Incorporating Retirement Assets Into an Estate Plan

December 17, 2015Articles New Jersey Law Journal

Many individuals hold substantial wealth in income tax-deferred retirement plans, including profit sharing plans, 401(k) plans, stock bonus plans, Employee Stock Ownership Plans (ESOPs), 403(b) plans and Individual Retirement Accounts (IRAs). Federal and state tax laws provide significant incentives to encourage retirement savings—deferring income tax on plan contributions and subsequent earnings during an account owner's working years—but the deferred tax must ultimately be paid when a retirement account is distributed to its owner or his or her beneficiaries. Given that retirement assets may also be subject to estate and inheritance tax, they may be subject to a near confiscatory combination of income and death taxes at the owner's death.

Estate planning for retirement assets addresses the same issues as are taken into account generally, e.g., 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 adds the additional goal of deferring income tax on benefits for as long as possible, consistent with other estate planning goals. In many cases it will be desirable to use a trust to hold retirement assets which otherwise would go outright to a surviving spouse, children or others. This article assumes an understanding of basic estate planning techniques and discusses some of the applicable tax rules and planning techniques to be considered when designating a trust as beneficiary of a retirement plan account.

Qualified retirement plans, IRAs and other employer-sponsored survivor benefit plans, including annuity and deferred compensation arrangements, are included in a decedent's estate under Code Section 2039. To the extent not withdrawn prior to death, the assets will be includable in the owner's estate for federal transfer tax purposes and in many cases also for state death tax purposes, including the New Jersey Estate Tax. Generation-skipping transfer tax implications of qualified retirement plans and IRAs are beyond the scope of this article, but note that GST tax is applicable to transfers of retirement plan assets.

Distributions from annuities, qualified retirement plans and traditional IRAs are taxed as ordinary income when received. Code §72. Assets in a decedent's estate which would have been subject to income tax had the decedent lived constitute "income in respect of a decedent" (IRD). Taxable distributions from qualified retirement plans and IRAs, and taxable gains in deferred annuity contracts are treated as IRD under Code §691. (There is no step-up in basis under IRC §1014 with respect to such assets.) For the taxable year in which the IRD is received, it is includable in gross income of the decedent's estate or of a beneficiary who acquires the right to receive it as a result of the decedent's death. Code §691(c). A beneficiary who includes IRD in gross income is entitled to an income tax deduction for the amount of any federal estate taxes paid attributable to the IRD. Id.

If a retirement plan participant or account owner dies before the date on which he or she must begin taking minimum annual distributions (RBD), then the account must be distributed by the end of the calendar year containing the fifth anniversary of the participant's death unless a "designated beneficiary" is named. Treas. Reg. §1.401(a)(9)-3, A-1. If a designated beneficiary is named, distribution of the account may be made over the designated beneficiary's life expectancy. (Different rules for calculation of life expectancy and required commencement of payments apply depending on whether a spouse or nonspouse beneficiary is designated.)

If an account owner dies after reaching his or her RBD, distribution of the account must be made over the course of the beneficiary's life expectancy or what would have been the life expectancy of the account owner. Only individuals may be designated as beneficiaries for purposes of "stretching" distributions over life expectancy—a person that is not an individual, such as the employee's estate, may not be a designated beneficiary. Treas. Reg. § 1.401(a)(9)-4, A-3.

Nevertheless, 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 a sole 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 qualifies as a "look-through trust" if it meets the following requirements:

• The trust is a valid trust under state law, or would be but for the fact that there is no corpus (A-5 (b)(1));

• The trust is irrevocable or will be upon participant's death (A-5 (b)(2));

• The beneficiaries are identifiable from the trust instrument (A-5 (b)(3));

• Trust documentation is sent to the plan administrator (A-5(b)(4)); and

• All trust beneficiaries are individuals (A-3).

If a trust which does not meet look-through trust requirements is named as beneficiary, the plan is treated as if it has no designated beneficiary, i.e., payout must be made under the five-year rule or a participant's remaining life expectancy.

A "look-through" trust may be structured as 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 required minimum distribution (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 comport with an account owner's intent 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 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.

• Marital Trust. Designating a marital trust as beneficiary of a retirement plan asset is generally not desirable, but sometimes unavoidable. In such cases, a planner must consider both the rules for qualifying the trust for the marital deduction as well as those to ensure the trust is treated as a "look-through" trust. Solely directing that retirement account RMDs be distributed to a QTIP trust may mean that less than all of the account income would be distributed to the surviving spouse, thereby failing the all income requirement for QTIP treatment. This may be avoided if the trust directs the trustee to withdraw and pay to the spouse all plan income or the RMD, whichever is greater. Alternately, the trust may give the spouse power to compel the trustee to withdraw all plan income and distribute it to the spouse annually—the spouse's power to withdraw income in excess of the RMD, whether or not exercised, will meet the all income requirement. Rev. Rul. 2006-26, IRB 2006-22 at 939 (applicable to taxable years beginning after May 30, 2006). Separate QTIP elections must be made for both the retirement asset and the QTIP trust.

• Credit Shelter Trust. For estate tax planning purposes, the goal generally would be to fund a credit shelter trust with assets which will grow in value during the spouse's lifetime so as to maximize the amount passing tax free to remainder beneficiaries. If a credit shelter is funded with retirement plan assets, this goal is unlikely to be met since RMDs are designed to be distributed and taxed over the surviving spouse's remaining life expectancy. The decision to fund a credit shelter trust with retirement plan benefits involves considering the trade-off between maximizing income tax deferral (generally available by use of a rollover to the surviving spouse's eligible retirement plan) versus minimizing estate taxes (by fully funding the credit shelter trust).

• Trusts for Children or Grandchildren. A typical estate plan may include provisions to create separate trusts to hold property for a child (or more remote descendant) to a stated age or for the child's life. If such a trust is to receive plan distributions based on the child's life expectancy, a separate account must be established for each child's trust by December 31 of the year following the year of the participant's death. Trusts for descendants often provide for staggered distribution of principal as the beneficiary reaches specified ages. Complications associated with transferring a retirement plan from a trust to the trust beneficiary make it preferable to limit the number of such distributions. If a child's trust is structured as a conduit trust, the child's life expectancy may be used to determine RMDs. If an accumulation trust is used, the trust remainder beneficiaries and potential appointees must be considered and limited to assure that all beneficiaries are individuals and all are identifiable. Depending on the child's age and the size of the retirement account, it may be advisable for a testamentary trust to provide conduit provisions for the retirement plan benefits payable to the trust, while retaining standard discretionary trust provisions for other assets.

• Pot Trust. A plan participant may wish to create a discretionary trust to receive and distribute plan benefits for multiple beneficiaries, e.g., a "pot trust" for the participant's minor children or a trust providing funds for the education of grandchildren. Remainder beneficiaries and potential appointees of such trusts must be limited to ensure that all beneficiaries are identifiable, and all are individuals. The trust beneficiary with the shortest life expectancy will be the designated beneficiary whose life expectancy is used to determine the required minimum distribution. Reg. §1.401(a)(9)-4, Q&A 3.

• Special Needs Trust. A third-party special needs trust established for a disabled child or other relative generally should not be structured as a conduit trust since the required distributions would be counted as available income or assets which would disqualify the beneficiary for needs-based programs, such as Medicaid and SSI. A discretionary special needs trust must meet the rules for a look-through trust to allow distribution of plan benefits using a beneficiary's life expectancy.

• Charitable Gifts. Retirement assets are a particularly tax-advantaged way to satisfy charitable gifts. If a charity is named as beneficiary of a retirement account, no income taxes will be assessed to the charity, and the owner's estate receives an estate tax charitable deduction under Code §2055(a) for the entire value of the gift. Various charitable entities are suitable recipients of retirement plans, including a §501(c)(3) public charity, private foundation, donor-advised fund or charitable remainder trust (CRT). Benefits paid to a CRT incur no income tax, and the account owner's estate is entitled to an estate tax charitable deduction for the present value of the charitable remainder gift. Code §2055(e)(2)(A). If an account owner's surviving spouse is given the right to a unitrust or annuity payment from a CRT, there would be no estate tax on the owner's death or the spouse's death because both the marital deduction and the charitable deduction apply. Treas. Reg. §20.2056(b)-8(a)(1).

While maximizing income tax deferral is a primary planning goal for estate planning with retirement assets, limitations imposed by the retirement plan itself or other considerations may trump options for deferred pay-out of plan benefits. A plan may limit how distributions may be made following a participant's death—the plan may offer only a lump-sum distribution, making deferred distribution a moot issue. Deferral options may also be trumped by the needs of the estate or beneficiaries—retirement assets may be needed to pay estate taxes or to provide funds for support and education of children or other beneficiaries. And, in many cases, a spouse's rights in certain retirement plans, e.g., 401(k) plans, may limit the participant's options for naming others as beneficiaries.

Reprinted with permission from the December 17, 2015, edition of the New Jersey Law Journal © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877.257.3382 -[email protected] or visit