The CPA Journal

Estate Planning for Retirement Benefits

By Bruce D. Steiner, JD, LLM, Kleinberg, Kaplan, Wolff & Cohen P.C.

Estates consisting largely of retirement benefits are often difficult to plan because of the inherent tension between income tax planning and estate tax planning. Given the extremely complex rules governing qualified plans and IRA distributions, careful consideration should be given to the plan owner’s wishes in choosing plan beneficiaries as well as the structure of the estate plan.

The Spouse as Beneficiary

The simplest and most common approach is to name the taxpayer’s spouse as beneficiary, which allows the spouse to roll the benefits over into her own IRA, defer both the income and estate taxes, elect new beneficiaries, select a new payout method, and potentially convert to a Roth IRA.

Indeed, there are numerous private letter rulings in which someone other than the spouse was the beneficiary, and the interested parties attempted, sometimes successfully and sometimes unsuccessfully, to get the IRA to the spouse—through disclaimer, intestacy, elective share, community property, or an estate or trust—so that the spouse could do a rollover.

The QTIP Trust as Beneficiary

Take the example of Vincent, who wants his wife, Wendy, to receive the income from his IRA but does not want her to manage it or to control the ultimate disposition of the principal. Instead, he wants to preserve the principal for his children. As with his other assets, Vincent can leave his IRA benefits to a qualified terminable interest property (QTIP) trust.

The trustees of the QTIP trust will take distributions from the IRA based upon the usual IRA distribution rules, generally over Wendy’s life expectancy. However, if Vincent has reached his life expectancy and has been using the term certain formula for his life expectancy, then distributions would be made over Vincent and Wendy’s joint and survivor life expectancy. If Wendy is more than 10 years younger than Vincent, then the minimum distribution incidental benefit (MDIB) rules with respect to the children may apply. The QTIP strategy achieves some income tax deferral, although not as much as if Vincent left his IRA to Wendy and she rolled it over into her own IRA.

Wendy must be entitled to all of the income of the trust. If the internal income of the IRA exceeds the minimum required distribution (MRD), which is most likely to occur if she is young or the IRA is invested largely for income, Wendy may be able to roll the excess over into her own IRA (PLR 9649045; contra, PLR 9145041). Alternatively, if the trust permits, the trustees can retain the excess income in the IRA, unless Wendy demands that the trustees withdraw the income from the IRA and distribute it to her.

For fiduciary accounting purposes, the trustees must determine the amount of income to which Wendy is entitled. Ignoring any basis, all distributions from an IRA are treated as income for income tax purposes (IRC sections 72 and 408(d). For fiduciary accounting purposes, however, the trustees must distinguish between income and principal. In New Jersey and Florida, receipts from a qualified plan or IRA are principal except to the extent of interest or other income earned after death [N.J.S.A. section 3B:19A-10a(3) and F.S.A. section 738.04(2)(c)]. In some states, 10% of each required distribution is allocable to income, unless a larger allocation is necessary to obtain the marital deduction [Uniform Principal and Income Act (1997) sections 409(b) and (c)]. New York law is silent on this point [N.Y. EPTL section 11-2.1(c)(2)].

Regardless of state law, a taxpayer leaving IRA benefits to a QTIP trust may wish to include unitrust or similar provisions in the QTIP trust.

The Credit Shelter Trust as Beneficiary

What happens when there are not enough nonretirement assets to fully fund the credit shelter trust? As the credit shelter amount increases and more people convert to Roth IRAs, using their other assets to pay the income tax on the conversion, this situation will occur more frequently.

For example, suppose Amy has a $1 million IRA and $300,000 in cash. She and her spouse, Zachary, jointly own their residence, worth $400,000. Amy’s will contains typical marital and credit shelter provisions. She has the following choices:

She can leave to her credit shelter trust the portion of her IRA needed to fully fund it. Based upon a credit shelter amount of $675,000, and ignoring any other items, if the credit shelter trust receives $300,000 of cash, it will receive $375,000 of her IRA. Amy can then leave the remaining $625,000 of her IRA to Zachary.

This approach ensures that Amy will fully utilize her credit shelter amount. However, Zachary will not be able to roll over the benefits payable to the credit shelter trust; instead, these will be paid to the credit shelter trust over Zachary’s life expectancy (or over their joint and survivor life expectancy if Amy reached her RBD and elected the term certain method).

This approach is complicated, requiring the use of a marital/credit shelter formula in the beneficiary designation. Some plan administrators or IRA custodians or trustees may balk at a beneficiary designation containing such a formula.

Amy can put the marital/credit shelter formula in a trust under the will or in a separate trust agreement and name the trust as the beneficiary, making it easier to deal with the IRA custodian or trustee. However, this risks accelerating IRD upon the funding of a pecuniary marital or credit shelter bequest with retirement benefits [Treasury Regulations section 25.2518-2(e)(2)], and may jeopardize Zachary’s ability to roll over the portion of the benefits payable to him through the trust.

Amy can name Zachary as the primary beneficiary and a disclaimer trust as the contingent beneficiary. A disclaimer trust is almost identical to a credit shelter trust, except that it only comes into existence if the spouse disclaims assets to which he is entitled.

This approach simplifies the beneficiary designation. It also permits Zachary to wait until after Amy’s death to decide whether to disclaim, potentially either saving estate taxes or maximizing the income tax deferral. Zachary cannot, however, have a special power of appointment over the disclaimer trust (unless it is limited to an ascertainable standard, such as health, support, maintenance, and education). Similarly, Zachary cannot participate in discretionary distributions from the trust in his capacity as a trustee, again except as limited by an ascertainable standard [IRC section 691(a)(2); Kenan v. Comm’r, 114F.2d 217(2d Cir. 1940)].

The credit shelter trust provides considerable income tax flexibility. If the trust permits, the trustees can distribute the IRA benefits to the spouse, the children, or the grandchildren or the trustees can accumulate the benefits, taking into account the beneficiaries’ tax brackets and needs, as well as considering estate tax ramifications.

Children as Beneficiaries

By naming children (or trusts for their benefit) as beneficiaries, an IRA owner can obtain a longer stretch-out period than by naming a spouse. This strategy makes sense if the spouse is expected to die first or is already deceased.

It may be possible to attain the best of both worlds by naming the children as the primary beneficiaries and the spouse as the contingent beneficiary. In this way, the MRDs during lifetime will be smaller than if the spouse were the primary beneficiary. If the spouse survives, the children can disclaim, allowing the spouse to roll the benefits over into her own IRA. If the spouse does not survive, the children will be able to use their own life expectancies (or at least the oldest child’s life expectancy) after the plan owner’s death.

Grandchildren as beneficiaries. By naming grandchildren (or trusts for their benefit) as beneficiaries, the benefits can be stretched out over the grandchildren’s life expectancies (subject to the MDIB rules during the plan owner’s lifetime), providing tremendous income tax deferral, especially in the case of a Roth IRA.

GST considerations. Before naming grandchildren or trusts as beneficiaries, the plan owner should consider the effect of the generation-skipping transfer (GST) tax. If a child’s or grandchild’s trust would or might receive both retirement benefits and other assets, or both Roth IRA benefits and either other retirement benefits or other assets, then separate trusts should be established, one for each type of property (Roth IRA benefits, other retirement benefits, and nonretirement assets). In this way, the plan owner’s executors can allocate the GST exemption to particular types of property, particularly Roth IRA benefits.

Check the Terms of the Plan

An employee or IRA owner should check the terms of the plan or IRA to ensure that the desired choices of beneficiaries and payout methods are permitted. For example, some plans do not permit beneficiaries to stretch the benefits over their life expectancies, even if permitted by law. A possible solution to this problem, if permitted by the plan, is to withdraw the benefits and to roll them over into an IRA.

Some IRA trustees or custodians will not accept complicated beneficiary designations; others will not permit certain investments, even if the law permits them. The solution to both problems is to find a different IRA trustee as custodian.

Escaping from the recalculation method. Many IRA owners name their spouse as beneficiary and elect (or default into) the recalculation method. If, after a spouse dies, these individuals have not selected a designated beneficiary (DB), the entire benefit must be paid out by December 31 of the year following the death.

The simplest way to avoid this predicament and escape from the recalculation method is to convert to a Roth IRA. Even if the IRA owner was ineligible to convert to a Roth IRA while the spouse was alive, she may be eligible after the spouse’s death.

If it is not possible to convert to a Roth IRA, another solution is to name a charitable remainder trust (CRT) as the beneficiary. The tax-exempt CRT would receive all of the benefits upon the employee’s death without having to pay any federal income tax upon receipt. The CRT can provide for payments to the IRA owner’s children over their lifetimes, with the remainder going to charity. This effectively stretches the payments out over the children’s life expectancies, producing a result very similar to the result if the children had originally been named as the beneficiaries. If the children are childless, this may be an attractive option. The children can purchase life insurance to hedge against the possibility of premature death.

Payment and Apportionment of the Estate Tax

To the extent the retirement assets are used to pay estate taxes, the stretch-out is destroyed. Assuming it is possible to stretch out the benefits after death, it is essential to provide another source of funding, such as life insurance, for the estate tax. The tax apportionment clause in the will should be considered for this, since in many states, including New York (N.Y. EPTL section 2-1.8), New Jersey (N.J.S.A. section 3B:24-2), and Florida (F.S.A. section 723.817), unless the will provides otherwise, the beneficiaries of nonprobate assets such as retirement benefits must contribute their pro rata shares of the estate tax.

Editors:
Milton Miller, Consultant
William Bregman, CPA/PFS, CFP

Contributing Editor:
Theodore J. Sarenski, CPA
Dermody Burke & Brown P.C.

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PERSONAL FINANCIAL PLANNING