For high-net-worth clients, the assets within the client’s retirement plan often constitute a significant portion of his or her net worth. Because of their tax-deferred status, these retirement plans are effective vehicles to provide for retirement, and they can be passed on to a surviving spouse and other heirs while maintaining their tax-deferred status. Designating a surviving spouse as beneficiary of a retirement plan is usually the preferred choice. However, there are a variety of reasons an individual may decide to leave his or her retirement plan benefits to a trust for the benefit of the surviving spouse—i.e., multiple marriages, dysfunctional families, a spendthrift spouse, or differing dispositive intentions of the retirement plan owner, to name a few.
Before advising clients in any of the above situations to leave their retirement plan benefits to a trust, advisers and their clients need to be aware of several pitfalls associated with this technique.
The first hurdle to consider is that the trust must qualify as a designated beneficiary. A trust that does not so qualify limits the deferral otherwise available to the plan benefits. If the participant dies before his or her required beginning date (RBD), the plan benefits will have to be completely withdrawn by December 31 of the year containing the fifth anniversary of the participant’s death (the five-year rule). If the participant dies after the RBD, the plan payout will be over the hypothetical remaining single life of the participant using the less-favorable fixed-term method. To avoid these undesirable scenarios, it is important to properly draft the trust document so that it will meet the designated beneficiary requirements.
Regs. Sec. 1.401(a)(9)-4 spells out the five requirements the trust must meet to be considered a designated beneficiary:
- The trust must be valid under the laws of the state in which it is created;
- The trust must be irrevocable or will become irrevocable by its terms upon the death of the participant;
- The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the participant’s benefits are identifiable from the trust instrument;
- All trust beneficiaries must be individuals; and
- Certain documentation must be provided to the plan administrator.
The most difficult part of testing the trust for designated beneficiary status is determining if all trust beneficiaries are individuals. In many cases, trusts are created to leave assets to other trusts upon the occurrence of some future event, such as the death of the surviving spouse. It is necessary to determine which beneficiaries of the trust “count” and which ones may be disregarded (a subject that is beyond the scope of this item) for purposes of determining if the fourth requirement above is met.
The next item that advisers and their clients should understand is that the required minimum distribution (RMD) rules are less favorable for benefits left in trust for the spouse unless the trust is structured so that the trustee must distribute to only the spouse all retirement plan distributions received by the trust (i.e., a conduit trust). When the surviving spouse is the outright designated beneficiary, his or her RMDs are based on recalculated single life expectancy. Furthermore, if the participant dies before his or her RBD, the spouse’s RMDs begin by December 31 of the year following the year the participant died or the year the participant would have turned 70½, whichever is later. For example, assume the participant dies at age 60. If the surviving spouse has other nonretirement resources to support him or her, he or she can defer taking RMDs for 10½ years, thus allowing additional tax-deferred growth of the retirement assets. If a conduit trust is used, the adviser can look past the trust to determine when the trust must begin receiving RMDs and how those RMDs are calculated.
If the retirement benefits are left to an accumulation trust (one in which the trustee is not required to distribute to the surviving spouse all distributions received from the plan and instead may accumulate the distributions within the trust) for the benefit of the spouse, the RMDs must begin by December 31 of the year following the year of the participant’s death. The RMDs are based upon the single life expectancy of the oldest trust beneficiary and will be determined using the fixed-term method instead of the more advantageous recalculation method, thus accelerating the pace at which the plan benefits will be depleted.
The Marital Deduction
Perhaps the most important item for advisers is to be certain that any trust for the benefit of the surviving spouse that is to hold retirement plan benefits qualifies for the marital deduction. For a trust to qualify for a marital deduction, it must be drafted as either a general power of appointment trust or a qualified terminable interest property (QTIP) trust. A general power of appointment trust likely circumvents the reasons the participant used the trust to hold the retirement benefits by allowing the spouse to appoint the trust assets to himself or herself. As such, most estate plans, especially in the case of second or later marriages, employ the QTIP trust. A QTIP trust must be drafted so the spouse is entitled to all the trust accounting income annually for the remainder of his or her life. It is important that advisers understand the “all income” and “entitled to” concepts.
Section 409 of the 1997 Uniform Principal and Income Act (UPIA) governs the trust accounting treatment of payments from retirement plans. Under Section 409, payments that are required to be made (RMDs) that are not characterized as interest or dividends are to be allocated 10% to trust accounting income and the balance to trust principal. This is referred to as the 10% rule.
Example: Q is a 69-year-old surviving spouse who is the beneficiary of a marital trust that is the beneficiary of the decedent’s IRA, with a value of $1 million. The applicable divisor of 17.8 from the single life table translates to 5.6% of the plan benefits. Under UPIA Section 409, just $5,618 [($1 million ÷ 17.8) × 10%] would be allocated to income for the benefit of the spouse. In the view of the IRS, this amount is insignificant.
As a result, in Rev. Rul. 2006-26 the IRS held that a marital deduction will not be allowed for a trust that is a beneficiary of a retirement plan if it is drafted to follow the 10% rule. For such a trust to qualify for the marital deduction, the surviving spouse must be entitled to the accounting income of the trust and the income of the retirement plan held by the trust. The IRS position is that the income of the retirement plan is either the plan’s internal investment income (a trust within a trust concept) or a unitrust amount of not less than 3% and not more than 5% of the plan’s assets.
In the above example, if the trustee receives statements from the retirement plan administrator that detail the interest and dividends earned by the assets held in the plan, the trustee may allocate that amount to trust accounting income to which the spouse is entitled. Otherwise the trustee may designate an acceptable unitrust amount to allocate to income. Assume that the trustee designates 5% of the retirement plan’s assets as the unitrust amount. In the example above, the spouse would be entitled to receive $50,000 ($1 million × 5%), plus whatever other accounting income is earned by the trust.
The next item to understand is the “entitled to” concept. The easiest way for the trustee to comply with the requirement that the spouse is entitled to the income from the plan is to withdraw from the plan the greater of the RMD or the plan’s income each year and distribute that to the spouse. Rev. Ruls. 89-89 and 2006-26 have approved this method as meeting the definition of “entitled to.” However, if an accumulation trust is used, this method will deplete the plan benefits if the spouse lives to his or her life expectancy, leaving nothing for the remainder beneficiaries. If the participant envisioned leaving some of his or her retirement benefits to the children, this method is not the preferred one.
Because the spouse is entitled to only the income from the plan and the marital deduction rules do not require the spouse to receive the entire RMD if it exceeds the plan’s income, the trustee of an accumulation trust may withdraw from the retirement plan the greater of the RMD or the income from the plan and pass to the spouse only the plan’s income. In years when the RMD is greater than the plan income, the excess may be accumulated in the trust for the benefit of the remainder beneficiaries.
Another option is to provide in the trust agreement the spouse’s right to demand the trust’s income. Regs. Sec. 20.2056(b)-5(f)(8) provides that the entitled to requirement is met if the spouse has the right, exercisable annually (or more frequently), to require distribution to himself or herself of the trust income; otherwise the trust income is to be accumulated and added to corpus. In Rev. Rul. 2000-2, the IRS allowed a marital deduction where the trust gave the spouse the right, exercisable annually, to compel the trustee to withdraw from the IRA an amount equal to the income earned on the IRA’s assets and distribute it to the spouse. However, this method comes with complications, a complete discussion of which is beyond the scope of this item. Notably, if the spouse’s right to withdraw lapses every year, failure to withdraw may constitute a completed gift to the remainder beneficiaries. Furthermore, the spouse’s failure to withdraw will cause part of the trust to be taxed as a grantor trust under Sec. 678(a)(2).
The general rule is that benefits that pass from a decedent to a surviving spouse may be rolled over by the surviving spouse into his or her own plan. Benefits that pass to the surviving spouse via an estate or trust are deemed to not be passed from the decedent. There currently is no precedent that allows the surviving spouse to roll the decedent’s IRA into his or her own IRA if the IRA is left to a marital trust. There are, however, no fewer than two dozen private letter rulings issued since 1993 that have allowed the surviving spouse to roll over retirement benefits left in trust, as long as the spouse has the unrestricted right of withdrawal of the retirement assets.
Giving the spouse the unrestricted right to withdraw the retirement benefits is similar to a general power of appointment trust in that it can allow the spouse to possibly circumvent the reasons the benefits may have been left to a trust in the first place. While a spousal rollover allows for maximum deferral of the plan benefits, it possibly changes the participant’s dispositive intentions of those benefits by allowing the surviving spouse to ultimately control where the benefits will pass after the participant’s death. It is important for advisers to understand their clients’ ultimate intentions for their retirement benefits before a trust document is drafted that gives the surviving spouse the unlimited right of withdrawal.
In situations in which there is family harmony and the participant is confident that the surviving spouse will comply with the decedent’s intentions regarding the ultimate disposal of the retirement benefits, leaving the benefits to the spouse directly is the best option. It allows deferral of distributions if the participant dies young and maximizes the deferral by using the more favorable recalculation method for calculating RMDs. It also allows the spouse the option to either roll the benefits into the spouse’s own plan or treat the spouse’s interest in the plan as his or her own plan. This adds to the deferral benefit by allowing him or her to use the uniform lifetime table instead of the single life table.
However, there are a variety of legitimate reasons that a participant may believe it more prudent to leave retirement plan benefits in trust for the benefit of the spouse. It is important that advisers are aware of the potential pitfalls associated with this option and understand the participant’s ultimate objective for the benefits. By doing so, advisers can be sure that the trust is drafted properly to meet the client’s goals with the minimum tax impact for the beneficiaries.
Editor: Frank J. O’Connell Jr., CPA, Esq.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.