Most people leave their Individual Retirement Accounts (for simplicity, IRA's and other pension plans will be referred to as IRA's) to their spouse. But if your spouse is adequately provided for, you may want to leave some or all of your IRA money to your children or grandchildren. You get the greatest mileage from an IRA that you leave to your grandchildren, or other beneficiaries who are much younger than you. Benefits of leaving an lRA to a grandchild. . .

•The IRA will continue for a long period of time—50, 60, or even 70 years, depending on the grandchild's age and the payout method selected.

•IRA earnings will accumulate on a tax deferred basis for that period of time. This can add hundreds of thousands of dollars to an IRA.

•There's a substantial income-tax saving in leaving money to a low-bracket grandchild rather than to a spouse. A spouse could pay income tax on IRA payouts at the 31% rate or more. But once a grandchild attains age 14, income is taxed at his or her marginal tax rate, not the parents'. A child is in the 15% tax bracket for the first $22,750 of income in 1994.

•There's an estate-tax saving. The IRA assets and their growth over the years will not be included in your spouse's estate.

•The IRA assets avoid probate.

Caution: The most you can give to your grandchildren is $1 million (together with your spouse, this would total $2 million). After that, gifts to grandchildren are subject to the generation-skipping tax, which is a 55% tax on gifts that pass over a generation of heirs—usually the parents' generation.

Problem: Few professionals know how to keep an IRA alive for a person's grandchildren. Some consultants may advise nonspouse beneficiaries to take all the money and pay tax on it the year after the account holder dies.

Solution: Understand how IRA distribution rules work Do the paperwork now to keep the IRA alive long after you are gone.

Distribution Rules

IRA owners are required to begin taking money out of their account by April 1 of the year after they attain age 70 1/2. But the distribution rules for beneficiaries are different.

•If you die before attaining your required beginning date, which is April 1 after the calendar year in which you attain age 70 1/2, and you've named a grandchild as beneficiary, your grandchild has two options. . .

•Option 1: Take all the money in the account by the end of the year following the fifth anniversary of your death, or

•Option 2: Begin taking annual distributions based on his or her life expectancy in the year following your death.

Example: A grandchild who was 20 at this time would have a life expectancy of 61 years. To satisfy the minimum distribution rules for IRAs, he or she would have to take only 1/61, out of the IRA in the first year. If there was $200,000 in the IRA at the end of the year in which you died, the required distribution would be $3,278.69 (1/61, of $200,000). The IRA would continue for another 60 years.

To use the life expectancy method (option 2), your grandchild or his trustee will have to file a written election with the IRA institution by no later than December 31 of the year after the year you die, saying the IRA money is to be paid out over the grandchild's life expectancy, 61 years in the above example. Payments from the IRA must commence no later than December 31 of the year after you die.

If these requirements aren't met, your grandchild will default into option 1, and all the money in the IRA will have to be paid out to your grandchild five years after your death, resulting in a much higher tax liability.

•If you attain your required beginning date, the rules are different. You must begin taking money from the IRA by April 1 of the year following the year you attain 70 1/2. The amount you withdraw each year can be based on the joint life expectancy of you and your beneficiary.

If your beneficiary is your grandchild and he or she is more than 10 years younger than you, the withdrawals must be based on what is called the Minimum Distribution Incidental Benefit (MDIB) table that is found in IRS Publication 590, Individual Retirement Arrangements, in Appendix E. The table calculates the withdrawals as if your beneficiary were only 10 years younger than you. This is required by the tax law.

Example: You are 71 and your grandchild, your beneficiary, is 12 in the year you attain age 70 1/2. (If you are born in the first half of the year, you are 70 instead of 71.) Your joint life expectancy is 69.8 years. But the MDIB tables say you must use 25.3 years and take out 1/25.3 as your first withdrawal. Each year thereafter, the period is adjusted based upon the MDIB table.

Surprising: When you die, your beneficiary can pick up the original joint life expectancy—69.8 years in the above example minus the number of annual withdrawals that have been made to calculate future annual withdrawals. The MDIB tables have to be used only while you're alive.

Example: You die at 74 after taking out four annual payments. Your grandchild would be able to withdraw the remaining money over 65.8 years, starting the next year (your joint life expectancy of 69.8 years minus the four years you've taken money out).

Letter to your lRA custodian: To make this all perfectly clear, you should write a letter to your IRA custodian spelling out the distribution methods you're using. . .

"I hereby elect to take the money out of my IRA based on my life expectancy and my grandchild's life expectancy determined in the year I attained age 70 1/2. (69.8 years in the above example.) However, while I'm alive, the MDIB rule is operative and that table shall be used. Upon my death, payouts shall be based on the original joint life expectancy of me and my grandchild, reduced by all years that have passed since I was 70 1/2."

Trust Required

You'll need an irrevocable trust for the benefit of your beneficiary(s) to handle the money being paid from the IRA. You can name a beneficiary (if they are an adult) as trustee.

A trust may be a designated beneficiary if the trust meets all of the four following conditions:

1. The trust is valid under local law.

2. The trust is irrevocable.

3. The beneficiaries of the trust can be identified.

4. A copy of the trust agreement is provided to the IRA administrator, custodian, or trustee.

These four conditions must be met as of the later of the date on which the trust is named as beneficiary or the IRA owner has attained the age of 70 1/2.

If the trust does not meet these four conditions, the entire amount in the IRA must be distributed to the trust on the December 31 of the calendar year containing the fifth anniversary of the IRA owner's death. This would be a taxable event.

If the trust meets these four conditions, then the beneficiary of the trust are treated as the designated beneficiaries of the IRA and the life expectancies of the beneficiaries of the trust will be used to calculate the time over which the payments must be made.

The most difficult condition to meet is number 2. Number 2 specifies that the trust must be irrevocable. When a living trust is designated as the beneficiary, the trust becomes irrevocable as of the death of the trustor (creator of the trust). In other words, a living trust could be designated as beneficiary because the trust agreement becomes irrevocable upon the death of the IRA owner who is the trustor.

The trust, however, must be irrevocable when the IRA owner attains the age of 70 1/2 and using a living trust, if the IRA owner lives beyond the age of 70 1/2, the trust will fail to meet condition number 2. There is a way, however, to get around this problem by making the living trust irrevocable as of the date that the IRA owner attains the age of 70 1/2. Another alternative would be to use an additional trust for the IRA only. This trust can be designed to become irrevocable upon the first of either spouse attaining the age of 70 1/2 or after both spouses die if this is before age 70 1/2.

If an irrevocable trust is not used it is usually best that the surviving spouse be the designated primary beneficiary with the living trust designated as the secondary beneficiary. The trust should contain a provision that permits the Trustee (usually the surviving spouse) to disclaim or waive part or all of the proceeds of the IRA. By the proper use of the disclaimer at the death of the IRA owner, a decision then can be made to minimize the impact of both Federal Income Taxes and Federal Estate Taxes.

By designating the surviving spouse as the primary beneficiary of an IRA, the maximum flexibility is given to the surviving spouse for Federal Estate Tax purposes. The surviving spouse has two important options that are not available to any other beneficiary. By designating the surviving spouse as the primary beneficiary, this gives to the surviving spouse the option of withdrawing all of the funds from the IRA and rolling the proceeds into his or her own roll-over individual retirement account. This permits the surviving spouse to delay distributions until the April 1 following the calendar year in which the surviving spouse attains the age of 70 1/2. This gives to the surviving spouse the right to obtain maximum tax deferral. The TAXPAYER RELIEF ACT OF 1997 repeals (retroactive to 1/1/97) the tax law which previously imposed a 15% penalty on portions of certain large withdrawals ("excess distributions") and on the balance of "over-funded" ("excess accumulation") retirement accounts at death. By also repealing the excess accumulation provisions, Congress has eliminated an incentive to accelerate lifetime distributions.

By designating the trust to be the secondary beneficiary of the IRA for the benefit of the children or grandchildren allows them to maximize the use of the tax deferral advantage of an IRA. If the trust is the designated secondary beneficiary, distributions from the IRA's must be made over a period of time not to exceed the life expectancy of the beneficiaries. If the trust does not establish a separate trust share for each beneficiary, the distribution must be made over the life expectancy of the beneficiary with the shortest life expectancy.

If the surviving spouse lives beyond 70 1/2, distributions must commence after the April 1 following the calendar year in which the surviving spouse attains the age of 70 1/2. If the surviving spouse dies after he or she commences to receive payments from the IRA, payments must be made to the trust over a period of time not to exceed the period of time during which the surviving spouse would have received the benefits had he or she lived.

When the surviving spouse attains his or her required minimum distribution date, he or she must start to withdraw the funds over a period of time not to exceed his or her life expectancy or the combined life expectancy of him or her and his or her designated beneficiary.

There are two other problems that need to be dealt with:

Problem #1. Section 1340.10 of the Ohio Revised Code reads as follows:

"1340.10 Receipts from property subject to depletion as principal or income.

Except as provided in section 1340.08 and 1340.09 of the Revised Code, if the principal consists of property subject to depletion, including leaseholds, patents, copyrights, royalty rights, and rights to receive payments on a contract of deferred compensation, or a contract or plan for the benefit of one or

more employees of an employer, receipts from the property, not in excess of six percent per year of its inventory value, are income, and the balance is principal."

In other words, if the IRA was valued in the Federal taxable estate as being worth $700,000.00, $42,000.00 each year would be treated as income. ($700,000.00 x 6% = $42,000.00). There does exist a possibility that if the funds generated over a 6% return, the Internal Revenue Service might take the position that the trust does not qualify as an A-Trust, under an A-B Trust arrangement, (the A-Trust is for the surviving spouse, the B-Trust is for the deceased spouse) since all of the income is not being paid to the surviving spouse. This means that the remaining income that is imputed to the A-Trust by the IRS would be taxed at a very high rate; usually at 39.6%. In order to overcome this potential problem, the trust agreement should contain language to the effect that the surviving spouse will receive the greater of 6% of the principal value of the A-Trust or an amount equal to the income generated by the entire A-Trust.

Problem #2. Once the surviving spouse attains 70 1/2, the IRA must distribute to the trust and the trust must distribute to the surviving spouse sufficient payments to meet the minimum required distribution. Once more, this problem can be addressed by the proper drafting of the trust.

Can the B-Trust be a designated beneficiary of an IRA? Yes. Again, the IRA must make minimum distributions to the B-Trust once the surviving spouse attains 70 1/2. Again, just like the A-Trust, this income would be distributed to the surviving spouse in order to eliminate the higher taxes that the B-Trust would have to pay for any income accumulated in the B-Trust.

Why designate the living trust as a designated beneficiary? There are several reasons to do so. Usually the trust contains the master estate planning for the husband and wife. Usually, the living trust contains various provisions regarding the disposition of the property in the event that the beneficiary dies before distribution. The usual procedure is that the deceased beneficiary's share would be made to his or her children starting at the age of 25 and then sprinkled over a longer period, or if the deceased beneficiary had no children, that beneficiary's share is then divided among the other beneficiaries (usually brothers and sisters). However, If a minor child is the designated beneficiary of an IRA, that child is entitled to receive the money he or she attains the age 18. Most people do not believe that a child at age 18 is capable of handling significant amounts of money.

Everyone is entitled to pass $650,000 (as of 1997 the Federal Estate Tax Exemption was raised from $600,000 to $650,000 in 1999 and is scheduled to be gradually raised to $1,000,000 by the year 2006) free of Federal estate taxes. This is called the Unified Credit Exemption. In order to reduce the impact of Federal estate taxes, ordinarily an amount equal to the Unified Credit equivalent is allocated to the B-Trust. The surviving spouse has a life estate (that is income for life) in the B-Trust, but upon the death of the surviving spouse, all funds in the B-Trust (as well as the A-Trust) are then passed free of Federal estate taxes to the beneficiaries.

Frequently the assets held by the husband and wife are divided so that the deceased spouse does not have $650,000 (as of 1997 the Federal Estate Tax Exemption was raised from $600,000 to $650,000 in 1999 and is scheduled to be gradually raised to $1,000,000 by the year 2006) worth of assets to fund the B-Trust unless the assets in the IRA are used. This is one of the major reasons for designating the B-Trust as the beneficiary of an IRA; to use all of the deceased spouse's $650,000.00 exemption.

On the death of the surviving spouse, the trustee would open up a bank account in the name of the trust. If a grandchild is the beneficiary, the trustee would also open a custodial account for the grandchild at a bank or brokerage firm.

The trust would specify that money goes from the IRA to the trust, and then from the trust to the custodial account, until the grandchild attains the age of majority—18 or 21, depending on state law. After the grandchild turns 21, the IRA income from the IRA goes directly to him or her each year in the amount to be distributed under the MDIB. At the trustee's discretion, the money could be used to pay for the grandchild's expenses, such as for education.

There's no tax to the trust because the money is going right out—the trust is just a conduit. The money is taxed to the grandchild, but at the grandchild's tax rates.

One of the advantages of having a trust is that the assets will be protected from the child's creditors, should the child have an accident or become involved in other legal problems—such as bankruptcy, divorce, etc.

Note: The fact that the trust is irrevocable doesn't mean that you can't change beneficiaries if circumstances dictate a change. You can make beneficiary substitutions until you die. Changing beneficiaries after age 70 1/2 does not allow you to recalculate your IRA distributions more favorably. If the new beneficiary has a longer life expectancy, the distribution method calculated at age 70 1/2 is continued. If the new beneficiary has a shorter life expectancy, the distributions are recalculated using the shorter life expectancy (which could result in faster distributions and therefore more income taxes being paid). To change beneficiaries, you would simply set aside the existing irrevocable trust for your IRAs (previously set up) and set up a new irrevocable trust for your IRAs with the desired beneficiaries.

Best: A separate trust for each grandchild to whom you leave IRA money.

Practical use: This could be a good way to develop a college fund for a grandchild at low tax cost.