Estate planners are often frustrated when clients defer estate planning despite potentially adverse financial consequences for their family members. The reluctance to confront one’s own mortality and the deferral of timely and appropriate action can lead to unnecessary tax problems and other unintended consequences.
This is particularly true with regard to the one asset (other than a principal residence) that most middle- to upper-income taxpayers possess: tax-deferred retirement accounts such as traditional IRAs, 401(k)s and 403(b)s. With the exception of Roth IRAs, where income tax has already been paid, all other tax-qualified accounts have complicated distribution rules and potentially significant income tax issues that must be fully considered in any estate tax plan.
In general, the receipt of property by inheritance does not normally expose beneficiaries to income tax. Under recently adopted estate tax laws, wealth passing down to family members may not be subject to estate tax. In the case of retirement accounts, however, all such accounts (other than Roth IRAs) represent income that the government has not previously subjected to income tax. After a taxpayer’s death, the beneficiaries usually will owe income tax on the amounts withdrawn from the decedent’s retirement account. When dealing with retirement accounts, the primary goal for the tax professional is to allow the beneficiaries the opportunity to defer income tax.
Estate planning for retirement assets addresses many of the same issues that are taken into account generally: taking advantage of applicable estate tax exemptions, qualifying transfers to a surviving spouse for the marital deduction, minimizing GST taxable transfers and holding assets in trust for beneficiaries who, because of age or disability, should not receive outright distributions. But planning for retirement assets generally adds the additional goal of deferring income tax on benefits for as long as possible, consistent with other estate planning goals. Subject to the possible complications outlined below, it may be desirable to use a trust to hold retirement assets which otherwise would be distributed to a surviving spouse, children or others.
In light of the U.S. Supreme Court’s recent decision in Clark v. Rameker, 134 S.Ct. 2242 (2014), that an IRA inherited by a non-spouse beneficiary may not be shielded from creditors for federal bankruptcy purposes, the use of trusts to protect retirement funds from creditors has received increased focus.
Naming a trust as the recipient of the retirement asset may be deemed to be essential, depending upon the client’s circumstances. For example, if the intended beneficiary has special needs and must rely upon the continuation of government benefits, a special needs trust may be required. A trust may be necessary when the beneficiary is a second spouse and the client wants to restrict the spouse’s access to the trust principal. A parent may wish to use a trust if the beneficiary is a minor, is a spendthrift or has substance abuse problems. Finally, retirement account assets can be used to fund a credit shelter trust.
To achieve these objectives, the planner might consider a “conduit trust,” an “accumulation trust” or even a “modified accumulation trust.” Natalie B. Choate had an excellent summary of the IRS rules for these trusts in her handbook. To say the least, it should be evident that planning with retirement assets can be challenging.
What about the income tax consequences of naming the trust as a beneficiary? Until the passage of our new tax law in 2018, the need to avoid estate taxes may have trumped possible increased exposure to income tax that an irrevocable trust might present. But now, greater exposure to income tax and lessening of estate tax exposure may call for the reconsideration of what may best serve the interests of qualified plan assets beneficiary.
In any such planning exercise, the professional assisting the account holder (“taxpayer” or “participant”) in formulating the estate plan must take into account the Required Minimum Distribution (RMD) rules applicable to qualified plan assets. There is an opportunity to assist the client in fixing certain mistakes in beneficiary designations prior to September 30 of the year after the year in which death occurs. These rules are complex and must be fully incorporated into the estate’s tax plan:
- During the Taxpayer’s Lifetime. RMD rules specify how long a taxpayer (and after the taxpayer’s death, his/her beneficiary) may defer withdrawals from a retirement account. Code §401(a)(9). During life, the taxpayer must generally begin taking withdrawals by the April 1 of the year after the taxpayer reaches age 70 1/2. This date is referred to as the Required Beginning Date (RBD). An IRS table that takes into account the taxpayer’s life expectancy sets the RMD amount that the taxpayer must withdraw in each year after the RBD. Treas. Reg. §1.401(a)(9)-5.
- Distributions After Death if the Spouse is the Beneficiary. The most favorable income tax result can be obtained by naming the taxpayer’s spouse as the primary beneficiary. A surviving spouse is the only person who has the option of rolling over the retirement account into his or her own IRA. The simplest way to accomplish the rollover is to retitle the account into the surviving spouse’s name. By rolling over the account, the surviving spouse can defer withdrawals from the account until he or she turns 70 ½, unless the spouse is more than 10 years younger than the pre-deceasing spouse. All other beneficiaries must commence withdrawals in the year immediately following the taxpayer’s death. The spouse enjoys the added benefit of being able to name his or her own beneficiaries for the IRA, and those beneficiaries are permitted the use a life expectancy payout.
- Distributions After Death if a Non-spouse is the Beneficiary. If someone other than the spouse is the beneficiary, the beneficiary’s RMD depends on whether there is a “Designated Beneficiary” of the account, as that term is specifically defined in Treas. Reg. § 1401(a)(9)-5. Although individuals and certain qualified trusts can be Designated Beneficiaries, estates, charities and business entities are not Designated Beneficiaries. Treas. Reg. §1.401(a)(9)-4.
- If there is a Designated Beneficiary and the taxpayer dies before his/her RBD, then the beneficiary’s RMD is based on an IRS table that takes into account the beneficiary’s life expectancy.
- If there is a Designated Beneficiary and the taxpayer dies after his/her RBD, then the beneficiary’s RMD is based on an IRS table that takes into account the longer of the (1) beneficiary’s life expectancy or (2) taxpayer’s life expectancy.
- If there is no Designated Beneficiary and the taxpayer dies before his/her RBD, the beneficiary must withdraw all of the retirement account within five years of the taxpayer’s death. If there is no Designated Beneficiary and the taxpayer dies after his/her RBD, then the beneficiary’s RMD is based upon the deceased taxpayer’s life expectancy.
A trust may be the beneficiary of an IRA without causing a loss of most of the income deferral opportunities if certain requirements are met:
- The trust is irrevocable or, by its terms, becomes so at the death of the IRA owner;
- The trust is a valid trust under state law, or would be if it had corpus;
- The beneficiaries of the trust who have a right to the IRA benefits are identifiable by the terms of the trust by no later than one year after the IRA owner’s date of death; and
- A copy of the trust or certain required information is provided to the IRA administrator.
When a properly structured look-through trust is designated as beneficiary, IRS rules allow the plan benefits to be distributed in annual installments over the life of the primary trust beneficiary, or over the life expectancy of the eldest beneficiary if there are more than one. According to Treas. Reg. §1.401(a)(9)-4, a trust is a look-through trust if:
- The trust is a valid trust under state law, or would be but for the fact that there is no corpus;
- The trust is irrevocable or will be upon participant’s death;
- The beneficiaries are identifiable from the trust instrument;
- Trust documentation is sent to the plan administrator; and
- All trust beneficiaries are individuals.
If a trust does not meet look-through trust requirements, this will be treated as if there is no designated beneficiary, i.e., payout must be made under the five-year rule or a participant’s remaining life expectancy if the participant died after his or her RBD. Revocable living trusts and credit shelter trusts sometimes run afoul of these technical requirements.
A look-through trust may be structured as either a conduit trust or an accumulation trust. In a conduit trust, the trustee has no power to accumulate plan distributions inside the trust and is required to distribute to the trust beneficiary any distribution received from the retirement plan. For purposes of the RMD rules, naming a conduit trust is the same as having named the individual trust beneficiary outright.
While a conduit trust is relatively simple to design and will allow distributions to be spread over a beneficiary’s life expectancy, it may not fulfill the owner’s intention to allow for accumulation of income within the trust or to limit distributions. If instead a discretionary trust is intended, an accumulation trust may be used and, in designing the trust, successor beneficiaries or potential appointees under a testamentary power of appointment (POA) granted to the beneficiary must be carefully considered so as not to run afoul of rules requiring that all trust beneficiaries must be individuals, and all must be identifiable from the terms of the trust instrument. POAs in accumulation trusts cause all possible takers-in-default to be considered as beneficiaries.
There can be many competing interests for the client in designating one or more trusts as the beneficiary of a qualified plan or non-Roth IRA. The major goal, of course, is to enable the trustee to defer income taxes on the benefits to the maximum extent possible while coordinating the requirements of the client, the trustee, the plan administrator and the IRS.
Young is a partner with Scarinci Hollenbeck in Lyndhurst. He is chairman of the firm’s Employee Benefits & ERISA Group. Brunetti is of counsel at the firm and chairs its Tax, Trusts & Estates Group. Brunetti is also a professor of taxation and law at Fairleigh Dickinson University.