Edward V. Atnally is a lawyer practicing in White Plains, New York, specializing in trusts and estates and employee benefits law.
In Part 1 of this article, which appeared in the July/August issue of Probate & Property , I discussed estate planning with retirement benefits from the point of view of smaller estates and those with complications arising from the need to provide for special needs trusts. Part 2 discusses 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.
These are estates in which the client's assets exceed $3.5 million (or even as little as $1 million or less in states that have "de-coupled"), in which estate tax liability becomes an important consideration, and in which it may be desirable to use a credit shelter trust to minimize estate taxes, if possible.
Assume that you have a couple with combined assets totaling $4 million, half of which consist of jointly held property and the other half IRA benefits, let us say in the husband's name. The husband could designate a credit shelter trust as beneficiary of the IRA, providing his wife with trust income for life, and whatever principal the "disinterested" trustee (or an "interested" one acting under a "benefit, comfort, maintenance and support" ascertainable standard) is willing to pay her. If all goes well, the result would be that on the husband's death the $2 million of jointly owned assets would pass to the wife by operation of law, but the retirement benefits would be held in the credit shelter trust for the wife's benefit, passing to the children on the wife's death hopefully free of estate tax. Without using a credit shelter trust and leaving the plan benefits directly to his wife, the total federal estate tax on the $4 million surviving wife's estate could amount to roughly $100,000 if both spouses die in 2009. For purposes of this discussion, the potential state estate taxes (which could amount to hundreds of thousands of additional dollars) in states that have "de-coupled" will be ignored.
Several important questions arise when retirement benefits are concerned before going further with the credit shelter trust. One of these is: might it not be better, despite the estate tax considerations, to designate the spouse as the primary beneficiary (with the children as contingent beneficiaries) of the retirement plan benefits and give the spouse control of the benefits rather than placing them in the hands of a trustee who might receive commissions, incur various administration expenses, legal fees, and so forth? In choosing the nontrust alternative, be sure that the retirement plan will allow the surviving spouse to withdraw the entire amount (despite the fact that substantial income taxes may be payable by the spouse) because the spouse may need the funds for emergencies and for other good reasons or may simply want to avoid the trust expenses and not care about estate taxes when he or she dies. A further stretching out of benefits can be achieved by designating the children or even grandchildren, instead of the spouse, as beneficiaries of the credit shelter trust.
On the other hand, many clients prefer having a credit shelter trust to save estate taxes when the survivor dies and because there are no other available assets, or for other good reasons, the couple must use retirement benefits.
When it is clear that a retirement plan funded credit shelter trust must be used, the steps to be followed are the four steps mentioned in Part 1 with certain caveats. In addition to the administration expenses and other problems of trusts generally, if the credit shelter trust is a pecuniary legacy formula trust and the trust is funded by in-kind distributions, the law requires that the distribution be treated as a sale for federal income tax purposes, which may result in immediate taxation of the retirement benefit. The benefit is considered to be income in respect of a decedent (IRD) with immediate taxation regardless of the fact that the plan distributions are made periodically over many years in the future. See CCM 20064420. The problem can be solved by making sure that a peculiar legacy formula is not used in the wills or, if it is, there is no distribution in-kind.
Another negative feature of using retirement plan assets to fund credit shelter trusts is that the mandatory distribution rules require that the retirement assets be taxed much more quickly than if the spouse or children were named as outright beneficiaries of the retirement plan. This is especially true if the spouse is younger and rolls over the funds on the death of the employee/participant to his or her own IRA account and designates the children as beneficiaries on his or her death.
The objective of the credit shelter trust, of course, is to have the property in the trust accumulate and grow substantially (something that may not be easy to do considering the income tax brackets applicable to trust accumulations) during the term of the trust and have these assets pass tax-free to the children on the death of the surviving spouse. The purpose of the marital trust (discussed in the next section) is to eliminate estate taxes when the first spouse dies and minimize them when the second spouse does. Using retirement plan assets to fund marital trusts could under some circumstances be preferable to using them to fund credit shelter trusts. If there are two such trusts, and there often are, the assets in the marital trust should be exhausted before those in the credit shelter trust.
Needless to say, there are many issues to consider before using a credit shelter trust when retirement plan benefits are part of the mix of assets, and often there has to be a "trade-off" between saving income or estate taxes. Calculations should be made considering both the estate and income tax consequences under various approaches with assumptions made for the assumed rate of return on the assets, projected life expectancies, and so forth. The ultimate question to be answered is whether saving estate taxes through the use of the credit shelter trust will be more beneficial financially than stretching out the payment of income taxes by a direct transfer to the spouse (especially a younger one) who can roll over (to his or her own IRA account), designating the children (or grandchildren) as beneficiaries on his or her death.
Another approach to consider in the factual situation mentioned above is to name the wife as the primary beneficiary and the credit shelter trust as the contingent beneficiary. The wife can then disclaim $500,000 of IRA assets (taking the remaining $1.5 million and rolling it into her own IRA account) during the "window period" and let the $500,000 portion of the retirement plan benefits fall into the credit shelter contingent trust. This will give the wife nine months after her husband's death to make the necessary calculations and decide if she prefers to put some or all of the retirement benefits in the credit shelter trust. If the husband dies first in the above scenario, there should be no federal estate tax when the wife dies because all that she will then own is the $2 million of real property that passes to her from her husband plus $1.5 million of assets in her IRA (equal to the $3.5 million exemption equivalent amount); however, if the wife dies first, the husband will have assets of about $4 million when he dies, thereby attracting the estate tax liabilities mentioned above unless he disclaims $500,000 of the jointly owned assets when the wife dies. Another estate planning approach to consider in this situation is to transfer all of the jointly held property into the wife's name (they each will now own $2 million of assets) with the credit shelter trust arrangement used in both wills.
Disclaimers are an excellent planning device and allow a surviving spouse to determine what, if any, amounts should be placed in the credit shelter trust versus what should go to him or her in the marital trust or outright, based on the facts as they exist after the first spouse's death. An older nonspouse primary beneficiary can disclaim all or so much of the retirement plan assets to a younger contingent beneficiary with distributions to be made over the contingent beneficiary's longer life expectancy. Of course, there is no guarantee that the surviving spouse or other primary beneficiary will exercise the disclaimer.
Whatever trust or nontrust arrangement is used, care must be taken in allocating estate taxes relating to the plan benefits to make it clear who will bear the burden of paying them. Normally, the plan beneficiary does not. In general, estate taxes should be charged to the nonretirement asset shares to avoid having the estate treated as a beneficiary for minimum required distribution purposes. If they must be used, do so before September 30 of the year after the year of the participant's death.
Credit shelter trusts can be funded with retirement benefits using the procedures and four steps mentioned in Part 1 of this article, but considerable care must be taken to avoid IRD problems. Federal and state estate and income tax consequences should be considered and compared with the benefits of a rollover by the spouse and other income tax saving devices including leaving the retirement benefits directly to the children.
The marital deduction is probably the most important estate planning tool available when there is a surviving spouse, whether or not retirement benefits are part of the estate assets. If the decedent is able to transfer assets to a spouse outright or with the proper trust arrangement at the time of his or her death, the property escapes estate tax until the spouse dies and most estate planning for larger estates is designed to use the unlimited marital deduction on the death of the first spouse. When retirement benefits are involved, the designation of the spouse as primary beneficiary of the plan benefits normally guarantees that the retirement benefits will pass to the spouse free of estate taxes on the participant's death. When a trust for the benefit of the spouse funded with retirement benefits (as contrasted with a direct transfer) is considered desirable, certain problems must be addressed to ensure that the marital deduction will be available and that the trust will be treated as a designated beneficiary for "stretch out" payment purposes. If possible, the spouse should receive the retirement plan benefits outright rather than in trust because the deferral period is longer, he or she can roll over (further extending the deferral period), and there is no need to worry about qualifying for the marital deduction. Many clients do not want the surviving spouse to have this absolute control over the assets of the first to die for various reasons, including a desire that their children not be excluded from inheritance if the surviving spouse remarries or because the spouse may need the protections of a trust, and for other good reasons. If there are sufficient nonretirement plan assets to fund the marital trust, use them, but, if not, the following discussion may be helpful.
Ignoring retirement benefits for the moment, any property passing to a trust for the benefit of the surviving spouse will be entitled to the marital deduction, provided the spouse has sufficient control of the assets to result in the spouse "owning" the property in the trust. For example, if the spouse receives all of the trust income and can terminate the trust at any time and remove the assets to himself or herself, the trust should qualify for the marital deduction. Another example is when the trust assets pass on death to the estate of the surviving spouse or one over which the surviving spouse has a general power of appointment exercisable during life or at death. A further important and frequently used trust arrangement is the qualified terminable interest trust (QTIP trust) designed to deprive the surviving spouse of the right to transfer the trust assets to anyone other than the other trust beneficiaries (usually children) at the time of the surviving spouse's death. With the proper elections (the QTIP election should be made for both the retirement plan assets as well as the trust assets) and various other provisions, such a trust holding retirement benefits can be entitled to receive marital deduction treatment. The principal barrier to obtaining the marital deduction when retirement benefits are held in a marital deduction trust is the failure in many cases of the surviving spouse to receive all of the trust income.
All QTIP trust income includes a requirement that if any unproductive trust property such as, perhaps, a closely held business or certain real estate is held in the marital trust, the spouse must be given a right to compel the sale of the property to produce the requisite trust income. How can you be sure that the spouse gets all the marital trust income when the trust is funded with retirement plan benefits? This is determined by applicable local law.
When it is clear that a marital trust will be used, follow the same procedures and four steps mentioned in Part 1, but be concerned about the language of the trust and the plan beneficiary designation to be sure that the spouse receives all the marital trust income.
The approved way to get all of the income generated by the retirement plan over to the spouse is to give the spouse the right to compel the trustee of the QTIP trust to withdraw, at least annually, from the retirement plan, an amount equal to all of the plan income (whether more or less than the MRD) for the year and distribute that and the QTIP trust ordinary income (or an acceptable unitrust amount—normally 3.5%) to the spouse. See Code § 2056(b)(7) and Rev. Rul. 2006-26. Also note that Treas. Reg. § 20.2056(b)-5(f)(1) refers to income including a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust and it must meet the requirements of Treas. Reg. § 1.643(b)(1). Successor beneficiaries are not considered in determining who are designated beneficiaries.
Using a conduit trust is another way to ensure that the marital deduction will be allowed (and the minimum required distributions will be made) for the retirement plan benefits received by the trust. This type of trust is authorized by Code § 2056(b)(5) and generally provides that all plan and IRA distributions paid to the trust are to be immediately distributed to the beneficiary and not accumulated for future distribution to the beneficiary. If they are in fact accumulated, the spouse is no longer considered the sole designated beneficiary, and the spouse and the beneficiaries are taken into account for purposes of determining the shortest life expectancy. There are advantages as well as certain disadvantages (requiring all income to be paid out, which the recipient may not want or need, thereby defeating the effectiveness of various trusts such as the supplemental needs trust) that should be considered in using conduit trusts.
Note also that, to be sure that the spouse receives all of the income of the QTIP trust in states that have adopted a 90% rule allocating 90% of retirement benefits distributions to principal and 10% to income, it may be necessary to include provisions overriding this default rule. See Rev. Rul. 2006-26 and the Uniform Principal and Income Act of 1997, § 409.
Planning for the Largest Estates
In the largest estates, especially those exceeding $5–10 million, consideration should be given, among other things, to the creation of a dynasty trust (in addition to the usual credit shelter, marital deduction, and other estate planning procedures). The purpose of the dynasty trust is to transfer assets (by inter vivos or testamentary trust) to descendants to be held in trust until such time as the rule against perpetuities requires (or a client desires) distribution of the trust assets. If all goes well, the trust assets pass to the intended descendants free of the estate and generation-skipping transfer taxes if the proper elections are made, and, if necessary, a division between taxable and nontaxable generation-skipping transfer tax trusts (using exclusion ratios of zero or one) is made.
The principal difficulty with using retirement benefits to fund dynasty trusts appears to be the possibility that dynasty trusts may not have beneficiaries whose identity can be established especially if the income beneficiaries are given powers of appointment that are often used to reduce generation-skipping transfer taxes. Some dynasty trust beneficiaries may be elderly such as the uncle mentioned in PLR 200228025, whose short life expectancy was used as a designated beneficiary. Of course, this shortens the time period for the payment of retirement benefit assets. PLR 200235038, which includes dynasty trust provisions acceptable to the IRS, should be reviewed in drafting dynasty trusts using retirement benefits.
Because retirement plan benefits usually represent a relatively small portion of the assets in the largest estates, they should not, as a general rule, be used to fund dynasty trusts.
The Best Approach
What is the best overall approach for obtaining the maximum estate and income tax benefits when retirement plans are held by your clients? Although everything depends on the facts and circumstances, the author would suggest that for smaller estates, it is better to leave the retirement benefits to the surviving spouse outright so that he or she can roll over the benefits to his or her own IRA and designate the children as beneficiaries when he or she dies. For larger estates the same rollover principle applies, but calculations must be made to determine the amount of the estate tax liabilities that may be incurred when the survivor dies. If the liabilities are sufficiently large, consider naming the spouse as beneficiary but designate the credit shelter trust as the contingent beneficiary; leave it up to the spouse to determine how much, if anything, to disclaim into the credit shelter trust. If trusts must be used for various reasons, including that the surviving spouse or other beneficiaries cannot be given control of the retirement plan assets, carefully draft the trust provisions, whether special needs, credit shelter, or marital trusts, to meet the various requirements and procedures for a "qualified trust" mentioned above, including those in steps 1–4, and explain the potential negatives as well as positives to the clients and hope for the best.
Estate planning with retirement benefits is a far from simple undertaking but the multiplicity of rules and regulations can be reduced, this author believes, to a few important general principles. If you do not need to use retirement benefits to fund various trust arrangements, do not do so but be sure that whatever beneficiary designations are used (trusts or otherwise) are carefully designed to avoid payment of unnecessary estate or income taxes. If you must use retirement benefits to fund various types of trusts because of your client's special requirements and there are no other assets to do so, be sure that the trust language and beneficiary designation is carefully drawn, that the plan administrator or fund custodian accepts the beneficiary designation form before the participant's death, and that the proper documents are submitted to the plan custodian in a timely fashion after the participant's death. Finally, consider carefully the benefits of spousal rollovers to achieve the maximum amount of income tax savings resulting from the "stretch-out" payments.
This article has reviewed a number of basic issues and should serve as a starting point for providing your clients with the type of advice they need to achieve their estate planning goals using retirement plan assets. Needless to say, many other topics have not been addressed, including such matters as nonqualified retirement plans, conversion of traditional to Roth IRAs, divorce, separation, and right of election issues, employer securities, and so forth, which are beyond the scope of this article.Return To Issue Index