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Edward V. Atnally is a lawyer practicing in White Plains, New York, specializing in trusts and estates and employee benefits law.
Much has been said and written about the use of retirement plan benefits in the estate planning process, but little has been done to simplify the concepts and procedures involved. This article is designed to help practitioners provide guidance to their clients when dealing with retirement plans in estates of all sizes and complexities.
Part I of this article reviews the steps to be taken in smaller estates when there is no need for a trust arrangement and in more complex estates in which trusts are useful to provide for beneficiaries with special needs. Part II, which will appear in the September/October issue, will review the steps to be taken when credit shelter and marital deduction trusts are desirable to reduce estate taxes. The planner's goal is to avoid the payment of unnecessary estate taxes and especially income taxes by "spreading out" retirement plan distributions and related tax liabilities thereby enhancing the value of assets eventually passing to the plan beneficiaries.
Retirement planning for estates has been described by some individuals as a "morass" or "quagmire," but it remains increasingly important as 401k plans, individual retirement accounts (IRAs), and other retirement plans become significant parts of clients' assets, having values, until recently, estimated to be about 40% of the average American family's financial worth. With automatic 401k enrollment and default investment selection (including target date investment funds and clients' greater reliance on their retirement plans for retirement security), dealing with these plans will remain, despite current economic conditions, a major part of estate planning.
The goal of the estate planner should be to help the client arrange his or her retirement plan benefits and other assets in such a way that, on the death of the plan participant, the intended beneficiaries will receive their benefits as anticipated and, if possible, not have them reduced by substantial estate and income taxes. Poor planning, mistakes, and bad decisions can result in two-thirds or more of the retirement plan assets being used to satisfy tax obligations. Malpractice claims often arise as a result of disregarding some of the principles discussed in this article.
In "smaller" estates, which the author defines as those having total assets of less than $1 million but in which hundreds of thousands of dollars or more may consist of retirement plan assets, the estate planning goals should be fairly easy to accomplish, especially when the overall plan is to leave all of the clients' property to the surviving spouse and, on death, to the adult children outright. Nevertheless, smaller estates as well as some larger ones require special planning for clients who wish to provide for a mentally or physically handicapped child (supplemental needs trust), plan for a minor child, protect against unscrupulous caregivers, or protect against the claims of divorced spouses or others if their property is left outright to their children or other beneficiaries. In these and other situations trusts may be desirable and the client's retirement benefits may be required to fund the trusts because available nonretirement assets are insufficient to do so. In "larger" estates, the goal is usually to try to reduce estate tax liabilities, and special care must be taken to properly draft and implement credit shelter, marital deduction, and other trusts in such a way that, if possible, both estate and income tax savings are achieved.
The author assumes that the reader is generally familiar with these "standard" trust and estate planning techniques and that he or she would like assistance in coordinating them with the retirement plan rules to achieve the best results.
Retirement plans come in many forms but for the most part consist of defined benefit plans covering corporate employees, defined contribution plans covering both self-employed individuals and corporate employees (generally 401k plans), and IRA accounts both regular and rollover (usually in which funds have been transferred over from a qualified plan). These plans are collectively called retirement plans and are tax favored because contributions to them are normally made on a "tax-free" basis (deductible for income tax purposes, with funds accumulated tax free) and with distributions made to plan participants usually at retirement or on separation from service. The distributions are taxed when received at ordinary income rates. Paying income taxes on taxable retirement plan required distributions under the complex rules of Code § 401(a)(9) is the price paid for getting "up front" favorable tax treatment. Other Code sections cover plans for nonprofit organization employees, plans for state and local governments, and so forth. Roth IRAs normally involve nondeductible contributions that are not taxed on distribution.
This article focuses on distributions made after a plan participant dies, and the estate planning steps to be taken before and after death to avoid paying estate and income taxes unnecessarily because the retirement plan beneficiary designation is inappropriate. The relatively simple step of naming a younger generation child or grandchild as beneficiary of a 401k or IRA plan that has been invested successfully can result in very significant after-tax benefits to the beneficiaries. This results from a "stretching out" of payments and tax liabilities (compared to other arrangements), especially when the beneficiary is a young adult. If the beneficiary is a minor, a trust should probably be used to avoid the need for the appointment of guardians, annual court accountings, and so forth.
The first step in planning for the disposition of retirement plan benefits is to determine exactly what those benefits are. How much will be received and by whom, when, and in what form? Will there be only a lump-sum payout or will payments be made over a period of years or some other period? These questions are normally answered by reviewing the "plan documents," which are legally binding and prescribed by the Employee Retirement Income Security Act of 1974, as amended (ERISA), the law generally governing the operation of tax-qualified retirement plans. The plan documents usually include a booklet or brochure (referred to as a summary plan description) that specifies when the employee will receive benefits, including his beneficiary in the event of the employee's death.
IRA plan documents (similar to the summary plan description) are issued by the IRA custodian and specify when the participant will receive benefits and what happens to the benefits when he or she dies. The estate planner cannot proceed without knowing what benefits will be paid and to whom on the death of the plan participant. As a general rule, retirement plans provide that benefits are payable on death to a spouse and/or children as contingent beneficiaries—individuals listed by the employee/plan participant on beneficiary designation forms furnished by the employer (plan administrator) or the IRA custodian. Although it is sometimes difficult to obtain copies of the clients' beneficiary designation forms or the plan documents (especially getting updated plan documents), they are necessary before doing anything further. Along with the documents, a statement of the value of the plan assets (benefit statement) will usually be available, and it should be reviewed, of course, to determine how much money is invested in the account and exactly what the title and nature of the account are—are we talking about retirement benefits or some form of joint account or annuity policies for which completely different rules may apply?
Usually, defined benefit plans provide that benefits will be paid to a corporate employee on retirement in the form of a joint and survivor annuity with a set amount of money paid to the retired participant and, on his or her death, 50% of that amount to the surviving spouse. Pre-retirement joint and survivor death benefits are usually provided as well. Shortly before retirement, the joint and survivor retirement benefit arrangements can often be changed by the employee based on various options allowed by the plan. Spousal consent forms may need to be filed in a timely fashion (during the period starting 180 days before the annuity commencement date) to provide for other types of spousal benefits (waiver of the joint and survivor annuity) as well as for the designation of nonspousal beneficiaries.
Defined contribution plans (the typical 401k plan) normally provide that contributions (usually a percentage of earnings with an employer match) are accumulated on a tax-free basis and received at retirement, termination of employment, or otherwise. Distributions made before age 59½ will, with some exceptions, subject the plan participant to penalties. Under Code § 401(a)(36), plan distributions can be made to employees who have attained age 62 even if they are still employed. IRAs are usually either plans that receive assets rolled over from 401k plans, called rollover IRAs, or they can be traditional IRA accounts to which qualified contributions have been made. IRAs are governed by the provisions of Code § 408. As a general rule, it is preferable to transfer funds from a company 401k plan to an individual rollover IRA (rather than to leave them with the company) when the participant is no longer an employee or has no ongoing relationship with the company. Management fees, outstanding plan loans, investment options and performance, the requirement in the case of non-IRA accounts for spousal consent, and other issues become important in making this decision.
Most estates are below the unified credit ($3.5 million for 2009) and therefore planning for federal estate taxes is usually not an issue. The more important planning issue is making sure retirement plan benefits are paid to the proper beneficiaries at the appropriate time and that income taxes are not overpaid as a result of making "inappropriate" beneficiary designations and distribution choices. The "typical" small estate could have jointly held real estate valued at perhaps $300,000, jointly held securities of a similar amount, and a 401k or IRA account in the wife or husband's name worth about $200,000. When substantial funds are held in a retirement plan account, it is important that the clients sign power of attorney forms accepted by the plan custodians that allow the attorney-in-fact to manage the account, including designating beneficiaries, should the plan owner become physically or mentally disabled. Normally, the spouse will be the designated (primary) beneficiary and the children contingent beneficiaries of the retirement plan. When the retirement plan owner dies, the jointly held property passes by operation of law to the spouse and the plan benefits go to the spouse if still living and, if not, to the children. The beneficiary designation could, if desired, indicate that the disposition to children will be divided into separate accounts (this can be done until December 31 of the year following death) for each child preferably on a per stirpes basis; some custodians will allow this per stirpes refinement but others will not. The 401k or IRA custodian will probably request that, after the clients die, the executor provide a list of the names of the children and possibly grandchildren, which the custodian can rely on to make payments without assuming personal liability for their identity.
The Designated Beneficiary
The estate planner should attempt to avoid designating the decedent's estate (or other nonperson entity) as a beneficiary. Doing so may trigger income tax under the five-year rule rather than minimizing or at least postponing payment of the taxes if the benefits are paid over a period of years (stretch out payments) to a "designated beneficiary." Generally, retirement plan benefits must be distributed over the life expectancy of the plan participant or the lives of the participant and his or her designated beneficiary, and this latter arrangement usually results in the best income tax deferral benefits. Normally, only a person and not a corporation, charity, or partnership can be considered a designated beneficiary. With a designated beneficiary, post-death benefits can be paid from a 401k or an IRA over the beneficiary's remaining life expectancy with certain adjustments made using prescribed life expectancy tables and benefit commencement dates as prescribed by Code § 401(a)(9). The "Single Life Expectancy Table" is used by beneficiaries. As will be discussed later, a "qualified trust" may also be a designated beneficiary using the "look-through" theory, which means that the life expectancy of the individual trust beneficiaries (usually the oldest one) is considered the life expectancy of the trust.
Therefore, for the small uncomplicated estate situation, getting the proper beneficiary designation of the retirement plan benefits that do not pass under the will but rather by operation of law is a must. This is not to say that an estate should never be designated as the beneficiary of plan benefits, but it is unusual to do so. Charities may be appropriate beneficiaries when, for instance, the clients are charitably inclined, and because qualified charities pay no income or estate tax, it may be preferable to leave the retirement plan benefits to them and the nonretirement plan property to individual beneficiaries.
Furthermore, the above discussion assumes that the plan allows for payments to beneficiaries over a period of years rather than in a lump sum. It also assumes that stretching out payments is desirable in the first place—keep in mind that in the smaller estate situation, the surviving spouse may need all of the assets to live on and may want to draw all of them out of the retirement plan immediately after the participant's death. Be sure that the plan allows this to be done especially if it appears that it will be necessary. The spouse should be advised that by taking a lump-sum payment rather than payments over a period of years, he or she will be liable for income tax on the amount as received.
More About Designated Beneficiaries
Several additional items should be mentioned regarding designated beneficiaries, or DBs, as they are sometimes called. A retirement plan beneficiary is a designated beneficiary determined as of September 30 of the year following the year of the participant's death. Therefore, the beneficiary can, in some cases, be changed after the participant's death if desired, for example, by the spouse or other primary beneficiary filing a qualified disclaimer and allowing the benefits to go to the contingent beneficiary. Also, certain designated beneficiaries receive special treatment depending on whether a surviving spouse is involved or another individual; for example, if a participant dies before his required beginning date, which is April 1 of the year following the year in which he or she reaches age 70½ and names a younger spouse as a beneficiary, the spouse does not have to begin receiving benefits from the plan until the point in time (December 31 of the year) in which the deceased spouse would have attained age 70½. If the designated beneficiary is a child, sibling, older spouse, or other individual, benefits must begin to be paid to the beneficiary by December 31 of the year after the participant's death. Finally, if there are no designated beneficiaries, the participant's remaining life expectancy or the five-year rule (for persons dying before age 70½) is used for measuring the minimum required distribution period.
The age 70½ date is important for other reasons especially for determining at which point in time the retirement plan participant must begin receiving minimum required distributions (MRDs) and is known as the "required beginning date" (RBD). The "Uniform Lifetime Table" is used by participants in calculating their MRDs. The "Joint and Survivor Life Expectancy Table" is used when the spouse is 10 years or more younger than the plan participant. There is a 50% penalty for failure to withdraw on a timely basis as well a 10% penalty on most premature (before age 59½) distributions. Qualified plan participants who are not 5% owners can defer receipt of MRDs until April 1 of the year following the calendar year in which they retire. Congress recently decided that because of economic conditions, participants are not required to take MRDs from 401k and IRAs in 2009.
For smaller uncomplicated estates without any estate tax issues, the goal in most cases is to make sure that (1) individuals rather than estates, partnerships, and similar entities are designated as plan beneficiaries, (2) the beneficiary designation forms are properly completed, received, and found acceptable by the plan administrator or custodian, and (3) careful consideration is given to the use of the rollover option discussed immediately below after the participant's death.
A rollover is a very important estate planning tool when retirement benefits are concerned. It may be used before or after a participant dies for an estate of any size. Instead of the surviving spouse receiving the participant's retirement benefits at death in lump-sum form or in a series of future payments, it may be preferable for the spouse (especially a younger one) to roll over the plan benefits (if permitted by the plan) into an IRA in the name of the spouse. Doing this can, in many cases, be much more beneficial than simply receiving benefits either outright or in a series of payments as a designated beneficiary. This is because the spouse can then defer distributions until his or her required beginning date, and, most importantly, the spouse's designated beneficiaries' life expectancies can be used to measure the payout period after the spouse dies resulting in a stretching out of payments and accompanying income tax liabilities over a 50-year period in many cases. Designated beneficiaries can designate other individuals to receive their benefits if they die prematurely. The spouse also can roll over the retirement plan funds into an IRA in the deceased spouse's name. This may be more advantageous when the participant is considerably younger than the designated beneficiary. Prescribed life expectancy tables (including joint and survivor tables) must be applied to measure the distribution period (how much must be distributed to the spouse or other beneficiaries each year). The rollover must be done within 60 days of the date of distribution, but in some cases a waiver of the requirement can be obtained.
Until recently, nonspousal beneficiaries could not roll over retirement benefits to their own IRA accounts. This is still true, except that under section 829 of the Pension Protection Act of 2006, Pub. L. No. 109-280, nonspousal beneficiaries can direct the transfer of the retirement plan assets directly (direct rollover) to an IRA held in the decedent's name for the benefit of the beneficiary. The inherited IRA account should be titled using the following type format: "Mary Jones, IRA deceased 3/1/09 FBO Tom Jones, beneficiary," with the funds paid out to the nonspousal beneficiary beginning before the end of the first year following the participant's death. Although the law has previously been that, on the death of the plan participant, nonspousal beneficiaries could receive benefits measured by their life expectancies, many plans did not allow a payout over a life expectancy period. Congress recently decided to require all plans, beginning in 2010, to allow nonspousal beneficiaries to receive benefits over their life expectancies.
Planning for a small estate seems easy enough, but smaller estates (and sometimes larger ones) often have complicating factors. These may include the desire of a couple, a surviving spouse, or an unmarried individual to provide for a mentally or physically impaired (or possibly financially irresponsible) child or grandchild after death—or perhaps they are concerned about the claims of divorced spouses of their children; in any event they do not want to leave their estates outright to their children or other beneficiaries. In this situation, they should fund the trust using nonretirement plan assets, but if none are available, they should then consider providing by beneficiary designation that the retirement funds will be paid, for example, to a trust such as a supplemental needs trust (a trust designed to facilitate the beneficiaries' ability to receive public assistance in the future). Trusts for minors may be used as well as those protecting against creditor claims when appropriate. Various estate planning questions arise at this point such as who, if anyone, will act as the trustee, how long will the trust last, how expensive will it be to manage (keep in mind that funds accumulated in trusts are subject to substantially higher than individual income tax rates), and so forth. Assuming these questions can be answered to the clients' satisfaction, the next step is to draft the appropriate trust language and to provide by plan beneficiary designation that the special needs or other trust is designated as beneficiary of the clients' retirement plan. This will become the "qualified trust" using the "look-through" theory mentioned earlier. What are the procedures to be followed?
Determine whether or not the retirement plan will allow a trustee of a special needs or other desired trust to be a designated beneficiary; if so, the "stretch-out payments" (that is, receiving the plan benefits over a period of years rather than in a lump-sum payment) can be paid to the trustee of the trust.
Make sure that certain compliance requirements are met such as that the trust is valid under state law, the beneficiaries (such as the "problem" child) can be identified in the trust agreement, the trust is irrevocable (testamentary trusts are acceptable) on or before the participant's date of death, and either a copy of the will or trust agreement, or a list of the trust beneficiaries and other information is supplied to the plan administrator or IRA custodian on or before October 31 of the year following the year of the participant's death. If the trust has multiple beneficiaries, the one with the shortest life expectancy is used for purposes of determining how long the payments can be stretched out under the minimum required distribution rules. All trust beneficiaries including contingent beneficiaries can be considered eligible designated beneficiaries, and if benefits arise from a defined benefit plan or a 401k plan (but not an IRA plan), spousal consent will probably be required to make the trust (rather than the spouse) the designated beneficiary.
Indicate on the beneficiary form that the trust is the beneficiary using words such as: "Primary beneficiary—trust for the benefit of Mary Smith u/w Tom Jones."
Provide for an appropriate contingent beneficiary.
The last and sometimes the most time-consuming step is to get the plan administrator or custodian to accept the trust beneficiary designation as written; when the funds in the account are large, it is usually easier.
If a trust is determined to be necessary or desirable as a recipient of retirement plan benefits, provide in your clients' wills (or living trust agreements as the case may be) that the residuary estate will be held in trust for the benefit of the disabled child (who will be treated as the designated beneficiary of the trust and his or her life expectancy will determine the minimum required distribution period) as you normally would, following a supplemental needs or other appropriate trust format. Make sure that there are no nondesignated beneficiaries including charities and other nonpersons as beneficiaries or remaindermen of the trust and authorize the trustee (not the income beneficiary) to withdraw all minimum required distributions and any other amounts from the plan that are deemed advisable. If possible, create separate trusts for each child rather than "pot trusts" benefiting the children as a group—in this way each child's trust will have the life expectancy of the particular child as its required distribution period.
If it is necessary or desirable to use retirement benefits to fund a supplemental needs, creditor protection, or other special trust arrangement and the plan allows the trust to be so designated, carefully complete the beneficiary designation form correctly and have it accepted by the plan custodian before death. Make sure that the will (or living trust agreement) and other documents are received by the plan administrator or custodian after the participant's death following the procedures mentioned above. Be careful that a nonperson is not named as a beneficiary of the trust (eliminating it by the use of a disclaimer or by reforming the will if possible) by September 30 of the year following death. Note that, although beneficiaries can be eliminated by that date, they cannot be added.
Part II of this article, which will appear in the September/October issue of Probate & Property , will discuss estate planning with retirement benefits in the context of larger estates in which the use of credit shelter and marital deduction trusts is desirable to reduce estate taxes.Return To Issue Index