In 2010, Congress introduced the law of portability for estates of married decedents to the federal estate tax paradigm. Under this temporary law (which exists only in 2011 and 2012, unless extended), the estate of a surviving spouse can use part or all of the first deceased spouse’s unused exemption amount (“deceased spousal unused exclusion amount” or DSUEA) to reduce the estate tax liability of the surviving spouse’s estate. IRC § 2001(b)(1), added by section 303 of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, Pub. L. No. 111-312, 124 Stat. 3296.
This law gives a married couple a combined $10 million exemption—double the $5 million exemption available to others. There are three principal advantages. First, the new law offers estate tax savings when the poorer spouse dies first. For example, if the husband owns $10 million of assets and the wife owns nothing, the prior law exacted punishment if the wife died first. Second, the new law permits spouses to transfer wealth in a manner that seems natural: to leave all wealth to the surviving spouse, rather than transfer some or all of it to other beneficiaries when the first spouse dies. For example, assume that the husband with $10 million of assets dies first in 2011, and he leaves his entire estate to his wife. If she dies in 2012, then her estate can claim a $10 million exemption (her own $5 million and her husband’s DSUEA of $5 million) and completely avoid the estate tax. Third, the new law provides an income tax benefit because assets (other than retirement accounts) that are included in both spouse’s estates will generally have their income tax basis stepped up two times instead of once.
Many estate planners, however, discourage married couples from using the new portability law as part of their estate plans. The law is scheduled to expire at the end of 2012 and would apply afterward only if extended. Of greater importance for this article, many estate planners feel that the tried and true credit shelter trust (aka “bypass trust”) continues to offer more benefits than portability offers, including greater potential estate tax savings and greater asset protection. Marc S. Bekerman, Credit Shelter Trusts and Portability—Does One Exclude the Other?, Prob. & Prop., May/June 2011, at 10–15; Steven R. Akers, Estate Planning Effects and Strategies Under the “Tax Relief. . . Actof 2010,” ABA Real Property, Trust & Estate Law eReport, February 2011, at 10–17, available at www.americanbar.org/content/dam/aba/publications/rpte_ereport/
Credit Shelter Trusts and Retirement Assets—A Miserable Combination
Whereas credit shelter trusts may be superior for traditional assets such as stock and real estate, there is one type of asset for which portability will usually be the first choice. That asset is a retirement plan account. Portability solves the serious income tax problem arising when a credit shelter trust for the surviving spouse is named as the beneficiary of a retirement account.
An estate planner’s objective for a credit shelter trust is to transfer as much wealth as possible to the next generation on the death of the surviving spouse. Paying retirement assets to a credit shelter trust that benefits the surviving spouse fails that objective miserably. First, the amount of assets will have significantly declined between the time the first spouse dies and the surviving spouse dies because of the income taxes that will be levied on much larger required taxable distributions made to the trust compared to the smaller required distributions that a surviving spouse would have received from a rolled over account. Second, when the credit shelter trust distributes taxable retirement plan payments to the surviving spouse (which is required if the trust is a “conduit trust,” described below), then all of the unspent after-tax proceeds will be included in the surviving spouse’s taxable estate, an outcome that is completely contrary to the purpose of a credit shelter trust.
This is why portability is a wonderful estate tax solution to the income tax challenges posed by retirement accounts. Portability permits these assets to be left outright to the surviving spouse, thereby preserving greater income tax benefits, without triggering the negative estate tax consequences that could have applied under the old law.
By way of background, if parties want a surviving spouse to have access to a decedent’s retirement assets, then usually the optimal income tax outcome will occur if the surviving spouse is named as the beneficiary of the retirement account. In most cases the best results will occur if the surviving spouse rolls over the decedent’s retirement assets into a new retirement account (typically an IRA) in the widow’s or widower’s own name. Only a surviving spouse is allowed to get a fresh start with a rollover to a new IRA. See IRC§ 402(c)(9) for inherited qualified plan accounts and IRC § 408(d)(3)(C)(ii)(II) for inherited IRAs. The best that any other beneficiary can do is to classify a decedent’s retirement account as an inherited account (or to transfer the assets to a new IRA administrator where it will still be classified as an inherited IRA) and to then take distributions over a time period that cannot extend beyond her or his remaining life expectancy. Treas. Reg. § 1.401(a)(9)-5, Q&A 5(a)-(c) and Q&A 6, and IRC § 408(d)(3)(C).
In the past, the positive income tax outcome of a surviving spouse rollover was offset by a negative estate tax outcome: the rolled over account could inflate the surviving spouse’s estate, so that it may have been wiser to have kept these assets out of the surviving spouse’s estate by using a credit shelter trust or an outright transfer of the assets to the children. Portability solves this problem for married couples, especially for those who have estates that are top-heavy with retirement plan assets. It offers the income tax advantage of a rollover by the surviving spouse with the estate tax advantage that, on the death of the surviving spouse, the estate can use the first deceased spouse’s DSUEA to reduce or eliminate an estate tax liability.
Income Tax Consequences of Paying Retirement Assets to a Trust for a Surviving Spouse: The Bad and the Ugly
What is so bad about naming a trust for a surviving spouse as the beneficiary of a retirement account? The income tax problem is that a deceased spouse’s retirement account payable to such a trust must generally be liquidated over the remaining life expectancy of (as opposed to the actual years lived by) the surviving spouse. The life expectancy tables (see below) represent an average: half of the population is expected to die before that age and half is expected to live beyond that age (oversimplified). For example, an individual who becomes a widow or widower between ages 60 and 80 has a projected life expectancy of between ages 85 to 90. This means that the account must be fully liquidated between ages 85 and 90, which is a serious problem for the half of the population who will live past their original projected life expectancy. In that case, no retirement assets will be available in the surviving spouse’s final years when she or he might need them the most to pay large medical and long-term care expenses.
There is a way to assure that the assets in a retirement account payable to a trust (including a credit shelter trust or a QTIP trust) will in fact last for the entire life of a long-lived surviving spouse. This is accomplished by having the trust qualify as a conduit trust—a trust that redistributes to the surviving spouse all of the retirement distributions that it receives and that does not accumulate any such distributions in the trust. Treas. Reg. § 1.401(a)(9)-5, Q&A 7(c)(3), ex. 1(ii). In contrast, if a trust can retain and accumulate retirement plan distributions, it is classified as an accumulation trust.
With a conduit trust for a surviving spouse, the required distributions can be annually recomputed to take into account the surviving spouse’s gradually extending life expectancy as she or he gets older. Treas. Reg. § 1.401(a)(9)-5, Q&A 5(c)(2). Thus, the retirement assets will not have to be fully depleted at age 85, 90, or whenever. The downside of this arrangement is that there will be very large mandatory distributions from the retirement account when the surviving spouse enters her late 80s (for example, between 14% and 25% of the retirement account’s assets each year between ages 85 and 95), so that the retirement account will likely be almost depleted in a long-lived surviving spouse’s final years.
By comparison, when the account is rolled over to the surviving spouse, the much smaller required distribution means that there could be vast amounts of cash available in the retirement account to pay for living expenses at any age. There also might be a large remaining balance on the death of the surviving spouse, which could then permit the surviving spouse’s IRA to provide income over the life expectancies of much younger children or grandchildren.
Even these large payouts assume that the maximum income tax advantages are available when a trust is named as a beneficiary of a retirement account. The outcomes could be even worse. Because a trust generally does not qualify as a “designated beneficiary,” several steps are necessary to have the trust qualify as a “look-through” trust so that the required distributions can be based on the life expectancies of the beneficiaries of the trust. Treas. Reg. § 1.401(a)(9)-4, Q&A 5 and 6. See also John Strohmeyer, Swimming Against the Stream: Advising Clients on Their IRA Options, Prob. & Prop., July/August 2011, at 25–27.
Many of the above principles also will apply to a tax-exempt Roth account (a Roth IRA, Roth 401(k), or a Roth 403(b) account) benefiting a surviving spouse. IRC §§ 408A and 402A. Although distributions from a Roth account will be tax free, whether to the spouse or to a trust for the spouse, the disadvantage of naming a trust as the beneficiary of a Roth account is that the income tax advantages of the Roth account (the ability to generate tax-exempt investment income) will be terminated earlier than if the surviving spouse had made a rollover of the deceased spouse’s Roth account to a new Roth IRA. Except for investments in municipal bonds, all future income generated by the surviving spouse or by the credit shelter trust will be taxable whereas it would have been tax-free if it had been earned inside the Roth account.
Income Tax Challenges with an Elderly Spouse
The income tax challenge is greatest for elderly couples, because the surviving spouse’s remaining life expectancy will be relatively short. The table on page 23 illustrates the required distributions when there is an 80-year-old surviving spouse. The annual required distributions from a rolled-over IRA are roughly half the distributions that would be required if a conduit credit shelter trust were named as the beneficiary of the retirement account, and an accumulation trust would be even worse. A rollover allows considerably more resources to remain in the retirement account to pay for major medical and long-term care expenses that may occur in the surviving spouse’s later years.
For older surviving spouses, even a rollover may still cause large annual required distributions well in excess of what the IRA or retirement account can be expected to earn. The minimum annual required distribution from a rolled-over IRA ranges between 7% and 12% of assets for a surviving spouse between ages 86 and 96. Estate planners frequently see this situation. Over half of all estate tax returns were filed for individuals who died after age 80: 53% for men and 66% for women. Over 19% of all returns were filed for individuals who died after age 90 (see table on page 24). Although many decedents may have a surviving spouse who is considerably younger, the majority of married decedents—particularly those who are in their first and only marriage—are very close in age to their surviving spouse.
What About a Younger Spouse?
Is the situation much better if there is a younger surviving spouse, say age 60? Is a trust for such a younger spouse a better deal? Usually not. The principles remain the same. The required distributions when there is a trust named as a beneficiary will force the retirement account to be liquidated at the end of the surviving spouse’s life expectancy (age 85, if paid to an accumulation trust) or a few years after the surviving spouse actually dies (for example, a conduit trust). By comparison, a rollover permits sizable retirement assets to remain in the account for the entire life of the surviving spouse.
On the other hand, for widows and widowers under age 60, it is often best to avoid rolling over all of the deceased spouse’s retirement assets. When a surviving spouse is under age 59½, the danger from rolling over all of the deceased spouse’s retirement assets is that it exposes the surviving spouse to the 10% penalty for early withdrawals if amounts are distributed from the rollover account before she attains age 59½. Peggy Ann Sears v. Commissioner, T.C. Memo. 2010-146. To achieve the best income tax savings, one should still name the surviving spouse as a beneficiary rather than a trust. But rather than roll over all of the deceased spouse’s retirement assets, it may be best to leave in the deceased spouse’s account sufficient assets to cover anticipated financial needs until the surviving spouse attains age 59½. There is no 10% penalty for receiving a distribution from an inherited retirement account. IRC§ 72(t)(2)(A)(ii).
How to Preserve More Assets for the Next Generation, Especially with Older Spouses
In most situations the primary concern of the parties is the welfare of the surviving spouse. Rollovers usually provide the best solution by making all of the retirement assets available. If the surviving spouse consumes assets over her or his remaining lifetime so that nothing is left for children or other beneficiaries, well, so be it.
In some situations, however, there may be adequate assets to assure that the surviving spouse will have a comfortable retirement and the parties may want assurance that some retirement assets will be available for other beneficiaries after the surviving spouse’s death. This issue often arises in a second marriage in which each spouse has children from a prior marriage. Usually they cannot fully trust each other’s promises that the surviving spouse will name the children from the deceased spouse’s prior marriage as beneficiaries of a rolled-over IRA.
One solution is for each spouse to name his or her own children from a prior marriage as the beneficiary of a fraction of the retirement accounts. Although this works for an IRA, there is a legal obstacle with a § 401 plan, including a 401(k) account. Assets in a deceased spouse’s § 401 retirement plan account (profit-sharing plan, stock bonus plan, pension plan, and so on) must be paid to the surviving spouse unless the surviving spouse executes a written waiver consenting to a different beneficiary (including a trust). IRC§§ 401(a)(11)(B)(iii) and 417(a)(2).
Another solution also will provide income to the surviving spouse. On the death of the first spouse, some (or all) of the taxable retirement assets can be transferred to a two-generation charitable remainder trust (CRT). Typically such a trust annually distributes 5% of its assets to the surviving spouse, then 5% of the assets to the children, and then on the death of the last child the trust terminates and distributes its assets to a charity. Investment managers can do a better job investing assets for a CRT that has a steady 5% payout than they can for an IRA that has much larger required distributions to an elderly beneficiary (see the required distributions listed in table on page 23).
The main income tax advantage offered by a CRT is that it is tax-exempt. A CRT will pay no income tax when it receives an otherwise taxable distribution from a retirement plan account. IRC § 664(c)(1); PLRs 200335017 (May 27, 2003), 200302048 (Oct. 15, 2002), 200215032 (Jan. 10, 2002), 200202078 (Oct.19, 2001), 200038050 (June 26, 2000), and 199919039 (Feb. 16, 1999). The CRT can then be viewed as a tax-sheltered credit shelter trust (there is no marital deduction available) that will pay a 5% quasi-annuity stream to beneficiaries over two generations, with the remaining proceeds payable to a charity. Thus, a CRT can be a great beneficiary of any source of income in respect of decedent (IRD), such as employee stock options or a nonqualified deferred compensation payment, if such income sources can be paid directly to a CRT rather than to an individual or to an estate.
The CRT arrangement works best when the surviving spouse has a short remaining life expectancy (for example, is over age 70) and when all of the individuals in the next generation (typically children) are over age 40. There are a series of technical issues that must be resolved—a minimum 10% charitable deduction, the lack of a marital estate tax deduction, challenges if there is indeed an estate tax liability, and so on. For the challenges, mechanics, and details of naming a CRT as a beneficiary of a retirement account, see Christopher R. Hoyt, Funding Bypass Trusts with Retirement Assets, Prob. & Prop., May/June 2004, at 10–15, and Christopher R. Hoyt, When a Charitable Trust Beats a Stretch IRA, Tr. & Est. (May 2002).
Married couples with estates too small to worry about the estate tax have been able to take full advantage of the income tax benefits from a rollover to a new IRA for the surviving spouse. Wealthier spouses whose estates were top-heavy with retirement assets used to face an estate tax problem because in some cases the negative estate tax consequences of a rollover could outweigh the income tax benefits. Portability is a welcome development allowing married couples, especially those whose estates are top-heavy with retirement assets, to take advantage of the income tax benefits of a surviving spouse rollover without paying an estate tax penalty. Let’s hope that Congress makes the law permanent.
Estate planners need to be aware that there are situations in which a rollover to a surviving spouse could be a problem. The estate tax advantage of portability could be lost if there are multiple remarriages. There could be concerns about spendthrift behavior by a surviving spouse, in which case a trust is appropriate despite the diminished income tax benefits. Same-sex couples who live in states that recognize their marriages will find that they may not qualify for federal tax benefits available to a surviving spouse, such as portability or an IRA rollover. In these situations and others, estate planners will look to alternative tax-favored arrangements in lieu of a rollover to a surviving spouse when planning for retirement assets.
Table A-1 of Treas. Reg. § 1.401(a)(9)-9 (“single life”), required by Treas. Reg. § 1.401(a)(9)-5, Q&A 5(a) & 5(c) and Q&A 6.