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Sebastian V. Grassi Jr. is a lawyer with Grassi & Toering, PLC, in Troy, Michigan. He is an ACTEC Fellow and a member of the Christian Legal Society. He is the father of an adult special needs child with cerebral palsy. Nancy H. Welber is an ACTEC Fellow in West Bloomfield, Michigan, and practices in the areas of retirement benefit planning, estate planning, and probate.
This is the second part of a two-part article on estate planning with defined contribution plans, which include profit-sharing plans (such as 401(k) plans), 403(b) tax-sheltered annuities, 457 plans, and IRAs in which, after the death of an account owner (and his or her spouse, who for purposes of this article is deemed to have predeceased the account owner), the beneficiary of the plan is the account owner's special needs child who is receiving (or otherwise eligible to receive) means-tested government benefits such as Supplemental Security Income (SSI) and Medicaid. See Sebastian V. Grassi Jr., Estate Planning for a Family with a Special Needs Child , Prob. & Prop. 14 (July/Aug. 2009). The article does not address defined benefit plans or other payouts from a retirement account in the form of an annuity, nor does it discuss nonqualified deferred compensation plans.
Part 1 of the article discussed retirement plan distribution rules and is relevant to all advisors who assist account owners or beneficiaries with retirement benefit plan distributions, especially when a trust is the beneficiary of the retirement account. See Sebastian V. Grassi Jr. & Nancy H. Welber, Estate Planning with Retirement Benefits for a Special Needs Child: Part 1—Understanding Retirement Plan Distribution Rules , Prob. & Prop . 28 (July/Aug. 2009).
Part 2 of the article discusses the types of trusts that can hold retirement benefits without jeopardizing a special needs child's receipt of means-tested government benefits. Both Parts 1 and 2 of the article should be read to understand the complexity and nuances of having retirement benefits payable to a trust for the benefit of a special needs child.
Note: In 2009, the Worker, Retiree, and Employer Recovery Act, H.R. 7327, Pub. L. No. 110-458, 122 Stat. 5092, added Code § 401(a)(9)(H), which placed a moratorium on certain required minimum distributions from qualified retirement plans, Code § 403(b) and Code § 457 plans, and IRAs during 2009. Because the moratorium applies only to 2009, the effects of the moratorium are not discussed in this article, except for Roth IRA conversions.
A conduit trust is a trust that requires the trustee to distribute to or for the benefit of the income beneficiary of the trust all of the retirement account distributions received by the trustee, in other words, all RMDs and any other withdrawals from the retirement account received by the trustee must flow free of trust to or for the benefit of the trust's income beneficiary and cannot be accumulated by the trustee. Treas. Reg. § 1.401(a)(9)-5, A-7(c)(3), ex. 2.
As its name implies, a conduit trust is a mere pass-through (or conduit) for the retirement account distributions. Because the conduit beneficiary can potentially receive the entire balance of the retirement account if the beneficiary lives to his or her full life expectancy, contingent trust beneficiaries, such as charities, the conduit beneficiary's spouse, siblings, issue, and appointees under a testamentary general or limited power of appointment held by the conduit beneficiary, and so on are "mere potential successors" and are not contingent beneficiaries under the Final Regulations, which are found at Treas. Reg. §§ 1.401(a)(9)-0, et seq.; Treas. Reg. § 1.401(a)(9)-5, A-7(c). Therefore, the mere potential successor beneficiaries do not have to be counted when determining which trust beneficiaries are "identifiable" (as of the account owner's date of death) and which trust beneficiaries are individuals. A trust that is not required to distribute all withdrawals from the retirement account to the beneficiary is known as an "accumulation trust," which is discussed below.
Although a nonmarital deduction conduit trust can be drafted to limit the trustee's withdrawals from the retirement account to the RMDs, if the trustee can withdraw more than the RMD, the "excess" retirement account distributions also must be distributed to or for the benefit of the conduit beneficiary. The conduit trust need require only the mandatory distribution/pass-through of the retirement account benefits payable or distributed to the trust. The trust income and principal from other trust assets can be accumulated or distributed as appropriate to meet the grantor's wishes. Likewise, the conduit beneficiary can have a testamentary general power of appointment or a testamentary limited power of appointment, or the default beneficiaries for the conduit trust can be individuals who are older than the conduit beneficiary or can be non-individuals, such as charities. Also, the IRS has ruled that the amount distributed to the conduit beneficiary can be net of proper trust administration expenses (as distinguished from the account owner's estate taxes and expenses of administration of the account owner's estate). PLR 200537044. Note that a conduit trust could be a sprinkle trust as long as the RMD and all other distributions from the retirement accounts payable to the conduit trust are distributed to one or more of the conduit beneficiaries each year.
Caution: A conduit trust is generally not appropriate for a special needs child who is receiving and is solely dependent on means-tested government benefits such as Supplemental Security Income (SSI) and Medicaid because the conduit income that must be paid out could cause the special needs child to lose his or her SSI and Medicaid benefits. Instead, an accumulation trust (discussed below) should be used for a special needs child. See Grassi, supra.
A conduit trust for a special needs child, however, may be appropriate in limited situations. For example, if a parent's third-party created and funded special needs trust has significant nonretirement assets (such as cash, marketable securities, or life insurance proceeds) available to the special needs child-beneficiary, a conduit trust for the benefit of the special needs child may be appropriate. In this situation there would need to be an understanding and agreement among the family, the trustee, and other advisors that the special needs child probably would not be eligible to receive means-tested government benefits as long as the funds in the conduit trust are "countable" (that is, disqualifying) assets for purposes of the special needs child qualifying for SSI and Medicaid. The conduit trust would be used to preserve the stretch-out of the retirement benefits over the special needs child-beneficiary's life expectancy, perhaps providing the special needs child-beneficiary with a better quality of life, while the parent's third-party created and funded special needs trust holding nonretirement assets can accumulate income and principal to provide a backup (financial) safety net for the special needs child if the conduit trust is eventually spent down. The conduit trust trustee should be given broad powers to invade the retirement accounts payable to the conduit trust to respond appropriately to the changing medical, social, and psychological needs of the special needs child-beneficiary. Likewise, the conduit trust trustee should be permitted to "spend down" the conduit trust assets (rather than continuing the stretch-out of the retirement assets) if the receipt of SSI and Medicaid would be of greater benefit to the special needs child-beneficiary. The combination of a conduit trust and a third-party created and funded special needs trust arrangement works particularly well if the special needs child-beneficiary is an only child and no other relatives are close in age to the special needs child. The conduit trust alleviates the concern that a much older relative of the account owner (or a charity named in the trust's failure of beneficiaries clause) will force an accelerated (for example, five-year rule) payout of the retirement benefits payable to the trust, as would be the case with an accumulation trust, because the special needs beneficiary's life expectancy will be used to determine the applicable distribution period in the conduit trust. It must be emphasized, however, that except for the wealthiest families for whom SSI and Medicaid will never be an issue for their special needs child, the conduit trust must be paired with a third-party created and funded special needs trust that will be used as a backup trust should the conduit trust's assets be depleted and the special needs child-beneficiary require SSI or Medicaid.
As its name implies, an accumulation trust is a trust in which the retirement benefits received by the trustee can be accumulated for future distribution to the current trust beneficiary and/or the remainder beneficiaries. Treas. Reg. § 1.401(a)(9)-5, A-7(c)(3), ex. 1. In an accumulation trust, the retirement account proceeds received by the trustee are not required to be immediately paid out to or for the benefit of the current trust beneficiary (as is the case in a conduit trust). Because the retirement account proceeds can be accumulated for future distribution by the trustee, the practitioner must continue looking through the trust document to determine which beneficiaries eventually will receive all of the retirement account proceeds outright and free of trust. Determining which beneficiaries will receive the retirement benefits outright and free of trust can be problematic if the trust is a long-term trust.
If the trust is a generation-skipping dynasty trust for the benefit of the account owner's issue, and the trust does not distribute the assets outright and free of trust to a beneficiary living at the death of the account owner (for example, the trust distributes outright and free of trust to unborn great-grandchildren) and the default (contingent) remainder beneficiaries are either a charity and/or the heirs-at-law of the account owner and the heirs-at-law of the account owner's spouse, the default (contingent) beneficiaries probably have to be included in determining whether the trust qualifies as a look-through trust and whether the default (contingent) remainder beneficiaries will be treated as designated beneficiaries (DB).
A charity named as a default (contingent) remainder beneficiary will cause the trust to fail as a look-through trust because the charity is not an individual (because the charity is an entity with a life expectancy of zero) and its (contingent) remainder interest cannot be eliminated (cashed out) by the beneficiary determination date (9/30/X2) unless the trustee can persuade the charity to disclaim its (contingent) remainder interest in the trust on a timely basis. See PLR 9820021. The account owner's heirs-at-law and his or her spouse's heirs-at-law, if they are identifiable at the time of the account owner's death, may be much older than the intended trust beneficiaries (the account owner's issue), causing a much faster payout of the retirement benefits than intended by the account owner. Moreover, in Michigan, under the Michigan Estates and Protected Individuals Code, Mich. Comp. Laws §§ 700.1104(n) and 700.2720, as under some state statutes, the state of Michigan is the final heir. And because the state of Michigan is an entity, it has a life expectancy of zero. In this situation, there would be no DB and the trust would not be a look-through trust. Careful drafting of the trust document can eliminate this problem by providing that retirement accounts may not be payable to charities or other non-individuals in the trust document, including states that name themselves as heirs in their statutes.
An accumulation trust is well suited to be the beneficiary of retirement benefits payable for the care of a special needs child, provided the accumulation trust is also drafted as a third-party created and funded special needs trust. See Grassi, supra. When using an accumulation trust, the trustee can be given absolute discretion to accumulate or distribute trust income or principal during the special needs child-beneficiary's lifetime, subject to any limitations necessary to allow the special needs child-beneficiary to qualify for means-tested government benefits.
Practice Point: When drafting an accumulation trust, the practitioner should name as the trust's remainder beneficiaries only individuals who are younger than (or close in age to) the primary trust beneficiary.
Caution: When drafting an accumulation trust, the practitioner must avoid naming a charity as a beneficiary or inserting a general power of appointment that can be exercised in favor of the beneficiary's estate or another entity. Likewise, a third-party created and funded special needs accumulation trust should never contain a general power of appointment (GPOA) exercisable by the special needs beneficiary, since a GPOA may result in the trust assets being deemed "available" and disqualify the beneficiary from receiving SSI and Medicaid benefits. The practitioner also should avoid granting any limited powers of appointment unless the potential appointees must be younger than the oldest beneficiary of the accumulation trust as of the date of the account owner's death.
If the accumulation trust is a wholly owned grantor trust for the current DB, the IRS should treat the retirement benefits payable to such a trust as being paid directly to the current DB, who would then be treated as the grantor of the trust for income tax purposes. Consequently, remainder beneficiaries and potential appointees under a testamentary power of appointment are disregarded. It is as if the wholly owned grantor accumulation trust were a conduit trust (even though it is not), and the only beneficiary of consequence is the current DB who is the grantor of the trust for income tax purposes. A wholly owned grantor accumulation trust is likely to occur in the following situations:
Practice Point: If the account owner's retirement plan benefits are payable to a statutory safe harbor first-party special needs trust, 42 U.S.C. § 1396p(d)(4)(A) requires that Medicaid be reimbursed on the death of the special needs child. In some states, Medicaid also must be reimbursed if the trust terminates during the lifetime of the special needs child.
Practice Point: The use of a statutory safe harbor first-party special needs trust provides an excellent postmortem planning device should a special needs child-beneficiary be named as the direct beneficiary of a retirement account. In PLR 200620025, a special needs beneficiary was allowed to transfer his interest in an IRA to a statutory safe harbor first-party special needs trust, which was a wholly owned grantor accumulation trust (with the special needs beneficiary being the grantor for both income and transfer tax purposes) without triggering any recognition of income tax under Code § 691. In addition, the special needs beneficiary was allowed to use his own life expectancy to determine the applicable distribution period even though the trust, by law, was required to reimburse Medicaid if any assets remained in the trust at the special needs beneficiary's death. The IRS representative at the 2008 ALI-ABA retirement benefits seminar indicated that the IRS will follow this letter ruling for taxpayers who are similarly situated but that the facts must be identical to those found in this private letter ruling.
It appears that the IRS has not directly addressed wholly owned grantor trusts in any PLRs other than PLRs 200826008, 200644022, and 200620025 .
Practice Point : Because of the dearth of PLRs in the context of wholly owned grantor trusts, it is recommended that a practitioner who desires to use the wholly owned grantor trust concept (to use the income beneficiary's life expectancy divisor to calculate the applicable distribution period) obtain a private letter ruling. The approval of wholly owned grantor trusts by the IRS in the three cited rulings seems to be directly linked to the very specific fact situation presented in each ruling. No inferences can be drawn from these rulings about a more general use of wholly owned grantor trusts as beneficiaries of retirement accounts.
A Roth IRA can be a useful vehicle for funding a third-party created and funded special needs accumulation trust. As a result of the account owner's death, the trustee of the Roth IRA special needs accumulation trust will be required to take minimum distributions each year from the Roth IRA. Except in a few circumstances, however, these distributions will be tax-free to the Roth IRA special needs accumulation trust. Moreover, during the account owner's lifetime the funds in the Roth IRA will accumulate income tax-free (in contrast to income tax-deferred for most other retirement accounts).
A Roth IRA payable to a special needs accumulation trust also can be useful if the remainder beneficiary of the Roth IRA special needs accumulation trust is someone much older than the special needs beneficiary or is a charity. The faster payout of the Roth IRA under these circumstances (because of the older remainder beneficiary or charity), although not ideal, at least will not cause a large diminution in the Roth IRA account value, because there will be no income tax liability (paid at a trust's compressed income tax rates) when the Roth account is liquidated by the trustee of the Roth IRA special needs accumulation trust. Of course, the potential for a tax-free build up and "stretch payout" of the Roth IRA will be lost, but it may be an acceptable trade-off if there are no "ideal" remainder beneficiaries of the Roth IRA special needs accumulation trust.
Roth IRAs may be especially attractive for grandparents in 2009 because of the moratorium on RMDs. If the grandparents' modified adjusted gross income is less than $100,000, they may be able to convert a traditional IRA to a Roth IRA at a relatively low tax cost. Because they will not be receiving RMDs for 2009, they may be in a much lower income tax bracket and may be willing to set up the Roth IRA naming a stand-alone third-party created and funded special needs trust that is an accumulation trust. Of course, the planner must be sure that the generation-skipping tax will not be an issue for that trust. Note also that older parents who are past their RBDs with an older special needs child also may find a Roth IRA conversion beneficial, without the concern of the generation-skipping transfer tax issues. But 2009 may be the year that a Roth IRA conversion will make sense for otherwise reluctant clients in any situation who are eligible for a Roth IRA conversion.
If a traditional IRA owner does not qualify for an IRA conversion in 2009, he or she need only wait until 2010 to take advantage of the special "sale" on Roth IRA conversions available only in 2010. Beginning in 2010, the $100,000 MAGI cap is scheduled to be lifted so all taxpayers will be eligible to convert IRAs and qualified plan monies to Roth IRAs. Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No. 109-222, § 512, 120 Stat. 345, amending Code § 408A(c). In addition, for conversions to Roth IRAs in 2010, the tax on the conversions can be spread over two years, 2011 and 2012. Given the current financial crisis in Washington, however, it remains to be seen whether Congress will keep this provision in place for 2010 or whether possible tax rate increases to high-income taxpayers will reduce the incentive to elect to spread the tax payment to 2011 and 2012.
Nevertheless, Roth IRAs are a planning tool that should be explored in each situation in which a special needs trust is indicated and retirement benefits are a part of the client's portfolio. Relieving the trustee of the burden of income tax issues that accompany traditional IRAs and most non-Roth qualified plan benefits allows the trustee to focus on using the resources of the special needs trust for the needs of the special needs child-beneficiary and not on the strategy for paying taxes.
It is difficult enough to master the area of the law in which estate planning and retirement planning intersect. It becomes especially challenging when a client has a child with special needs and SSI and Medicaid eligibility must also be taken into account, along with a host of considerations specific to the special needs child and his or her family. Therefore, it is important to understand the issues in all these areas of the law and to know when to seek the assistance of a practitioner who is knowledgeable about special needs law and retirement benefits law. Not to be aware of the problems when these various laws intersect can result in unnecessary taxes or a loss of the special needs child's government benefits, or both. To paraphrase Winston Churchill, special needs planning with retirement benefits is an enigma wrapped in a mystery, contained in a riddle. Therefore, much thought must go into "solving" the riddle when a special needs child is a beneficiary of a retirement account.