Probate & Property Magazine
Trusteed IRAs as an Estate Planning Option for Retirement Plans
By Edwin P. Morrow III
Edwin P. Morrow III is a regional trust and estate consultant for Key Private Bank. Opinions expressed herein are those of the author and not Key Private Bank.
Experienced estate planning practitioners know that the “stretch” IRA promise is often deceptive without using a trust. Beneficiaries receiving retirement plan assets outright can and do withdraw more than the minimum required distribution (MRD), if not the entire amount. Trusts are necessary to keep larger funds in the family bloodline, ensure maximum income tax deferral, use generation-skipping leverage, and provide asset protection benefits to heirs.
The federal income tax rules, however, regarding such use are often unclear and, even when clear, can be problematic. See Keith A. Herman, Coordinating Retirement Accounts with Estate Planning 101 (What Every Estate Planner Needs to Know), Prob. & Prop. 52 (Jan./Feb. 2006), a great primer.
This article introduces an increasingly available option, the trusteed IRA, and compares it to the main trust architectures available for trusts receiving retirement benefits: creating a “conduit” trust or an “accumulation” trust (modeled after the two examples in Treas. Reg. § 1.401(a)(9)-5 A-7). Recall that the “conduit” trust example creates a seemingly simple safe harbor for qualifying as a “see-through” trust: if the trust mandates that the trustee pay any distributions from the IRA “immediately” to the designated beneficiary, only that beneficiary is considered for determining life expectancy. With a conduit trust, the remainder and contingent beneficiaries are irrelevant—even if it is a charity, estate, or other entity without a life expectancy. The “accumulation” trust example is murkier, but in theory the IRS allows a trust to “accumulate” IRA distributions in the trust. Absent conduit trust language, this is probably how any traditional long-term trust is drafted. These options will be compared and contrasted with the trusteed IRA.
What Is a “Trusteed” IRA?
Many people are unaware that there are two legal forms of individual retirement accounts (IRAs): a custodial IRA under Code § 408(h) or a trusteed IRA under Code § 408(a). Historically, most IRAs have been opened as custodial accounts. Under Code § 408, there is no income tax difference between the two forms of IRA. While an IRA owner is living, the minor state law differences in the form are unlikely ever to surface, because most litigation about IRAs pertains to the tax treatment rather than the form of the agreement.
With a more advanced IRA provider, however, there can be estate planning advantages to a trusteed IRA after the owner’s death, provided the IRA trustee is flexible and the owner and counsel opt for more robust beneficiary designation planning. A trusteed IRA can combine many of the estate and asset protection planning advantages of a trust while ensuring the simplicity, compliance, and income tax benefits of an ordinary IRA. In essence, an IRA owner can create a conduit trust without the complexities of a separate instrument.
How much flexibility is allowed depends on the IRA provider. Some companies have complicated forms with a few boxes to check for different options. Others may expect an attorney to draft an entire agreement from scratch. Still others strike a balance by having a simple beneficiary designation form with the two most commonly customized provisions left blank for client’s counsel to choose from additional options for flexibility.
An example may help. Jane Doe is retired and has a $1.5 million IRA. This is the bulk of her estate. She would like to leave half the IRA to her daughter and half to her son. Her daughter is nice enough, but on her fifth marriage. Her son is a bachelor and, although hard working, is also “hard living.” She moves her IRA to a trusteed IRA and elects to restrict the payout options to the beneficiary to no more than the required minimum distributions and limits the beneficiary’s ability to appoint at his or her death. The attorney then customizes these two most commonly addressed concerns—what additional distribution standards to use to give the trustee flexibility beyond this floor and what limited or general powers of appointment to allow the beneficiary. Thus, Jane provides for different distribution standards for each beneficiary, ensuring that improvident spending or spousal influence will not blow the “stretch” income tax deferral possibilities.
Payout options for a trusteed IRA can be customized in ways similar to a conduit trust, provided that the IRA rules are obeyed. The IRA trustee would rightly reject some customizations as inappropriate, such as provisions for an individual co-trustee or for investment in insurance or collectibles, which would disqualify the IRA. But the most common distribution provisions are probably acceptable: an owner can mandate that only the minimum required distributions (MRDs) be paid to a beneficiary until a certain age, after which the restrictions become more liberal, or that only the MRDs be paid out unless additional distributions are needed for emergencies or for “health, education, and support.” An owner also may limit the ability of a beneficiary to name another beneficiary or to define the class of permissible appointees; this keeps funds in the family.
Because the minimum required distributions of a trusteed IRA must be paid to the beneficiary after the death of the owner, the trusteed IRA essentially is a conduit trust without the separate entity. Complexity and uncertainty are avoided by using this structure as opposed to a separate trust (whether “conduit” or “accumulation”). The benefits can be divided into several categories: post-mortem tax and trust accounting, triggering IRD, post-mortem compliance titling and transfer, determining the measuring life expectancy for minimum required distributions, investment management and trustee fees, planning for different IRAs, GST planning, and prohibited transaction risk. Let us consider each of these.
Post-mortem Tax and Trust Accounting
A trusteed IRA provider sends one 1099-R to the beneficiary. This is much easier than even the simplest trust, which would have a Form 1041 and
Even conduit trusts appearing simple on the surface have unsettled issues. What does the IRS mean by “immediate” distribution (the language from the example in the Regulation) of IRA funds from the conduit trust? Is 60 days fast enough? 180 days? Within the year? Can a trustee wait until February of the following year and make the 65-day election? No one really knows.
And must the retirement plan distributions in a conduit trust be traced? Fiduciary income tax rules generally do not trace income. Yet the conduit trust example may be read to require this for purposes of the designated beneficiary safe harbor. Suppose that a trustee of a conduit trust receives $50,000 in income from non-IRA sources, then pays out $40,000 to a beneficiary, then later gets a $40,000 IRA distribution. Does the trustee have to follow the safe harbor strictly by immediately distributing the $40,000 IRA distribution, or is this requirement already satisfied? Does the character of the first $40,000 matter, such as whether it is ordinary income, qualified dividends, or tax-exempt interest?
If sloppy administration or misunderstanding leads to failed compliance with the conduit trust safe harbor, could the IRS argue that the trust never was a see-through trust, similar to the IRS’s successful attack on a mis-administered charitable remainder trust in Estate of Atkinson v. Commissioner, 115 T.C. 26, aff’d, 309 F.3d 1290 (11th Cir. 2002)? Many attorneys do not have ongoing contact with trustees after the initial administration of the estate, and many trustees and tax preparers do not have the faintest idea what exactly a conduit trust is. Although an Atkinson-type retroactive disqualification seems extreme, even a prospective disqualification as a see-through trust could be disastrous.
Another issue for conduit trusts is that, as trusts have become more sophisticated, many trust instruments have clauses that might interfere with payment of the IRA distributions contrary to the safe harbor. Provisions such as spendthrift clauses that cause a forfeiture of a beneficiary’s interest, hold-back clauses, lifetime powers of appointment, spray provisions, trust protector provisions, decanting provisions, in terrorem clauses, incentive/disincentive clauses, and the like may negatively affect qualification as a see-through trust.
Trusteed IRA beneficiaries may also be able to take advantage of charitable IRA rollovers that are currently allowed until the end of 2007. Code § 408(d)(8); Notice 2007-7, 2007-1 C.B. 395, A-37.
Leaving retirement plan assets to a separate trust that has a pecuniary share formula may inadvertently trigger the income built up in the IRA on funding a subtrust. To simplify the IRS position in CCM 200644020, funding a pecuniary obligation (say, the $2 million commonly found in married couple’s trusts) with a $1 million IRA could trigger up to $1 million of income in respect of a decedent (IRD). Most IRAs (with rare exceptions such as nondeductible IRAs that have basis or Roth IRAs) are 100% IRD, meaning that the beneficiaries are still liable for income tax on all the distributions when received. Triggering this income tax early through a poorly considered AB funding clause could be a disaster.
Post-mortem Compliance, Titling, and Transfers
A trustee must timely provide a copy of the trust instrument or qualifying documentation to the IRA custodian/trustee as a prerequisite for qualification as a see-through trust. With a trusteed IRA, the trustee already has the IRA trust document.
Every time the titling changes on an IRA, there are more opportunities for gaffes, not to mention opportunity for frustration with uncooperative IRA custodians. A nonprofessional trustee dealing with a high-volume discount IRA provider may very well mis-title such an account. Form outweighs good intentions. In PLR 200513032, a decedent left his IRA to his trust. The trustee (his child), with incompetent help from the investment firm, subsequently botched the titling. The IRS denied relief, and the entire income in the IRA was triggered. Trusteed IRAs avoid these tricky titling changes and in-kind transfers that can occur between the decedent and the master trust, subtrusts, and beneficiaries when a separate trust is named.
Determining the Measuring Life Expectancy for MRDs
Even when a trust qualifies as a see-through trust, it must use the life expectancy of the oldest beneficiary of the trust, unless the division is made at the level of the retirement plan/IRA beneficiary designation form. For example, if the trust splits into three shares for age 25-, 27-, and 35-year-old beneficiaries, the life expectancy of the 35-year-old may have to be used. If a 75-year-old had a 1% share, that beneficiary’s life expectancy may have to be used for the entire conduit trust. Treas. Reg. § 1.401(a)(9)-4, A-5(c). Because a trusteed IRA is effectively divided at the beneficiary designation form level, this should not be an issue for a trusteed IRA; it is more likely to use each individual’s life expectancy for the separate IRAs created after death.
There are still unanswered questions regarding a trust provision allowing payments for an estate’s debts, expenses, and taxes from the trust. This may not only jeopardize asset protection, but the fear in the income tax arena is that this effectively makes the estate a beneficiary of the IRA, thus disqualifying the trust as a designated beneficiary. Although the IRS has been liberal in several PLRs and there is yet no adverse case, it remains a danger that should be avoided by careful drafting. See, for example, PLR 200608032.
Qualifying a separate trust as an accumulation trust is especially dicey. Although many practitioners feel comfortable using accumulation trusts, in many instances they are relying on PLRs, which are not citable as precedent. Page 56 of Mr. Herman’s article warned: “Because of uncertainty in this area of the law, a private letter ruling should be obtained before naming such a trust [an accumulation trust] as a beneficiary.” ACTEC recently echoed similar fears in an October 23, 2007, letter to the IRS requesting a revenue ruling to clarify this issue (www.actec.org/public/Governmental_
Accumulation trust drafting typically entails restricting the use of general powers of appointment or broad limited powers of appointment that may bring unwanted beneficiaries into consideration under the designated beneficiary rules. This is especially problematic when there is a GST-exempt and non-GST-exempt split in which a general power of appointment would otherwise be desirable in the GST-non-exempt share.
Some argue that a “Delaware Tax Trap” provision could be inserted to permit the triggering of estate inclusion without violating the accumulation trust rules. Such a provision would allow a beneficiary to use a limited testamentary power of appointment to appoint to another trust that also would have a power of appointment effectively extending the time for vesting (perpetuities period). If so used, such an appointment would trigger estate inclusion and avoid GST under Code § 2041(a)(3). Because this power could be limited to apply only to those of similar or longer life expectancies, this appears to solve the “what if an older beneficiary, charity/estate can become a beneficiary?” problem. This may run afoul of Treas. Reg.
Caution also should be exercised before naming charities anywhere in accumulation trusts as potential beneficiaries. Unlike trusteed IRAs or conduit trusts that allow one to ignore contingent beneficiaries, naming a charity as beneficiary may disqualify an attempted accumulation trust from qualification as a designated beneficiary. Yet excluding charities as contingent beneficiaries runs counter to many people’s natural intent.
Professional Investment Management and Trustee Fees
Separate trusts risk double dipping for trustee and investment fees. For instance, a trust may pay load fees or wrap investment management fees of 1% or more, plus the trustee’s fee of 1% or more. A trusteed IRA would typically have one fee, which may halve the fees for a separate trust and IRA. Of course, do-it-yourself investors picking their own stocks, bonds, and no-load mutual funds may dislike the wrap-like investment management fee typically associated with trusteed IRAs. Although trusteed IRAs can use outside investment management like any directed or delegated trust (depending on the provider), it is generally more economical to combine the two duties.
A professional trustee also reduces the risk of embezzlement and avoids the risk of an individual trustee changing citizenship or residence to another country, thus causing the trust to be treated as a “foreign trust,” which could trigger additional compliance or income tax or subject the trust to taxation in the foreign country.
Planning for Differences Between Different Types of IRAs
Planning with significant Roth IRAs is easier with trusteed IRAs. There is always the danger that a trust has inappropriate provisions and administration for these two completely different tax animals. Having trusteed IRAs separate from the master trust makes it easier to use differing powers of appointment, GST, and discretionary distribution provisions.
Another issue is planning for nonspousal rollovers from qualified plans to inherited IRAs under the recent Pension Protection Act. Practitioners had hoped for corrective amendments to overturn the IRS’s stringent interpretation of Code § 402(c)(11) in Notice 2007-7, which allowed plan administrators to refuse to make the nonspousal rollovers authorized by the statute. Although it remains to be seen to what extent this will ultimately help taxpayers, the rollover potential paradoxically increases the potential liability for trusts that do not qualify as “see-through” trusts. This is because a 401(k) previously forced into a lump-sum distribution may now be eligible for decades of tax deferral.
Practitioners may wish to consider trust provisions to be triggered in one way if a retirement plan can be rolled over, but in another way if the plan does not so allow. For instance, may or must the trustee make the rollover, and is the new inherited IRA subject to a conduit provision? May or must the trustee roll out net unrealized appreciation (NUA) employer securities separately? What criteria should it use? If employer stock is rolled out in a lump sum, has the trust addressed what to do with this? One can imagine current beneficiaries and remaindermen at odds over the trustee’s choices. For instance, the conduit trust beneficiary may want a complete rollover to an IRA, while the remainder beneficiary wants a lump sum distribution.
Generation-Skipping Transfer Tax (GST) Planning
A trusteed IRA, by keeping the IRA assets separate, makes GST allocation easier. In small estates, a trusteed IRA will have GST allocated, but for larger estates it is usually more advantageous to have GST allocated to non-IRD, nonwasting assets. With the possible exception of Roth IRAs, GST is usually allocated to non-IRA assets. This becomes more complicated to accomplish with a trust holding IRA, Roth IRA, and non-IRA assets together, which may lead to wasted or inefficient use of the GST exemption.
Prohibited Transaction Risk
A trusteed IRA has less chance that prohibited transactionswilldisqualify the IRA and therefore trigger the income tax. This is a danger when a family member is a trustee and takes compensation for his or her services. Prohibited transaction rules enforced by the IRS and the Department of Labor are often confusing and unclear. Although there is no on-point case law and this issue appears well below the IRS radar screen, one author recently opined: “It is not certain if that [Code
Disadvantages of a Trusteed IRA vs. a Conduit or Accumulation Trust
A trusteed IRA cannot fit every situation. There are instances when a separate trust must still be named as beneficiary. Although the number of providers is increasing, only a handful of banks and trust companies currently provide trusteed IRAs, which generally have larger minimum account sizes (typically $500,000–$1 million, but often less if other non-IRA assets are managed). Even if a client wants to transfer accounts to a trusteed IRA and meets the minimum requirements, qualified plans generally cannot be rolled over while the participant is still employed (especially if the employee is under 59½). And although the latest bankruptcy act largely put IRAs on an equal footing with other retirement plans in bankruptcy, asset protection for IRAs in some states is more limited.
Purely discretionary trusts have superior asset protection to conduit trusts and trusteed IRAs with mandatory payouts. This makes the accumulation trust (assuming it is purely discretionary—most are probably not) ideal for extreme situations such as special needs trusts or trusts for beneficiaries with other special problems. Although “pay to or for the benefit of” language might give some flexibility to protect mandatory MRD payouts in a trusteed IRA or conduit trust, and most states still protect mandatory payment trusts from garnishment (see, e.g., Uniform Trust Code § 506), a purely discretionary trust still has the greatest flexibility.
In addition, conduit trusts and trusteed IRAs are not optimal users of GST and applicable exemption amounts. Because of mandatory payments, they “leak” out distributions that could be better leveraged if left in trust. Of course, retirement plan assets in general are not optimal for funding GST-exempt or bypass trusts, because even if funds are “accumulated,” they have built-in tax that depletes their value and they risk being taxed at the compressed trust income tax brackets.
Trusteed IRAs, conduit trusts, and accumulation trusts are not panaceas to the dilemma of estate planning for IRAs. None of these is appropriate for clients with smaller accounts. It is no longer uncommon, however, to see IRAs exceeding a million dollars that clients understandably want to integrate with the rest of their trust planning. Cookie cutter estate techniques can create disasters for large IRA planning.
Properly customized, trusteed IRAs offer a simpler compliance and administrative solution for the client, beneficiaries, and attorney. Until the IRS clarifies its position on accumulation trusts with more than private letter rulings, trusteed IRAs and conduit trusts will remain important options for the conservative client or practitioner.