers decided to transfer all assets that were readily transferable from joint names to Emily's name. In addition, Eddie and Emily decided to transfer their house to Emily's name, though it certainly would have been a reasonable choice not to make that transfer. The purpose of transferring assets to Emily's name is to provide some money to fund "The Emily Engineer Bypass Trust" defined in her will or living trust. Though Emily's assets will still be insufficient to fund the full $675,000 a partial funding is better than no funding at all. Jim drafted a disclaimer type will for Emily. It is Eddie's current plan that if Emily predeceases him, he would disclaim all her assets into her bypass trust or possibly even "carve them out" for the children. Eddie does not want to commit himself irrevocably to that strategy which is why a disclaimer will and/or revocable trust is such a powerful alternative.

Gifting

Jim explained in their meetings that making annual gifts to children and/or grandchildren is perhaps the best and simplest estate planning technique. Eddie and Ethel didn't feel comfortable with gifts of cash but they did consider making a gift of their existing life insurance policies to their children. Then, when the policies mature, the proceeds will be outside both of their taxable estates. This strategy is similar to creating an irrevocable life insurance trust, but without the expense and much less annual paperwork. Jim cautioned them to carefully weigh their goal of removing assets from their estate against the survivor's potential need for cash before making their decision. They decided to gift the insurance policies to the children. The children will own the policies and they will have to pay any remaining premiums. Eddie and Emily also have the option of making cash gifts to the children to pay for any future premiums. They decided that at least for the next year or two, they would only make gifts to their children for the life insurance premium and on an as-needed basis. Furthermore, with the income taxes due on the Roth IRA conversions, the funds needed to make cash gifts would be limited.

Estate Projections or "Running the Numbers"

Eddie asked Jim to provide him with spreadsheets showing the calculations of how their estate assets would change throughout their lifetime, and how much would be inherited by their children at Eddie's and Ethel's deaths-a service Jim's office refers to as "running the numbers." A concise summary of all the details on the Overview of Results page allowed them to see how their financial situation would be effected by each of the estate planning strategies Jim had suggested.

As an engineer, Eddie was impressed with the data included on the spreadsheets, which showed many details, including:

• Their income, including social security, retirement plan distributions, and investment income from both retirement and non-retirement sources,

• Their expenses, including their spending and gifting amounts for each year,

• Detailed income tax calculations for each year, and

• A pro-forma estate tax calculation on the balances at the end of each year.

Additionally they were able to see calculations that illustrated the difference between how much their heirs would inherit with and without the estate planning strategies they had decided upon. The table below outlines two scenarios. Assuming that Eddie dies in the year 2003 and that Emily survives to age 83, the results are as follows:

Amounts Inherited by the Children

Implementing Jim's estate plan would provide their children with an inheritance 34% greater than without his plan. Jim also pointed out that this figure really understates the value of their inheritance because the children would have over half a million dollars in a Roth IRA which could continue to provide additional value through its tax-free growth long after it had been inherited. In addition, though shown as an immediate offset in the above chart, the 28% tax on the traditional IRA funds would not be due and payable upon the second death.

The spreadsheet calculations and analyses that Jim prepared provided the Engineers with the statistical and mathematical reassurances that they had done the right thing. Jim's advice and the documents his staff drafted were well worth the cost of the engagement!

Conclusions

With Jim's expert guidance, Eddie and Emily designed a retirement and estate plan that optimized their assets for themselves and eventually their children. After the design of the plan was completed, Jim's staff prepared all the necessary paperwork to execute the plan. They drafted the wills, the trusts, the beneficiary designations of the IRAs and retirement plans, etc.  Jim's staff also ensured that the right papers were delivered to the right places so there would be no problems executing the plan.  The Engineers were relieved. Finally they had made the decisions they had been delaying for years. Jim and his staff provided them with an estate plan that made it possible to achieve their goals and minimize estate taxes.

Contact Information

Jim Lange, CPA, JD concentrates his practice in retirement and estate planning for individuals with significant IRAs and other retirement assets. Jim is the sole owner of a law firm and a CPA firm located in Pittsburgh on the corner of Murray and Phillips Avenues in Squirrel Hill, one block from Poli's restaurant. Jim has a staff of eleven employees. Jim has done more than 450 retirement and estate plans, many quite similar to Eddie's and Emily's. If you should have any questions, Jim can be reached at 412-521-2732.

We mailed this case study to over 100 estate planning attorneys and other estate planning professionals of the Upper Ohio Valley Estate Planning Council. In November 1999, forty-five members met to discuss the case study.  By the end of the evening no one had come up with a significant improvement on the suggested plan. 

The information contained in this case study is not intended as legal advice. Due to the personal nature of retirement and estate planning, the fictional estate plan discussed in this case may not be appropriate for another situation.

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