IRA Beneficiary designations of trusts

IRA Beneficiary designations of trusts
April 26, 2017

presenters Kevin C. Findley, Esq. Taxation Law & Estate Planning
Vincent J. Oddo, Esq. Estate Planning & Probate

overview Our goal: How do beneficiary designations fit into the overall estate planning scheme? In general, our comments will apply to certain financial assets which are distributed on the death of the owner by a beneficiary designation Specifically, what are the considerations of designating a trust as an IRA beneficiary? How are financial assets subject to beneficiary designation disposed of at death? Intestate succession – No beneficiary designation and no estate planning Estate planning – Can coordinate with but not replace beneficiary designations Operation of law Account agreements, annuity contracts, and assets paid to a named beneficiary If no beneficiary then through a formal or informal probate process

Advantages and disadvantages of beneficiary designations
Many individuals neither understand nor appreciate how beneficiary designations complement an estate plan Often times, individuals assume that his or her will or trust will control over beneficiary designation Further, there is an inherent overemphasis on disposition of accounts with designated beneficiaries after death Discussions regarding beneficiary designations do not address administration during lifetime

Advantages and disadvantages of beneficiary designations (cont.)
After-tax investments (e.g. life insurance) Ability of successor trustee or agent under durable power of attorney to act May involve the appointment of a conservator Pre-tax assets (e.g. annuity contracts, IRAs, qualified and non-qualified retirement plans) Institutions are uncomfortable with these being held in a revocable living trust Possibility of triggering income tax consequences upon the death of the participant No longer a “grantor trust” Recognition of income operates as if it is distributed to another person Most pre-tax assets will be held in the name of an individual during his or her lifetime Distribution after death will depend upon the beneficiary designation Management during lifetime will involve an agent under a durable power of attorney or the appointment of a conservator

Relying on beneficiary designations in practice
Differences among certain pre-tax accounts Rules of controlling contracts will vary E.g., annuity contracts may not permit as much flexibility as an IRA IRA v. 401(k) Both are pre-tax accounts. Each are held in different custodial capacities, the rules can be different in terms of distributing those assets. For example, “qualified plans” (which include 401(k)’S) do not allow beneficiaries to “inherit” accounts within the plan. Also, tax rules for IRAs are under IRC § (k)s and other qualified plans subject to different tax rules. Non-qualified plans subject to separate tax rules (e.g. IRC § 457) Based upon experience, IRAs tend to have more flexibility with distributions options (i.e., who will succeed, ability to roll-over, etc.) After-tax accounts Life insurance benefits, brokerage accounts, and other investments acquired with after-tax dollars The focus of our inquiry pertains to traditional and Roth IRAs after death

Minimum distribution rules – IRA’S
Once the owner of an IRA dies, the account must make certain required distributions to the individual beneficiaries of the account. The most desirable form of post-death payout is annual installments over the life expectancy of the beneficiary, thus allowing the longest tax deferral and compound growth. This “stretch” payout is available only for benefits payable to a “designated beneficiary”. The IRS regulations allow a trust to qualify for this favorable form of payout if various requirements are met

Considerations in designating a trust as a beneficiary of an ira
Practical considerations of designating a trust Control and management of post-death IRA distributions to beneficiaries Some adult beneficiaries may not be in a prime position to manage this type of asset Minor children Without a beneficiary designation, a guardianship would have to be imposed Effective and efficient management Creditor/marital risk protection Spendthrifts with inexperience or poor judgment Preservation of large IRA to ensure stretch out Securing funds to pay for estate taxes Disadvantages Complexity of tax rules Cost of maintenance (i.e., annual tax returns, costs of administration, etc.) Income tax rates of trusts versus individuals To be discussed in further detail

Considerations in designating a trust as a beneficiary of an ira (cont
Considerations in designating a spouse A participant can obtain the most favorable income tax results by naming his or her spouse directly as the sole primary beneficiary. A surviving spouse is the only person who has the option of rolling over an inherited retirement account into his or her own IRA and treating the IRA as the spouse’s own. IRC § 408(d)(3)(C)(ii) By rolling over a traditional plan, the spouse can defer all distributions until he or she reaches age 70 ½ Once the spouse reaches age 70 ½, the spouse’s required minimum distributions are calculated using the Uniform Lifetime Table, leaving more in the plan for the spouse’s later needs or more for the plan owner’s children After the spouse’s death, the participant’s children can stretch out the balance of the IRA over their life expectancies. This puts the power of tax-deferred compounding to work for the children for a longer period. It also helps reduce the children’s income taxes by keeping the annual income generated by the required minimum distributions as low as possible There are some disadvantage to naming a spouse as a primary beneficiary Risk of disinheritance: the risk that the spouse rolls over and names someone other than the participant’s children as the new beneficiary of the plan (a concern with mixed families) Spend down risk: the risk that the spouse spends the plan on luxuries, leaving less (if anything) for the participant’s children to inherit

When weighing these considerations, it may be prudent to consider designating a participant’s trust as the beneficiary of these retirement accounts with a successor trustee other than spouse This could take a variety of forms: In trust for the spouse (whether conduit or accumulation); split between spouse and children in trust, etc. If someone other than the spouse is the beneficiary, the beneficiary’s required minimum distribution depends upon whether there is a designated beneficiary on the account Who is a “designated beneficiary”? [Treas. Reg. § 1.401(a)(9)-4] A designated beneficiary is an individual who is formally named as a beneficiary under the plan (which includes IRAs). Generally, only individuals may be designated as beneficiaries. But, there are special rules that apply to trusts If certain rules are met, the beneficiaries of the trust will be treated as having been designated as beneficiaries and for purposes of determining the distribution period

Generally, for purposes of stretching out an IRA, the designated beneficiary is limited to an individual But, trusts may maintain favorable “stretch IRA” treatment by “seeing through” the trust to the underlying beneficiaries Calculating the stretch depends upon which type of “see through trust” is used The type of “see through” trust affects the life expectancy used to determine the applicable distribution period for the stretch IRA If there is a designated beneficiary Participant dies before the “required beginning date” (April 1st after age 70½ ) The beneficiary’s required minimum distribution is based on an IRS table that takes into account the beneficiary’s life expectancy Participant dies after the “required beginning date” The beneficiary’s required minimum distribution is based on an IRS table that takes into account the longer of: The beneficiary’s life expectancy; or The participant’s life expectancy See Treas. Reg. § 1.401(a)(9)-9 for these tables

If there is no designated beneficiary (or estate or charity is named beneficiary) Participant dies before the required beginning date The beneficiary must withdraw all of the retirement account within 5 years of the participant’s death The beneficiary is not eligible to use the life-expectancy method to calculate post-death distributions Participant dies after the required beginning date The beneficiary’s required minimum distribution is based on an IRS table that takes into account the deceased participant’s life expectancy See Treas. Reg. § 1.401(a)(9)-5, A-5(a)(2)

Qualifying Trusts as Designated Beneficiaries A trust that qualifies as a designated beneficiary is often referred to as a “see through trust.” If a taxpayer names a see-through trust as the beneficiary, then the trust may make withdrawals from the account based on the life expectancy of the oldest beneficiary of the trust In this context, oldest beneficiary simply means the beneficiary with the shortest life expectancy But see, below, regarding multiple beneficiaries and separate shares Although the general rule is that a designated beneficiary must be an individual (IRC § 401(a)(9)(E), the regulations allow a participant to name a trust as a designated beneficiary for purposes of the minimum distribution rules. Treas. Reg. § 1.401(a)(9)-4, A-5(b), (1)-(4) contains the IRS’s four “minimum distribution trust rules” The trust must be valid under state law The trust is irrevocable or will, by its terms, become irrevocable upon the death of the participant The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the employee’s benefit must be identifiable from the trust instrument

Certain documentation must be provided to the plan administrator by October 31 of the year immediately following the year in which the participant died An inherent fifth rule: the beneficiary must be human Does the trust qualify as a designated beneficiary? If yes: If the participant dies leaving his retirement benefits to a trust that satisfies the requirements above, then for purposes of IRC § 401(a)(9), the beneficiaries of the trust and not the trust will be treated as having been designated as beneficiaries of the employee under the plan. Treas. Reg. § 1.401(a)(9)(4), a-(5)(A) If retirement benefits are left to a “see through trust”, the benefits can be distributed in annual installments over the life expectancy of the oldest trust beneficiary, just as if the benefits had been left to an individual human designated beneficiary. The life expectancy of the oldest trust beneficiary is used to determine required minimum distributions. Treas. Reg. § 1.401(A)(9)-5, Q&A 7(a)(1)

If no: If the trust does not qualify as a see-through trust under the rules, the retirement benefits must be distributed under the “no designated beneficiary” rules The distributions must occur under either the 5 year rule (see Treas. Reg. § 1.401(A)(9)-3, Q&A 4(a)(2)) or the life expectancy of the deceased IRA owner (see ibid) Types of See-Through Trusts Two Types Conduit Trusts A conduit trust requires that as each IRA distribution is received by the trust, the trust merely distributes the same to the current beneficiary The trustee of the conduit trust automatically withdraws and pays the required minimum distribution to the beneficiary of the trust until the plan is fully distributed

Since this type of trust merely distributes to the current beneficiary of the trust, remainder beneficiaries or potential appointees are not considered when considering (1) life expectancy and required minimum distributions, and (2) whether the beneficiaries are identifiable in satisfying the see-through trust rules. They are considered mere potential successors since nothing is being accumulated for their benefit See Example 2 of Treas. Reg. § 1.401(a)(9)-5, A-7(c)(3) Accumulation Trusts An accumulation trust allows the trustee to exercise discretion and accumulate IRA distributions within the trust Distributions from this trust are not automatic; instead, the trustee has the discretion to distribute some, all, or none of the required minimum distributions received from the plan each year. Anything not distributed is accumulated in trust for later distribution When considering life expectancy and required minimum distributions for an accumulation trust, the analysis becomes more involved

All potential beneficiaries must be taken into account since distributions may be accumulated in trust for multiple generations See PLR (July 12, 2002) This includes future and remote beneficiaries, including heirs at law under most default distribution provisions drafted into trusts This can be avoided by directly naming a subtrust as beneficiary of the benefits (as opposed to naming the funding trust) A person is removed as a beneficiary by the Beneficiary Finalization Date (Sept. 30th of the calendar year following death) Examples include: Distribution; Disclaimer; Termination of rights by operation of trust terms

Which type of see-through trust is more favorable? There are several situations in which an accumulation trust may be more appropriate than a conduit trust: Special Needs Trust Trust for a child in a high risk profession Trust for child with known substance abuse issues Marital and creditor protection Importance of the 2014 Supreme Court decision of Clark v. Rameker, 134 S.Ct. 2242, which unanimously held that non-spousal inherited IRAs are not “retirement funds” within the meaning of federal bankruptcy law. Thus, these inherited IRAs are available to satisfy creditors’ claims A “see-through” trust may provide creditor protection But, calculating life expectancy in determining required minimum distributions to the trust may be less favorable with accumulation trusts a. Conduit trusts are the “safe harbor” in this arena b. But, see below regarding multiple trust shares

Designating Trusts on Beneficiary Designation Forms Multiple Beneficiaries The Regulations provide that “the separate account rules under A-2 of section 1.401(a)(9)-8 are not available to beneficiaries of a trust with respect to the trust’s interest in the employee’s benefit” Simply put, separate account treatment is not available when a single trust is named as the beneficiary But separate account treatment is available when each of the separate trust shares created under the trust are directly named on the beneficiary designation form Where multiple beneficiaries exist under a trust and their interests are severable, it may be possible to divide the account into “separate accounts” payable to the different beneficiaries. Treas. Reg. § 1.401(a)(9)-8, A-3 The regulations provide that separate shares must be established no later than December 31st of the year following the year of death for purposes of determining the applicable distribution period. Treas. Reg. § 1.401(a)(9)-8, A-2(a)(2)

The use of separate shares allows the share beneficiary to calculate required minimum distributions based upon his or her own life expectancy It is best to directly name the separate trusts to be created, as opposed to naming the funding trust. If the funding trust is named, the age of the oldest beneficiary is used in determining the required minimum distributions Clean-Up Strategies To Ensure “See-Through” Status Problem: the trust is not valid under state law; the trust is not irrevocable (or will not become irrevocable upon the participant’s death) If the participant is still alive and qualification is desirable, consider having the participant amend his or her trust so it qualifies If the participant is deceased, consider disclaimers or reformation of trust According to numerous Private Letter Rulings, the IRS does not have a bright line rule with respect to whether it will bless post-mortem court actions that caused noncomplying trusts to be reformed, settled, divided into separate trusts, or otherwise re-engineered to comply with the “see-through” trust rules

Check the plan’s default beneficiary The default beneficiary may be the participant’s estate, and the plan may operate via a “pour over” will (assuming the “see-through” trust rules can be satisfied) Reformation of Defective Beneficiary Designation Form

TAX CONSIDERATIONS Trusts have a lower threshold with respect to reaching the highest income tax bracket when compared to individual taxpayers. A non-grantor trust is a separate taxpayer and pays tax on its taxable income at the rate prescribed for trusts and estates When retirement benefits are distributed after the participant’s death to a trust named as beneficiary, the distribution is includible in the trust’s gross income The threshold is much lower for trusts As of 2016, the highest federal income tax bracket of 39.6% is met at just over $12,400 of income Single filers do not hit the same top 39.6% federal income tax bracket until well over $400,000 of income (which is even higher for married couples filing joint returns) Trusts have different deduction rules than individuals This may allow trusts (e.g., an accumulation trust) to deduct certain expenses that a beneficiary may not be able to deduct

TAX CONSIDERATIONS (CONT.)
But, a trust is entitled to an income tax deduction for distributions it makes from the trust’s “distributable net income” (DNI) to individual trust beneficiaries, subject to various (and more complex) requirements If the trust’s income resulting from retirement plan distributions can be passed out to the individual beneficiaries of the trust as part of DNI, the income tax burden is shifted to the individual beneficiaries, and overall income taxes will be lowered if those beneficiaries are in a lower tax bracket than the trust But, the mere fact that a trustee receives a retirement plan distribution and later makes a distribution to a trust beneficiary does not automatically mean that the distribution to the beneficiary carries with it the gross income arising from the retirement plan distribution In order for the trust’s distribution of income in respect of a decedent (“IRD”) to carry out the income tax burden to the trust beneficiary as part of DNI, there are certain requirements that must be met These requirements include, but are not limited to, the following: The trust must authorize the distribution; Income must be required to be, or must actually be, distributed in the year received; Allocation of DNI when there are two or more beneficiaries with separate and independent shares will not carry out DNI to all shares if a distribution is made to only one beneficiary

TAX CONSIDERATIONS (CONT.)
Annual accountings, trustee fees, filing trust tax returns, as well as the complexity of administering a trust year after year, should also be considered before designating a trust as beneficiary A cost/benefit analysis of these costs and expenses becomes critical Are the protection benefits worth it? If the trust or trust share at issue is a special needs trust, these costs may be unavoidable

POTENTIAL PITFALLS Trust is eligible to disclaim the assets
If the trust is designated as the primary beneficiary but has the ability to disclaim assets, the contingent beneficiary usually inherits the assets and the provisions of the trust no longer apply The participant’s original intent in designating the trust is overridden To avoid this result, it may be prudent to include a provision in the trust requiring that in the event the trust disclaims the assets, the disclaimed assets must be disposed of according to certain provisions of the trust (instead of to an individual contingent beneficiary) Assume a participant designates his trust as the primary beneficiary. The trust qualifies as a “see-through” trust. At his death, the trust continues in trust for the benefit of his spouse, and at her death, continues in trust for the benefit of his son If the trustee disclaims the interest in the IRA on behalf of the wife, the contingent beneficiary would inherit the assets and the trust provisions would no longer apply Instead, supplementing the trust with additional protection may prevent this type of result Example: if the trustee of the trust share of Jane Doe created under this Trust disclaims an interest in the IRA of which I am the participant, then the disclaimed portion shall be paid to the trustee of the trust share of James Doe

POTENTIAL PITFALLS (CONT.)
An alternative option would be to name the trustee of Jane Doe’s share as the primary beneficiary with the trustee of James Doe’s share as the contingent beneficiary to ensure the same result (and avoid the involvement of trust interpretation after the participant’s death) Proper documentation is not provided by October 31 of the year following the year in which the participant died (Rule # 4) The IRA custodian is not involved during the beneficiary designation process to ensure the designation and relevant trust provisions comply with the IRA plan Potential for the trust to conflict with the IRA plan document

PROPOSED LEGISLATION The Senate Finance Committee recently proposed legislation eliminating the beneficial tax “stretch” and replacing it with a mandatory 5 year liquidation rule for non-spousal beneficiaries S. 3471—Retirement Enhancement and Savings Act of 2016 Under this proposed legislation, an inherited traditional IRA for non-spousal beneficiaries would have to be liquidated within 5 years of the original participant’s death, with some exceptions Not entirely bad news: the proposal includes a $450,000 exclusion It’s unclear whether retirement planning is a priority for the Trump administration

IRA Beneficiary designations of trusts

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