RETIREMENT PLANS AND THE ESTATE: The Thirty Year “Hot Topic” for Estate Planners
The dramatically increasing federal and New York estate tax exemptions have made estate planning professionals all too aware of the current focus on retirement planning in pre and post-mortem estate planning. This and Medicaid Planning will remain their focus for the next several decades.
II. Types of Retirement PlansA general on-going theme of estate planning is looking at it as ASSET planning, rather than income planning. While a client's income is an important matter during their lives, it is an issue more appropriately addressed by financial planners, accountants or Medicaid planning practitioners: An estate planner's control over transferring income is somewhat limited (you know what the client and his spouse will receive, and often much of that income ceases upon their passing). However, by its very nature, an asset can be transferred to beneficiaries with greater certainty of the size of the asset and control over the asset. Any income generated by that asset is, again, often better left to the determination of other professionals.
As such, while an understanding of defined benefit plans is important for the current needs of a living client (because they are paying the client income that often ceases at death), the focus should be on understanding the nature of defined contribution plans, where the retirement plan contains an asset that can be transferred to future generations. Non-qualified plans shall be included in this discussion too, as they are also effectively asset-based plans.
The vast majority of employer-sponsored defined contribution plan assets are held in 401(k)s and 403(b)s. Inherited retirement accounts ["IRAs"] may either be funded during working years, or may receive "roll overs" from other retirement plans (such as 401(k)s) when a plan participant leaves an employer. The most basic concept of defined contribution retirement plans is that income tax is NOT accessed on plan contributions at the time of deposit.
The effect of this arrangement between the IRS and taxpayers is as follows:
- Working individuals are incentivized to save for retirement by deferring immediate income taxes
- Funds held in the defined contribution plan do not pay taxes on dividends, capital gains, etc. while they remain in the plan
- When funds are eventually withdrawn they have appreciated, and the IRS assesses income tax liability on every dollar withdrawn at the time of withdrawal
The types of investments available for retirement plans are substantial. While employer-sponsored plans tend to have some limitations on the investment options available to employees, this is more readily due to the fact that they do not wish to pay administrative expenses associated with having several thousands of mutual funds available for their plan. As such, most 401(k) and 403(b) plans are limited to anywhere from 10 - 40 mutual fund options.
IRAs, particularly rollover IRAs, are far less limited. Because the assets are usually held at large brokerage houses with access to thousands of mutual funds and other investments, the owner of a Rollover IRA has many more options, and pays higher expenses as a result of this flexibility and the fact it is solely administered. Real estate may also be held in an IRA, but the restrictions associated with this investment option are somewhat arduous. If you aren't familiar with these restrictions, have an outside firm or professional oversee the account for liability purposes. In addition, certain investments are prohibited.
III. Required Minimum Distribution RulesIRC ?72 mandates that owners of certain retirement accounts begin taking distributions the year the beneficiaries turn 70 1/2 . These distributions are known as required minimum distributions ["RMDs"]. Missing an RMD or underpaying what is owed enables the IRS to assess a 50% penalty on the shortfall. The amount of RMD due is determined using (1) the total IRA and qualified plan balance on December 31st of the prior year, divided by (2) the percentage noted in the standard IRS "uniform tables."
RMDs are based on a person's life expectancy: The tables require a higher percentage of plan assets to be distributed to older recipients and lower amounts to younger recipients. A 70 year old has to withdraw 3.77% of her retirement funds (100 / 27.4*), and pay income taxes on this amount, whereas a 93 year old will have to withdraw 10.4% (100 / 9.6**) of her combined retirement account values. Some commonly used abbreviations to describe how the RMD process works include:
o Applicable Distribution Period ["ADP"]: the period during which benefits can be distributed
o Required Begin Date ["RBD"]: April 1st of the year following the year in which participant reaches age 70 1/2
o First Distributions Year ["FDY"]: Typically the year owner reaches 70 1/2 , at which time the distribution can be made by December 31st of that year. However, this can be postponed to April 1st of the following year. The RBD is the following year (because a distribution is "required" by then). Waiting for the RBD will lead to two years-worth of distributions and income taxes (one for FDY and one for the RBD year).
Remember that defined contribution plans have RMDs that commence at 70 1/2 years of age, but may be withdrawn without penalty starting at age 59 1/2 . Otherwise, a 10% penalty is assessed in addition to the income that is assessed to the withdrawal. An exception to the early withdrawal rule can be found under IRC Section 72(t), known as "Separate and Equal Periodic Payments" (SEPP), which effectively allow a plan participant to commence earlier withdrawals on an accelerated schedule over a span of years. SEPPs are essential in understanding how a potential Medicaid recipient will be able to have defined contribution assets exempted for Medicaid resource limitations.
RMDs After LifeEstates and charities receive the worse RMD treatment, because an estate or charity does not have a life expectancy. Of course, since a charity is not required to pay federal income taxes this is not a terrible outcome. However, for the estate this will lead to the 5 Year Rule for RMD purposes: The retirement account must be distributed in full by the fifth year after the death of the participant, leading to large income tax rates in the short term. If you have an IRA with four children and one charity named as beneficiaries then ALL 5 must withdraw all funds over the five year period; this "all or nothing" approach (mistake) should be identified by the estate practitioner immediately, and avoided at all costs.
Spouses receive the most favorable RMD treatment: A surviving spouse may either (1) keep the funds in the deceased spouse's retirement account (and distribute RMDs based on the deceased spouse's life expectancy), or (2) transfer the account to his or her own retirement plan. All other individuals must transfer the retirement account of a decedent to an "inherited IRA." A non-spousal beneficiary must begin taking RMDs no matter what his age, but because he/she will typically be younger than the participant, the RMD rates are relatively low. This allows for gradual distribution, thereby assessing lower income taxes in any given year, with longer tax deferral periods. This is known as a stretch IRA, since the beneficiary is stretching distributions in accordance with his or her longer life expectancy.
Eligible Designated Beneficiaries ["DB"]: A designated beneficiary is different than a "beneficiary." Many entities (charities, corporations, estates, non-qualified trust) can be the latter, but only an individual or a qualifying trust can be a DB. Remember: If even ONE beneficiary is not a DB then NONE of the beneficiaries are DBs. Whether or not a beneficiary is "applicable" to be a DB is determined on Sept. 30 of the year following the participant's date of death.
Naming one or several DBs on the beneficiary designation form allows for the most favorable post-mortem stretch RMD treatment using the beneficiary's longer life expectancy. Failing to name DBs, or naming multiple beneficiaries where even one is not a DB, will invoke the 5 year rule, forcing the beneficiaries to withdraw all funds from the retirement plan within five years. This negates the opportunity to stretch distributions. The DB's actual name need not be stated as long as the DB(s) can be identified using a class or distinction, such as "my children" or "my living lineal issue at the time of my death."
If there are multiple DBs for only one qualifying trust, even if all of the beneficiaries are eligible DBs (i.e. identifiable individuals), then RMD treatment is based on the DB with the shortest life expectancy: the oldest beneficiary. In this case, the client may want to retitle and separate their assets into separate IRAs; this can also be done post mortem by September 30th of year following the date of death, to ensure all DB's get their own life expectancy for stretch RMDs. For all beneficiaries to use their own life expectancy, IRAs must be in separate accounts.
Inherited IRAsAside from instances of fraud or the use of a QUADRO in divorce disputes, retirement plans generally cannot be transferred to another person or creditor during the account owner's life. However, when a plan participant (the owner of the retirement plan) passes away, the funds may either be transferred to his or her spouse's IRA, or be transferred to another person through the use of an "Inherited IRA."
These must be titled as "IRA f/b/o Tom Smith, John Smith, Dec'd" or "John Smith, IRA (deceased on May 21, 2007) f/b/o Tom Smith, Beneficiary." Be very cautious in working with the financial institution that is holding the account: Failure to fulfill Inherited IRA requirements--for example, rolling over the funds directly into a non-spousal beneficiary's IRA--may cause immediate taxation of ALL the funds, which will result in an income tax nightmare.
As stated herein, inherited IRA beneficiaries have to take RMDs, even before the age of 59 1/2 . However, unlike the plan participant's IRA withdrawals prior to age 50 1/2 , Inherited IRA beneficiaries are NOT assessed a 10% penalty on these withdrawals. In addition, no additional funds can be contributed to the IRA by the beneficiary: The plan is essentially its own entity waiting to be depleted without any ability to be replenished.
Suggestions for Naming Children as Primary or Contingent Beneficiaries to a Retirement Plan:
1. Split up IRA accounts so that each child is a contingent beneficiary of his or her own account for RMD purposes (this can be done as an alternative to "see-through" trusts, and can be completed after death).
2. Younger beneficiaries are able to "stretch" RMDs for longer periods of time due to their increased life expectancy, which allows for a longer period of tax deferral.
3. If children need funds now and the retirement plan does not have a Trust as the beneficiary, the RMD rules won't matter. They need the money immediately, so they will have to take it along with incurring a hefty income tax.
4. If the account owner's estate will be subject to IRD consider (1) converting the plan to a Roth IRA, and/or (2) having desired charitable legacies paid for out of the retirement plan to minimize short term and future income taxes.
5. Name a see-through trust as the beneficiary of the plan.
Creditor Rights and Clark v. RamekerMoney within qualified retirement plans is protected from almost all creditors, save a divorcing spouse, or in cases of fraud. In other words, an employer-sponsored retirement plan is free from liens placed by the IRS, standards creditors, Medicaid (provided RMDs are being withdrawn), etc. In the world of estate planning, the typically moniker for funds within the control of the client is "You can't protect yourself from your creditors, but you can protect your children from their creditors." Defined contribution plans are the exact opposite: In general, the client can protect his funds from his creditors, but cannot protect the funds from his children's (or beneficiaries') creditors.
This was made dramatically apparent in Clark v. Rameker, 134 S. Ct. 2242 - 2014. In a nutshell, the fact pattern had a daughter beneficiary of a parent's IRA claim that the funds, now in the daughter's inherited IRA, were exempt from the daughter's bankruptcy creditors.
The US Supreme Court determined that funds held in an inherited IRA were not protected from bankruptcy creditors: The funds in the inherited IRA (1) were never earned or saved by the daughter beneficiary, and thus were never truly saved by her for retirement purposes, (2) the beneficiary did not have to pay the 10% penalty associated with withdrawals prior to age 59 1/2 , even in the event that all plan assets were immediately depleted, (3) the beneficiary could not make additional contributions to the inherited IRA. As such, the assets in the inherited IRA were available for bankruptcy creditor invasion.
This leads to some troubling questions: Can the IRS pursue inherited IRA assets? What about the Department of Social Services in an instance in which a child is receiving Medicaid? The history of government agencies would suggest that their exercise of creditor rights is not far behind...
Retirement Plans with Trusts as BeneficiariesQualified / "See-Through" Trusts: With these trusts, the beneficiary is treated as the beneficiary of the retirement account for purposes of determining whether there is a DB. This is the most desirable outcome for a parent-to-child transfer, especially if the child is still a minor, since RMDs will take place at the rate of the child beneficiary. In order for a see-through trust to accomplish this end, the following requirements must be met:
(1) The trust must be valid under state law,
(2) The trust must have identifiable beneficiaries; "classes," such as "my children" are
okay, but the beneficiaries with the longest and shortest life expectancies must be
identified at the time of the transfer,
(3) The trust must be irrevocable before or as of the participant's death,
(4) A copy of the trust must be sent to the plan administrator or trustee by 10/31 of the
year following participant's death, or the plan administrator or trustee must receive a list of all trust beneficiaries (including contingent and remainder beneficiaries) by September 30th of the year following the participant's death, and
(5) All primary trust beneficiaries must be individuals
Conduit trusts: With a conduit trust, all distributions paid to the trust are immediately distributed to the beneficiary and not accumulated for future distributions to the successor beneficiaries. This language must be written into the trust in order for it to be effective. In addition, make sure there are separate trusts for each beneficiary in order to take advantage of favorable stretch RMD distributions for the younger beneficiaries.
Accumulation trusts: These trusts are good if the settlor / plan participant wants to withhold principal and income from the initial trust beneficiaries, and thus it is the opposite of a conduit trust. However, these trusts receive the least desirable RMD treatment, as they must use the life expectancy of the oldest beneficiary, even if he or she is only a contingent beneficiary, and even if there is an extremely low probability that beneficiary will collect the funds.