Pitfalls and Opportunities in Distributing Retirement Assets to Trusts
Ground rulesIn order to be able to "stretch out" the Minimum Required Distributions ("MRDs"), there must be one or more "Designated Beneficiaries."
We're trying to create a "See-Through Trust: -- one that is ignored for purposes of determining the Designated Beneficiaries. See Choate, "Life and Death Planning for Retirement Benefits, 7th ed., 2011" herein cited as "Choate," pp. 413-414. This excellent reference work is available at Natalie Choate's web site: www.ataxplan.com
Another type of trust that allows the beneficiary to be considered as a Designated Beneficiary is a "Conduit Trust," which will not be discussed in this outline.
A trust, as such, can't be a Designated Beneficiary. Designated Beneficiaries must be identifiable individuals.
Prior to October 31 of the year after the participant's death, the trustee must provide the plan administrator with a copy of the trust document and a "final list" of all of the trust's beneficiaries.
How not to designate shares for childrenAjax has two children. Bjax and Cjax, ages 20 and 23, by his first wife, He has 1 yr. old Djax by his second wife. His IRA is payable to the trustee of his revocable trust which provides that the trust assets be divided into shares, with one share for each of Bjax, Cjax and Djax. The trust meets the "See Through" criteria.
? Is this a good plan ?
No, it's a poor plan. Here's why. The Regulations provide that, if a retirement plan is divided into "separate accounts," the MRDs will be calculated separately for each account. Regs. ?1.401(a)(9)-8; A-2(a)(2). Although the trust document provides for separate shares, because the beneficiary designation does not, the MRDs for each of the children's shares will be based on the life expectancy of Bjax. Djax will lose over 20 years of "stretch." Choate, p. 429 at "C".
The right way to designate separate sharesSuppose that the beneficiary designation had language similar to:
"I direct that, at my death, my IRA be divided into separate accounts, with one account for each of Bjax, Cjax and Djax who survive me. I designate the separate trusts for each of them under the provisions of the Ajax Revocable Trust, u/a dated [date] as the beneficiaries of those separate accounts."
By creating the separate shares in the beneficiary designation, as well as in the trust document, each child's MRDs will be determined using his or her age. See, e.g., PLR 200607031.
The problem with QTIPsThe QTIP rules require that spouse be entitled to all "income," distributed at least annually. Suppose that the only asset of the trust is an IRA. Does a direction to pay out all of the "income" comply with the QTIP rules? Unless we do more, the answer is "No."
"Income" in the QTIP rules means "trust accounting income," not taxable income. MRDs are taxable income, but are trust accounting principal, with the exception of the "10% rule" in the Revised Principal and Income Act.
Do NOT rely on this Statute. It may not work. In Rev. Rul. 2006-26, I.R.B. 2006-22, the Service held that this attempted legislative fix "does not satisfy the requirements of ? ? 20.2056(b)-(f)(1) and 1.643(b)-1 because the amount of the aEUR?MRD is not based on the total return of the IRAaEUR?."
How to do itIn Rev. Rul. 2000-2, 2000-1 C.B. 305, a trust holding an IRA qualified as QTIP where the surviving spouse could compel the trustee to withdraw, and distribute to her, from the IRA an amount equal to internal income of the IRA. There are, however, other requirements. The trust language in Rev. Rul. 2006-26, supra, is instructive. It contains all of the elements of a qualifying QTIP under Rev. Rul. 2000-2 and more.
As in Rev. Rul. 2000-2, the beneficiary has the power, exercisable annually, to compel the trustee to withdraw an amount equal to the "internal" IRA income. If she exercises the power, the trustee must withdraw the greater of the income or the MRD from the IRA and distribute the income to her.
Any income in excess of the MRD is added to the trust's principal.
If the spouse does not exercise her withdrawal right, the trustee need only withdraw the MRD.
NOTE: The Executor must elect QTIP for both the trust and the retirement plan.
Eliminating a Disqualifying BeneficiaryAll beneficiaries of a "See-Through Trust" must be individuals.
FACTS: Papa dies survived by his daughters, Lola and Lula He left his retirement plan to a trust. 95% of the trust assets go to the girls, outright. 5% passes to a charity. There is nothing in the document that requires the charitable distribution to be made from non-retirement assets.
"The employee's designated beneficiary will be determined based on the beneficiaries designated as of the date of death who remain beneficiaries as of September 30 of the calendar year following the calendar year of the employee's death." ?1.401(a)(9)-4, A-4(a). We're going to call this date the "Determination Date.
Beneficiaries who are eliminated prior to the Determination Date are not counted. If the trustee satisfies the charity's distribution with non-retirement assets prior to the "Determination Date, the charity is ignored. Lola's and Lula's MRDs would be determined based on their ages.
Watch out for contingent interestsSame facts, except that the girls' shares are in trust for them until age 30. Alternatively, the shares will pass to each of the girls' children other sister or her sister's children. If no beneficiaries are living, the assets would pass to older relatives and to a church.
One would think that, for purposes of computing the MRDs, the remote contingent interests would be ignored. .WRONG !
A potential beneficiary will not be counted...."merely because the person could become the successor to the interest aEUR? after a beneficiary's deathaEUR?[T]his sentence does not apply to a person who has any right aEUR? to an [account owner's] benefit beyond being a mere potential successor to the interest of one of the [his or her] beneficiaries upon [his or her] death" Regs. ?1.401(a)(9)-5, A-7(c).
This Reg. would seem clear. However, the Service only appears to only "bless" trusts where a living beneficiary receives a remainder interest outright. See, e.g., PLR 2004380
What we didIn the real "Lula and Lola" example, all of the contingent beneficiaries disclaimed their interests. This was our only option because there was no "saving provision" in the document.
DRAFTING TIP: If you are inserting an "atom bomb" provision, consider exempting all retirement plan assets. For example, you might provide:
"If, at any time, any assets of any Trust are undistributable because no beneficiaries of that Trust are living, the Trustee shall distribute those assets, with the exception of any Retirement Assets, as follows: [insert disposition].
Don't pay tax on distributions to charityEllsworth created a trust with percentage shares distributable to charitable and non-charitable beneficiaries.
The trust agreement did not provide for allocating specific assets to the charities. If paid to the trustee, the IRA would be part of the trust's Distributable Net Income. The trust would not be entitled to a charitable deduction because the trust does not create "separate shares."
In Chief Counsel Memorandum ILM 200848020, An IRA owner had left the account to a trust for his children and charities. The trustee immediately funded the charities' shares with IRA assets, so that the children were the only beneficiaries left. The Memorandum concluded that the IRA distribution created taxable income with no offsetting charitable income tax deduction. The trust document contained no instructions to distribute the IRA to charity.
Obviously, we wanted to have the IRA included in the charity's income, not the trust's.
What we did and whyThe trustee assigned the IRA to a charitable beneficiary. The assignment provided that the custodian distribute the IRA directly to the charity, and not to the trust.
This technique has been blessed by the Service in several Private Letter Rulings, including 200652028, 200633009 and 2006180923.
The facts in PLR 200234019 are very similar to those in our situation. The estate assets were left to charities and individuals. The charities' shares were greater than the value of the retirement accounts. The will contained TWO VITAL PROVISIONS. Without them, this technique will not work.
The executor could distribute assets "in cash or in kind".
In making those distributions, the executor could allocate assets among the beneficiaries without regard to their basis.
Drafting tipBe sure that the trust document includes both of the required provisions. Consider inserting language similar to the following:
"To the greatest extent practical, the Trustee shall allocate and assign the Trust's interest in all Retirement Accounts, and not the proceeds of those Accounts, to the Charities' Share, and not to the Shares distributable to non-charitable beneficiaries."
Get it right the first time. You might not get a second chance.In PLR 201021038, Distributions from an IRA could be accumulated in a trust and been subject to the beneficiaries' power of appointment. The appointees included charities. Because the beneficiaries could name non-individuals to receive the retirement benefits, there was no Designated Beneficiary. The IRA had to be distributed within a five year period.
The Trustees attempted a repair by obtaining a judgment from a state court modifying the terms of the trust.
The Service refused to recognize the effect of the post-mortem judicial reformation on the grounds that it was not authorized in the Code. For an example of an authorized reformation, see ?2055(e)(3) regarding split-interest charitable trusts.
The MORAL OF THE STORY is that, in some cases, one has to get it right the first time. You can eliminate unwanted beneficiaries by disclaimer. You can make distributions prior to the Designation Date. You can't repair a defective document.
ConclusionTrusts are wonderfully flexible estate planning tools, allowing our clients to protect their beneficiaries from the ravages of inability, disability, creditors and predators. They can save estate taxes.
Retirement plans are also wonderful things.
Putting these two wonderful things together sometimes creates a chamber of horrors. Probably the best avoidance technique is to ask, "do we need a trust at all?" If you do need a trust, then do what I do.
Consult Natalie Choate. Her book should have a prominent place in your library.