Coordinating retirement plans with wealth transfer planning can be
challenging. This is primarily because retirement accounts are driven by
income tax laws designed to encourage Americans to accumulate wealth
for retirement, not for transferring wealth upon death.
In this edition of The Wealth Counselor,
we will examine some of the critical rules in using IRAs and qualified
retirement plans for wealth transfer planning, common misperceptions in
this area, and why naming a trust as beneficiary may be the only way to
accomplish some of the client’s planning objectives. Completely covering
these subjects requires volumes, so we will cover only the basics.
This
topic is especially important now as the baby boomer generation begins
retiring. At the end of 2010, IRAs and qualified retirement plans held
nearly $17.5 trillion, accounting for 37% of all household financial
assets. And because of how lifetime minimum required distributions are
calculated, IRAs and qualified retirement plans may be the largest
assets held at death.
The Fundamentals
Distribution Calendar Year
A
distribution calendar year is a year in which the participant is
required to take a distribution from the plan. The first distribution
calendar year is the calendar year in which the participant reaches age
70 1/2 (for some employees under some qualified retirement plans, this
may be the year in which the participant retires)
Required Beginning Date (RBD)
A
special rule applies to the first distribution calendar year. The
required distribution for that year may be taken as late as April of the
following year, which is called the required beginning date (RBD).
Because all other required distributions must be made within their
assigned year, the distribution for the second distribution calendar
year must be made before December 31 of the year in which the RBD falls.
Minimum Required Distribution (MRD)
In
each distribution calendar year, the participant is required to take at
least a prescribed distribution, called the minimum required
distribution (MRD). The MRD for each distribution calendar year is
determined by dividing the prior year-end account balance by a life
expectancy factor for the participant that is supplied by the IRS. If
the participant’s sole beneficiary is his or her spouse who is more than
10 years younger than the participant, the MRD is calculated using the
Joint and Last Survivor Table. Otherwise, the Uniform Lifetime Table,
which assumes a joint life expectancy with someone presumed to be ten
years younger, is used. Under the Uniform Lifetime Table, a participant
who only takes the MRD each year cannot outlive his or her retirement
benefits.
Planning Tip: Taking
only the MRD also means that the account will probably grow for years
past the RBD. For example, if an IRA is growing at a rate of 5.5%, at
age 100, the participant will still have about 60% of the original
account balance is still in the account. Planning for the beneficiaries,
therefore, is very important.
Minimum Required Distribution for the Year of Death
If
the participant has not yet taken the entire MRD for the year in which
he/she dies, the beneficiary must withdraw the remaining amount of the
participant’s MRD by before the end of that year. If there are multiple
beneficiaries, the MRD rules are satisfied as long as the beneficiaries,
in the aggregate, take the balance of the year-of-death MRD and it does
not have to be pro rata.
Minimum Required Distributions after Death
After
the participant’s death, MRDs apply to the beneficiary and normally
begin the year after the year of the participant’s death. The
after-death MRD rules are more complicated than the lifetime MRD rules,
and are based on three factors:
(1) Whether death occurs before or after the participant’s RBD for that IRA or qualified retirement plan;
(2) Who, or what, is the beneficiary; and
(3) For qualified retirement plans, what the plan allows.
Note: The rules are different if the spouse is the sole beneficiary; that will be covered later.
Planning Tip:
If your client is a participant in a qualified retirement plan, make
sure you review and understand what the plan will allow as a part of any
planning, because, in many cases, plan rules trump the general rules.
Who is the Participant’s Beneficiary? Is There a “Designated Beneficiary” (DB)?
Beneficiary
means those who are entitled to the plan benefits upon the
participant’s death. Retirement benefits generally pass as non-probate
property, by contract, to the beneficiary named in the participant’s
beneficiary designation form or, if there are none, as specified in the
plan. The provisions in the participant’s will or revocable living trust
are irrelevant as to who receives the benefits, unless the plan or the
participant’s beneficiary designation provides otherwise.
“Designated
beneficiary” does not mean the beneficiary designated by the
participant. It is a legal term and understanding its meaning is crucial
to planning and for compliance with post-death MRDs.
There is a
Designated Beneficiary for an account if, on September 30 of the year
following the year of the participant’s death, there is no beneficiary
that has to be considered in making the analysis that is not a human
being or a qualified “look-through” trust and the plan administrator or
custodian can know, with certainty, the oldest person who has to be
considered in making the analysis.
Planning Tip: During
this period of at least nine months, clean-up strategies can be used.
These include removing non-qualified beneficiaries and division into
separate shares (discussed below).
Planning Tip: Most
IRAs and qualified retirement plans have printed beneficiary
designation forms they expect the participant to use. Most, but not all,
will accept attachments. Some will accept a separate instrument. Due to
the limited space on most forms, it will probably be necessary to add
an attachment. When drafting beneficiary designations, make sure the
plan permits what you are trying to accomplish.
Keys to Achieving “Designated Beneficiary” Status:
Only an individual or a qualified “look through” trust can be a
Designated Beneficiary. Estates, partnerships, corporations, LLCs, other
trusts, and charities do not qualify. If there are multiple
beneficiaries, all must be individuals and the oldest must be
identifiable.
Determining the MRD for the Beneficiary after the Participant Dies
When
determining the MRD for years after the participant’s death, the
critical questions are: (1) Is there a Designated Beneficiary; (2) Did
the participant die before or after the Required Beginning Date? and (3) What does the plan provide?
If
there is a Designated Beneficiary, regardless of when the participant
dies, each beneficiary may use the Designated Beneficiary’s age factor
as shown in the Single Life Table to determine his or her MRD
unless the plan requires more rapid distribution. Using the Designated
Beneficiary’s age is commonly known as a “stretch-out,” and, in most
cases, maximum stretch-out results in significantly more wealth passing
to the beneficiary.
Using the Life Expectancy Rule, the
beneficiary calculates the MRD for the first year by dividing the
account balance by the Designated Beneficiary’s life expectancy. Each
subsequent year, calculate the MRD by dividing the remaining account
balance by the prior year’s divisor minus “1.” Thus, using this method, a
beneficiary will withdraw all of the retirement benefits by the life
expectancy of the Designated Beneficiary, even if taking only the MRD
each year.
Death before Required Beginning Date
If
the participant died before his or her RBD and there is no Designated
Beneficiary, distributions must comply with the Five-Year Rule unless
the plan requires more rapid distribution. Under the Five-Year Rule,
the entire plan balance must be distributed by December 31 of the year
containing the fifth anniversary of the participant’s death. Annual
distributions are not required. If there is a Designated Beneficiary,
use of the Five-Year Rule is optional unless the plan provides
otherwise.
Planning Tip: The Five-Year Rule only applies if the participant dies before his or her RBD.
Death after Required Beginning Date
If
the participant died after his or her RBD, unless the plan requires
more rapid distributions, the beneficiary’s MRD is determined using the
Single Life Table factor for the longer of the life expectancy of a
person the same age as the participant and the life expectancy of the
Designated Beneficiary, if any.
Planning Tip: Because
a Roth plan has no RBD, the Five-Year Rule applies to Roth plans with
no Designated Beneficiary, even if the participant has reached his or
her RBD for other IRAs or qualified retirement plans. Also,
distributions from a Roth plan cannot satisfy MRD requirements for
non-Roth plans.
Multiple Beneficiaries
If
there are multiple beneficiaries, there is no Designated Beneficiary
unless all of the beneficiaries are individuals. If all of the
beneficiaries are individuals, the Designated Beneficiary is the oldest
beneficiary and it is his or her life expectancy that sets all MRDs.
There are, however, two “escape hatches:”
(1) The ability to remove a beneficiary through disclaimer or distribution of that beneficiary’s share. This must be done by September 30 of the year following the year of death.
Example:
If the beneficiary designation is to a trust that distributes a
specified sum to a charity and splits the balance between Child 1 and
Child 2, you can make the distribution to charity prior to the critical
date. That would leave you with the two individuals, Child 1 and Child
2, and the older of the two would be the Designated Beneficiary.
Example:
If the beneficiary designation is to a trust that distributes one-third
to the participant’s mother and one third each to Child 1 and Child 2,
if the beneficiary’s mother disclaims her interest prior to the critical
date, the beneficiaries would be Child 1 and Child 2 and the older of
the two would be the Designated Beneficiary.
(2) The separate accounts rule:
If the participant’s benefits under a plan are divided into separate
accounts with different beneficiaries, the post-death MRD rules apply
separately to each account. This allows multiple beneficiaries to each
use their own life expectancy in determining post-death MRDs. (The
separate account rule is not applicable to multiple beneficiaries who
take their interests through a trust that is named as a beneficiary of
the plan.)
Planning Tip:
In order to satisfy compliance for the separate accounts rule, there
must be pro rata sharing in gains and losses, which is normally done by
fractional or percentage division. A pecuniary gift would not meet the
definition unless (under local law or beneficiary designation) the gift
shares in post-death gains and losses pro rata with the other
beneficiaries’ shares. However, you can eliminate the recipient of a
pecuniary gift from being included in the Designated Beneficiary
determination by distributing that gift before September 30 of the year
following the year in which the participant died.
Planning Tip: Separate
accounts must be established by December 31 of the year following the
year of the participant’s death to use separate life expectancies. If
established later, the separate accounts are still effective for all
other purposes.
Critical Dates
September 30 of the year following the year of death
* Beneficiaries must be identified
* Non-designated beneficiaries eliminated by disclaimer or satisfaction of bequest
October 31 of the year following the year of death
* Trust documentation must be filed with the plan administrator if a trust is named a designated beneficiary
December 31 of the year following the year of death
* First distribution to beneficiary must be made
* Separate accounts must be created to be able to use individual life expectancies
Surviving Spouse as Sole Beneficiary
Special
rules apply if the surviving spouse is the sole beneficiary. For
example, if the surviving spouse is more than ten years younger than the
participant and the sole beneficiary, the participant’s MRDs are
determined by using the Joint and Survivor Table.
If the
surviving spouse is the only beneficiary, he or she can roll over the
inherited benefits into his or her own retirement plan or elect to treat
an inherited IRA as his or her own IRA. There is no deadline by which
the spouse must make the rollover decision, but until the rollover is
made, MRDs would have to be under the inherited IRA rules based on the
spouse’s age unless the plan requires more rapid distributions.
Planning Tip: A
spouse who is under 70 1/2 can postpone distributions until reaching
his or her own required beginning date, and can take MRDs using the
recalculation method from the Uniform Lifetime Table.
In addition, after rollover the spouse can name his or her own
beneficiaries who can then use their own life expectancies after the
surviving spouse dies, resulting in the maximum stretch-out.
Planning Tip:
If the surviving spouse is under 59 1/2, special care must be taken in
deciding whether and when to do a rollover. This is because
distributions taken from the account after rollover and before the
survivor reaches age 59 1/2 are subject to the 10% early withdrawal
penalty.
If the participant dies before his or her RBD
and the spouse does not do a rollover (i.e., treats the plan as an
inherited plan), annual distributions to the surviving spouse can be
postponed until the end of the latter of the year following the year in
which the participant died or the year in which the participant would
have reached age 70 1/2. If, after rollover, the surviving spouse dies
before his or her RBD, the MRDs for her beneficiaries will not be based
on the participant’s remaining life expectancy. For them, MRDs will be
based on either the five-year rule or, if the spouse has a Designated
Beneficiary, the life expectancy of that Designated Beneficiary.
While
the surviving spouse remains the beneficiary and has reached his or her
RBD, following the surviving spouse’s death, distributions may be
stretched over the surviving spouse’s hypothetical remaining life
expectancy under the fixed-term method (life expectancy rule).
Trust as Beneficiary
There are two common myths about estate planning for qualified retirement plans and IRAs:
(1) You cannot name a trust as beneficiary and get a stretch-out; and
(2) Naming an individual as beneficiary will result in a stretch-out.
The
problem with naming an individual as beneficiary is that he or she is
likely to cash out the IRA or plan account, thus negating the
participant’s careful planning for long-term tax-deferred growth.
Example: A 25-year-old inherits a $100,000 IRA. Will he choose a $60,000
automobile (the amount after cashing in the IRA and paying the income
tax) or $400,000 in after-tax income over his or her life expectancy
(based on 5% growth and combined state and federal income tax of 35%)?
If the client’s goal is to preserve tax-deferred growth, it is advisable
to have a trustee involved who will ensure that happens.
Normally
a trust is a non-individual and cannot qualify for Designated
Beneficiary status, but it is possible to name a trust as beneficiary
and still have a Designated Beneficiary for purposes of determining
MRDs. Special rules allow a “see-through trust” that lets you look
through the trust and treat the trust beneficiaries as the participant’s
beneficiaries, just as if they had been named directly as beneficiaries by the participant.
Planning Tip: If
a trust is made the beneficiary, neither the spousal rollover nor the
special accounts treatment is available. However, if the trust states
that property can be distributed out to the spouse, then the IRA could
be distributed to the spouse and the spouse could roll over the IRA.
Requirements for a See-Through Trust
To qualify as a see-through trust, the trust must meet certain criteria:
(1) The trust must be valid under state law.
(2)
The trust must be irrevocable or will, by its terms, become irrevocable
upon the death of the participant. (While it is not necessary to
include this wording in a revocable living trust or testamentary trust
under a will, WealthDocxTM does so out of caution and for the benefit of
the plan provider. Also, a trustee’s power to amend the administrative
provisions of the trust should not be considered a power to revoke. See
PLRs 200537004 and 200522012.)
(3) Certain documentation must be
provided to the plan administrator by October 31 of the year after the
year of the participant’s death.
(4) Trust beneficiaries who are to
be included in the Designated Beneficiary determination must be
identifiable from the trust instrument and all must be individuals.
A
Designated Beneficiary need not be specified by name as long as the
individual who is to be the Designated Beneficiary is identifiable under
the plan. Thus, the members of a class of beneficiaries capable of
expansion or contraction will be treated as being identifiable if it is
possible to identify the class member with the shortest life expectancy.
For example, “my descendants” is a class that can be identifiable even
if they are not individually named.
Which trust beneficiaries
are to be included in the Designated Beneficiary determination? The
general rule is that contingent and successor beneficiaries count,
unless the beneficiary is a “mere potential successor to the interest of
one of the beneficiaries upon that beneficiary’s death.” What is a
“mere potential successor” beneficiary is demonstrated by an examination
of “conduit” and “accumulation” trusts.
Conduit Trusts:
These specifically require that any distributions that come from the
IRA and go into the trust must be immediately distributed to the
identifiable current beneficiaries. The IRS regulations say that, with a
conduit trust, the Designated Beneficiary analysis has only to look at
the current beneficiaries because all others are mere potential
successors. Thus, with a conduit trust remainder beneficiaries could be
charities and older beneficiaries.
Planning Tip:
With conduit trusts distributions cannot accumulate in the trust, so
there is no asset protection for those distributions. Also, if there is a
special needs beneficiary, required distributions could result in the
loss of government benefits.
Accumulation Trusts: The
advantage of these trusts is that distributions can accumulate and do
not have to be immediately distributed to the beneficiaries, so they
provide asset protection for plan distributions. However, these trusts
are more difficult to draft so that there will be a Designated
Beneficiary. All potential remainder beneficiaries must be identifiable
and they must all be individuals. This is not possible, for example,
when the remote contingent beneficiaries are someone’s heirs at law.
Stand-Alone Retirement Trust (SRT)
Using
an SRT to receive retirement plan benefits is often the best solution.
As you have seen, qualified retirement plans and IRAs are special assets
with unique tax rules that provide well for accumulating wealth for
retirement but do not work so well when trying to pass this wealth on to
the next generation. It is always best to transfer property to the next
generation in trust rather than outright. When the facts are such that
an accumulation trust is best, it is difficult to draft it in a
revocable living trust.
An SRT is an inter vivos trust created
by the participant as grantor; it can be revocable or irrevocable. It is
nominally funded during the grantor’s life and will receive retirement
plan benefits upon the death of the participant by means of properly
drafted beneficiary designations.
Planning Tip:
Using an SRT can ensure stretch-out (if that is the client’s objective)
while also allowing the financial professional to maintain the assets
under management.
Conclusion
Understanding
retirement planning helps the planning team help clients pass more
wealth to their loved ones, integrate a client’s IRA with their overall
wealth plan, maximize continued tax-deferred growth, protect and grow
IRA savings for their families, and take advantage of the rules applying
to separate accounts governing IRAs and qualified plans so that each
beneficiary can control his or her own inheritance.
Like other
aspects of planning, it is helpful to review client retirement planning
objectives and beneficiary designations frequently to ensure they
coordinate with the client’s planning.
To comply
with the U.S. Treasury regulations, we must inform you that (i) any U.S.
federal tax advice contained in this newsletter was not intended or
written to be used, and cannot be used, by any person for the purpose of
avoiding U.S. federal tax penalties that may be imposed on such person
and (ii) each taxpayer should seek advice from their tax adviser based
on the taxpayer's particular circumstances.