Estate Planning With Retirement Accounts
The Importance Of Implementing A Trust
Planning with retirement savings plans should preserve the beneficial income tax treatment for your beneficiaries. Family considerations, however, may require that those retirement accounts flow to a trust. The IRS imposes rules as to how such a trust must be designed for the income tax benefits to be preserved. A fundamental job of an estate and trust planning lawyer is to assist clients in coordinating the design of their wills and trusts with their retirement plans and IRAs.
Retirement Plan Basics
The policy behind the tax provisions governing defined contribution plans and IRAs was to encourage retirement savings. The main thrust of the federal tax provisions encouraged savings by allowing a tax deduction for the contributions into the plan. However, federal tax provisions also mandate an age when the participant has to begin taking funds out so that the plan does not become simply a way to accumulate wealth. Instead the plan creates a (taxable) stream of income during retirement. The point of the minimum distribution amounts are to deplete the savings account over someone’s life expectancy. At age 70 ½ the plan participants must begin withdrawing from the account based on actuarial calculations. As originally enacted, these plans could easily be rolled over to a spouse to provide for his or her retirement upon the death of the primary participant.
The rules governing the retirement savings plan going to non-spouses, however, seemed almost an afterthought of Congress. A trust is often the most effective way to ensure that your retirement account is handled according to your wishes after death if your estate planning does not involve a spousal rollover. “In many cases, a spousal rollover to a surviving spouse is almost a reflexive choice and, in fact, works well from an estate planning perspective. If there is no surviving spouse, or if the spouse is from a second marriage with children from the first, you should consider using a trust as the designated beneficiary. Unlike estate planning with other assets, the use of a trust at your death for retirement assets comes with important income tax considerations,” says David Sessions, a principal of the Maryland estates and trusts law firm of Franke, Sessions & Beckett, LLC.
What Happens to Retirement Accounts When the Owner Dies?
If there is no designated beneficiary to receive the account proceeds at the death of the plan participant, then the post-death distributions are withdrawn over a short period. This accelerated withdrawal period also applies if there is a defective beneficiary designation on the account—for example, if a trust is designated as a beneficiary, but the trust terms violate certain IRS rules (this is discussed below).
If a beneficiary was designated (typically on a form provided by the plan provider or custodian, which is governed by contract law), however, the rules are different. For IRAs, the rule is that a non-spouse beneficiary can elect to treat it as an inherited IRA and therefore take it out over the non-spouse beneficiary’s actuarial life expectancy. Since 2017, all 401(k)s have been treated the same as IRAs and, assuming a person was designated as a beneficiary, the plan was to be liquidated over that beneficiary’s life expectancy. Also, after leaving the company supporting the 401(k), the employee may roll over the plan to an IRA. Thrift Savings Plans (TSP) is the Federal government’s version of the 401(k) plan and can be rolled over to an IRA. Inherited IRA treatment is available to both 401(k) plans and TSPs.
When an IRA or other retirement plan is distributed to a beneficiary, all of the distribution is treated as ordinary income whether it is taken in smaller increments over the beneficiary’s life expectancy or whether it is taken out as a lump sum. Being able to stretch the payments over the beneficiary’s own life expectancy is a benefit, as the beneficiary is typically younger than the plan participant. The amount left in the inherited IRA continues to grow tax free. Additionally, unlike the original plan participant, an inherited IRA beneficiary can take out more than the minimum distribution amount without incurring a penalty (but, of course, must pay income tax on the distribution). Thus, inherited IRA status should be preserved to the extent possible in the estate planning.
Using Trusts As Designated Beneficiaries of Retirement Accounts
A trust can be designated as a beneficiary of an IRA, 401(k), or similar retirement plan. This is advantageous for several reasons. For example, a spendthrift clause can prevent the beneficiary’s creditors from attaching the inherited IRA. Although Maryland law provides inherited IRAs with this protection, the law of where the inheriting beneficiary lives will control, and many states do not have similar protection. So to lock in creditor protection, a Maryland spendthrift trust is worth considering.
Designating a trust as the beneficiary of a retirement account may cause complications. Given that the inherited IRA structure depends on a person with a life expectancy to be calculated, any trust that would be a designated beneficiary has to clearly identify a person as the ultimate beneficiary of that trust.
The “Problem” With A Single Pot Trust
If an IRA or other retirement savings plan is left to a “pot” trust (such as a single trust for the benefit of several children or to a spouse and children) those trust beneficiaries have different actuarial life expectancies. The IRS developed a rule that the life expectancy of the oldest beneficiary would dictate the rate of mandatory withdrawals. An alternative that makes this calculation easier and trust administration more workable is to have separate trusts for each beneficiary, which then would enable each beneficiary’s actuarial life expectancy to dictate the withdrawals. Although separate trusts for children may work well, using this technique instead of a pot trust for a second spouse and children from a prior marriage may defeat the estate planning goal. “The IRS rule using the oldest potential beneficiary to establish the mandatory withdrawals can complicate planning. What is important is that the client understand the income tax ramifications of the various estate planning options so to avoid any unintended consequences,” says Fred Franke, a principal of the Annapolis estates and trusts law firm of Franke, Sessions & Beckett, LLC.
“See-Through” Trusts In General
In determining whether a trust that has been designated as a beneficiary of a retirement account qualifies for the extended withdrawal period (as opposed to the shorter withdrawal period applicable when there is no individual designated as a beneficiary), the trust generally must qualify as a “see-through-trust” under applicable IRS guidance. With a “see-through trust”, the trust beneficiary is treated as if he or she had been designated as the designated beneficiary for the retirement account.
The most common see-through trust is the “conduit” trust. A conduit trust requires that all distributions from the retirement plan or IRA must be distributed by the trustee to the named beneficiary. If there is more than one beneficiary of a conduit trust, as in the case with a “pot trust” for several minor children, as mentioned, the default rule is that the oldest beneficiary is treated as the designated beneficiary. A way around using the oldest as the designated beneficiary is to create separate inherited IRA accounts (as opposed to separate trusts) corresponding to the individual trust beneficiaries. The rule is that the trust agreement and the designation in the IRA or retirement plan must create these separate shares.
Special Needs Trust Planning: The Accumulation Trust
One reason to not use a conduit trust is if you are designing a trust for a special needs child. The conduit process of paying the minimum distribution amount into the hands of the beneficiary or for the benefit of the beneficiary might disqualify that beneficiary from needs-based government assistance. In this situation, to comply with the IRS rules that require the IRA to be drawn down over a period determined by the beneficiary’s actuarial life expectancy, the trust terms must generally limit any successor beneficiaries to persons younger than the primary beneficiary. This type of trust is called an “accumulation trust.” The accumulation trust should not have a power of appointment that is either general in nature (which would effectively result in no designated beneficiary thus triggering an accelerated withdrawal period and negative tax consequences) or a broad special power of appointment that could result in an older individual being the measuring life. Any estate planning documents whether a will or a revocable trust should anticipate that a retirement plan or IRA might be put into a trust under certain circumstances. In that event, special provisions should be included to preserve the income tax planning.
“The difficulty in designing a discretionary special needs trust that will become the beneficiary of a retirement plan or IRA stems from the IRS requirement that there is an identifiable measuring life for calculating distributions. The whole point of the third-party SNT is that distributions to the beneficiary are wholly discretionary. Yet if possible, you want to avoid accelerating the income tax which requires that some person will receive distributions over their actuarial lifetime. One technique, depending on the family structure, is to lock in remainder beneficiaries roughly the same age as the primary beneficiary like siblings. The planning objective is to preserve the stretch-out while not disqualifying the primary beneficiary from needs-based public benefits. This requires thoughtful planning,” comments Jack Beckett, a principal of the Maryland estates and trusts law firm of Franke, Sessions & Beckett, LLC,
Retirement Accounts and Revocable Trusts
If a plan recipient or the owner of an IRA is using a revocable trust to manage the possibility of their own disability, it is important that the IRA or retirement plan not be transferred into the revocable trust. That would trigger an income tax based on the value of the entire account. Accordingly, there should be a power of attorney with authority for the agent to withdraw the minimum distribution amount and turn it over annually to the revocable trust. In certain circumstances, one might consider providing that the agent also have the ability to modify beneficiary designations within a pre-determined scope: for example, changing an outright beneficiary to a trust for the primary benefit of the outright beneficiary for his or her share. This would permit the agent under a power of attorney to direct one of the otherwise designated beneficiaries to a special needs trust if the occasion requires.
Contact a Maryland Trust Lawyer to Ensure That Your Retirement Accounts are Handled Properly
Given the popularity and number of IRAs, 401(k)s, and other qualified retirement savings plans, one would expect that planning with these types of accounts would be straight-forward. If trusts are needed to implement an estate plan involving qualified retirement plans, however, such planning becomes somewhat complex. Experienced estate and trust planning lawyers should be able to guide clients through the process of achieving the estate planning objectives without sacrificing the income tax advantages of inherited retirement plans.
The Maryland estate and trust attorneys at Franke, Sessions and Beckett LLC understand the complexity of various retirement plans and are prepared to guide you in planning to make sure that your retirement assets are coordinated with your wills and trusts. For over 35 years, the law firm of Franke, Sessions & Beckett, LLC has concentrated on the law of estates and trusts – including meeting the unique needs of clients with complex assets or family situations. All of our lawyers are involved in all three aspects of an estates and trusts practice: estate/trust planning; fiduciary litigation; and, estate/trust administration. Because “we do it all” within the niche of estates & trusts, we stay current and bring a wide understanding of the law of estates and trusts to our estate planning engagements. In order to schedule a consultation with an experienced Maryland estate and trust attorney, call 410-263-4876 to get in touch with our Annapolis office.