Estate Planning and IRAs: The Selection of a Traditional IRA Beneficiary

Transcription

1 Estate Planning and IRAs: The Selection of a Traditional IRA Beneficiary CPAs Attorneys Enrolled Agents Tax Professionals Professional Education Network TM

2 Contents 1 Introduction 1 Required Minimum Distributions 5 Designating the Beneficiary Key Considerations 6 Naming a Spouse as Beneficiary 7 Naming a Nonspouse Individual as Beneficiary 8 Naming a Charity as Beneficiary 9 Naming a Trust as Beneficiary 12 Conclusion 13 How Edward Jones Can Help 13 How Edward Jones Trust Company Can Help Building a Team of Professionals to Help Provide Solutions for Our Clients At Edward Jones, we believe that when it comes to financial matters, the value of professional advice cannot be overestimated. In fact, in most situations we recommend that clients assemble a team of professionals to provide guidance regarding their financial affairs: an attorney, a tax professional and a financial advisor. The legal, accounting and financial services industries are governed by constantly changing complex laws and regulations; by working together as a team, driven by similar philosophies and guiding principles, professionals in a variety of financial fields can use complementary knowledge and skills to assist mutual clients in planning for today s financial, tax, legal and estate-planning challenges.

3 Introduction As Individual Retirement Accounts (IRAs) have become an increasingly popular retirementplanning tool, and the value of assets in them has grown, it has become more important to understand their place in IRA owners estate plans. One of the most fundamental questions related to IRAs is whom the client will name as beneficiary. Unfortunately, this question is often not given the careful attention that it demands. The IRA beneficiary designation should be part of a comprehensive estate plan unique to each individual; no standard beneficiary designation can be advised for all clients. When determining the proper beneficiary designation, consideration must be given to the same issues addressed for all of a client s assets, such as planning for estate and income taxes, multiple marriages or special needs children. Additionally, consideration must be given to issues unique to IRAs, such as the required minimum distribution (RMD) rules. Clients must balance these sometimes competing interests when making their beneficiary selections. This brochure addresses many issues a client and his or her estate-planning professionals must consider when making a beneficiary decision for a traditional IRA administered under a standard traditional IRA agreement. (Although outside the scope of this brochure, a similar, thoughtful analysis should be employed for a client s Roth IRAs.) The brochure is not intended to be an exhaustive discussion of the issues but an overview of common issues that should be addressed. It begins with a short review of the RMD rules and continues with a discussion of common issues involved in selecting an IRA beneficiary. Emphasis is placed on stretchout opportunities to maximize beneficiaries continued tax deferral of an IRA. Required Minimum Distributions Earnings and previously deducted contributions inside a traditional IRA are not subject to income taxes until they are distributed. As the name implies, the RMD rules govern the minimum amount of distributions required annually from an IRA both before and after the client s death. The client, or the beneficiary after the client s death, always has the ability to take distributions larger than the RMD from an IRA, including a distribution of the entire account. However, because of the tax deferral benefits of IRAs, many clients and/or beneficiaries prefer the opportunity to take the smallest possible distributions and potentially allow the IRA to grow for as long as possible. The client needs to understand the RMD rules, which may influence how the client structures the beneficiary selection. The IRS issued proposed regulations in 2001 that greatly simplified the RMD rules. The final regulations were promulgated in April 2002 and amended in 2004, and they generally allow for smaller RMDs than the prior rules. A client must begin receiving distributions from his or her IRA no later than the required beginning date (RBD). The RBD is April 1 of the year following the year in which the client attains age 70½. Although the client has until the RBD to receive the first RMD, he or she must receive RMDs for each successive year by Dec. 31. The 1

4 RMD is calculated by dividing the client s account balance as of Dec. 31 of the prior year by a life expectancy factor, or applicable divisor, for the client. The applicable divisor can be found in tables published by the IRS. Most clients use the Uniform Lifetime Table. Another table, the Joint Life and Last Survivor Expectancy Table, is generally used for clients who have elected as the sole beneficiary a spouse who is more than 10 years younger than they are. Example Karl, a single client, attains age 70½ in His first RMD is for Karl s RBD is April 1, 2017; the 2016 RMD must be distributed by that date. The RMD is calculated by dividing the IRA value as of Dec. 31, 2015, by the applicable divisor found in the Uniform Lifetime Table. Karl s RMD for 2017 must be paid by Dec. 31, 2017, and is calculated using the IRA value as of Dec. 31, Clients should be aware of possible tax consequences resulting from bunching the first two RMDs in the same tax year. If the client in the above example waits until his RBD on April 1, 2017, to take his 2016 RMD, he will receive both the 2016 and the 2017 RMDs in the same tax year. The combined taxable income could potentially subject him to a higher marginal tax rate for the 2017 tax year. Under a recent rule change, a client may invest up to $125,000 in a Qualified Longevity Annuity Contract (QLAC) for his or her IRA. A QLAC is a deferred income annuity that must be converted to an immediate income annuity no later than age 85. The client s interest in a QLAC is not included in the account balance for RMD calculation purposes. QLACs are designed to provide RMD relief in early retirement coupled with steady income for life in later retirement. Following a client s death, his or her beneficiary s RMDs are based on the identity (spouse, nonspouse, trust, etc.) of the beneficiary; his, her or its qualification as a designated beneficiary ; and whether the client died before or after the RBD. Designated beneficiaries use the Single Life Expectancy Table to calculate RMDs, unless a spousal rollover option is selected, which would allow the spouse to defer distribution until he or she attains age 70½ and then calculate the RMDs using the Uniform Lifetime Table. Designated Beneficiary Designated beneficiaries can stretch out RMD payments, but only certain beneficiaries can qualify as designated. A designated beneficiary is an individual or a qualifying trust (generally a valid, irrevocable trust with only identifiable individuals as beneficiaries). The requirements of a qualifying trust can be complex and are discussed in more detail later in this brochure. An estate, nonqualifying trust or charity cannot be a designated beneficiary. Determination of the identity and designated beneficiary status of the beneficiary is not required to be finalized until Sept. 30 of the year following the year of the client s death (the designation date ). The period of time before the designation date may provide a valuable opportunity for postmortem planning by the beneficiary and his or her team of financial professionals. In situations with multiple beneficiaries, distributions may be used to satisfy or eliminate a certain beneficiary that cannot qualify as a designated beneficiary. This allows the remaining beneficiary or beneficiaries to qualify as a designated beneficiary and benefit from further deferral opportunities. Additionally, estate-planning techniques, such as a disclaimer, may be used during this time to provide a more tax-efficient distribution of the IRA. If a trust is named as beneficiary, this period may also provide an opportunity for the trustee to use distributions or estate-planning techniques allowing the trust to become a qualifying trust. 2

5 Death of a Client before RBD If a client dies prior to his or her RBD, and if the beneficiary is not a designated beneficiary, the balance of the IRA must be completely distributed before Dec. 31 of the year of the fifth anniversary of the client s death (the five-year rule ). If the beneficiary is a designated beneficiary, the balance of the IRA can also be distributed through RMDs, calculated using the life expectancy payout based on the age of the designated beneficiary. If a client has selected a nonspouse designated beneficiary, RMDs must begin by Dec. 31 of the year following the year of the client s death. If the designated beneficiary fails to receive his or her initial RMD by that time, the entire IRA balance must be distributed under the five-year rule. If the client has selected his or her spouse as the designated beneficiary, the spouse may choose to begin distributions from the IRA by Dec. 31 of the year following the year of the client s death, or to receive distributions under the five-year rule like any other designated beneficiary. The spouse may also choose to begin distributions by Dec. 31 of the year in which the client would have attained the age of 70½. If the spouse is the sole beneficiary, he or she may use the recalculation and fixed-term combination method when calculating RMDs. This method has the advantage of allowing recalculated payouts during the spouse s lifetime but fixed term payouts following his or her death. The spouse may also choose other options that are not available to nonspouse beneficiaries. If the spouse is the sole beneficiary, or under certain other circumstances, the spouse may elect to roll over the client s IRA to his or her own account, or he or she may elect to treat the client s IRA as his or her own. Example Nick names his daughter, Joan, as the beneficiary of his IRA before dying in 2016 at age 66. As an individual, Joan qualifies as a designated beneficiary. Joan may choose the five-year rule and receive a distribution of the entire IRA balance by Dec. 31, She may also choose the life expectancy payout by taking her first distribution by Dec. 31, The RMD is calculated by dividing the balance of the IRA as of Dec. 31, 2016, by the applicable divisor from the Single Life Expectancy Table for Joan s age. If Nick instead selects his wife, Katherine, as the sole designated beneficiary, Katherine can choose to begin distributions by Dec. 31, 2017, or receive distributions under the five-year rule like any other designated beneficiary. Katherine may also choose to begin distributions by Dec. 31 of the year in which Nick would have attained age 70½ (either 2019 or 2020, depending on Nick s birthdate). Katherine s RMDs may commence either by Dec. 31 following Nick s date of death or when Nick would have attained age 70½, and may be made over Katherine s recalculated single life expectancy. Katherine may also choose to roll over Nick s IRA to her own account or treat Nick s IRA as her own. With multiple beneficiaries, if any single beneficiary does not qualify as a designated beneficiary by the designation date, the IRA must be distributed under the five-year rule. If all of the beneficiaries qualify as designated beneficiaries as of the designation date, the RMDs must be calculated using the oldest designated beneficiary s life expectancy. If a qualifying trust is a designated beneficiary, the RMD must be calculated using the life expectancy of the oldest trust beneficiary. The section titled Separate Account Treatment for Multiple Designated Beneficiaries discusses possible postmortem planning opportunities under such circumstances. 3

6 Death of a Client on or after RBD If a client dies on or after his or her RBD, the RMD is calculated in the year of his or her death as it would have been had he or she not died. Any RMD not distributed before the client s death must be distributed to the beneficiary by Dec. 31 of that year. If the beneficiary is not a designated beneficiary, he or she may take a total distribution of the account or may take RMDs, using the Single Life Expectancy Table, over a period no longer than the client s remaining life expectancy in the year of the client s death, beginning Dec. 31 of the year following the year of the client s death. With a nonspouse designated beneficiary, all post-death RMDs must begin by Dec. 31 of the year following the year of the client s death. The designated beneficiary may choose to calculate the RMDs based on his or her life expectancy or on the client s remaining life expectancy in the year of death if the client was younger. A spouse who is the sole beneficiary may use the more advantageous recalculation and fixed-term combination method when calculating RMDs. The spouse also has the option to roll over the client s IRA or treat it as his or her own. If multiple beneficiaries are named, and one or more are not designated beneficiaries by the designation date, the client is treated as having no designated beneficiary, and the account must be distributed over a period no longer than the client s remaining life expectancy. If all of the beneficiaries qualify as designated beneficiaries, the RMDs may be calculated using the oldest beneficiary s life expectancy or the client s life expectancy, if the client was younger than the oldest beneficiary. If a qualifying trust is the designated beneficiary, the RMDs may be calculated using the life expectancy of the oldest trust beneficiary or the client s life expectancy, if the client was younger than the oldest trust beneficiary. Example Clara names her son, Juan, as the beneficiary of her IRA before dying in 2016 at age 75. She does not receive her RMD for 2016 prior to her death, so that distribution, calculated as if she were alive, must be made by Dec. 31, Juan must begin receiving RMDs by Dec. 31, Those RMDs are calculated by dividing the IRA balance as of Dec. 31, 2016, by the applicable divisor from the Single Life Expectancy Table for Juan s age. If Clara instead selects her husband, Miguel, as the sole designated beneficiary, he can choose to begin RMDs by Dec. 31 of the year following the year of Clara s death, just like any other designated beneficiary. However, he may also choose to receive RMDs over the longer of his own recalculated single life expectancy or Clara s unrecalculated single life expectancy. Miguel also has the option to roll over Clara s IRA to his own IRA or elect to treat Clara s IRA as his own. 4

7 Separate Account Treatment for Multiple Designated Beneficiaries Regardless of whether a client dies before or after his or her RBD, the RMDs are calculated using the life expectancy of the oldest beneficiary, if multiple designated beneficiaries are named. However, an opportunity exists for some beneficial postmortem planning by using the separate account rules. If separate accounts are created for the designated beneficiaries prior to Dec. 31 of the year following the year of the client s death, each designated beneficiary may calculate RMDs using his or her own life expectancy. In the case of a spouse beneficiary, he or she has all the same options for the new separate IRA as would apply if he or she were the sole beneficiary. Separate accounts may be created by segregating assets within a single decedent IRA or, more simply, by dividing the decedent IRA into a separate account for each beneficiary. The regulations provide that the separate account rules are available only if the investment gains and losses accruing after the date of death are allocated pro rata among the beneficiary shares. Therefore, a client and his or her financial professionals should calculate shares by using a percentage or fractional formula. Separate account treatment could be problematic if the shares are determined under a pecuniary formula and the beneficiary designation language does not specifically provide for pro rata allocations of investment gains and losses. The separate account rules are not available to the beneficiaries of a trust. For example, if a trust is named as beneficiary, and the trust agreement provides for distribution of the trust assets equally among three children, the IRA may be divided into a separate decedent IRA for the benefit of each child. However, the RMDs for all three decedent IRAs are calculated using the life expectancy of the oldest trust beneficiary, and the separate account rules cannot be used to allow each child to use his or her own life expectancy for the decedent IRA. Designating the Beneficiary Key Considerations Many clients believe that the selection of an IRA beneficiary is a simple matter of deciding who should receive the benefits of the IRA. However, that is only the first step in the selection process. The second step is to determine if any special estate-planning factors should be considered. For example, a client may have decided that his or her child should receive the benefits of the IRA, but may also have concerns regarding the child s ability to handle money. In such a case, the client may consider naming a trust as the IRA beneficiary as opposed to naming the child outright. This would enable the child to enjoy the benefits of the IRA but also allow the client to put restrictions on the benefits to ensure that the child does not mismanage the funds. In addition, an inherited IRA held by the child individually may not be protected from the child s creditors; holding the IRA in a trust may allow the assets to be protected from creditors and used for the child s benefit. Regarding these estate-planning issues, the client may want to consider naming a trust as a beneficiary if he or she answers yes to any of the following questions: Does the client have creditor protection concerns for any of the beneficiaries? Does the client have children from a prior marriage? Does the client have any special needs children? Is the IRA necessary to fund a credit shelter trust at the client s death? 5

8 The third step is to determine the consequences of the beneficiary designation on the RMD rules. For example, a client may prefer to name a marital trust as the beneficiary to ensure that children from a prior marriage have the possibility of receiving unused benefits upon the spouse s death. However, by naming a marital trust as the beneficiary, the client generally denies his or her spouse the opportunity to benefit from the spousal rollover rules. Other tax-planning factors to consider include the following: If the client desires a charity to benefit from the IRA, can it be done in a manner that allows for other beneficiaries to qualify as designated beneficiaries? If a trust is necessary for estate-planning concerns, can it be drafted as a qualifying trust? Estate- and tax-planning considerations should also be evaluated with regards to the size of an IRA relative to other client assets. For example, if a client is charitably inclined, it may be beneficial to name a charity as the beneficiary of a small IRA. This allows the charity to receive the IRA with no income tax consequences and allows the client s other beneficiaries to receive after-tax dollars from other assets. Another example can be illustrated in a second-marriage situation. If an IRA is smaller, it may be more beneficial to name the current spouse as the outright beneficiary, if enough other assets are available to eventually benefit children from a prior marriage through other estate-planning devices, such as a credit shelter trust and marital trust. Naming one s spouse as beneficiary allows the spouse to benefit from the variety of spousal options and has the advantage of simplicity; a professional does not need to be concerned with some of the complex rules associated with qualifying a trust as a designated beneficiary. However, the beneficiary designations in both examples may become less appropriate as the size of the IRA increases. Combinations of the various estate- and tax-planning factors are far too numerous for discussion here. The circumstances applicable to each client, as well as his or her desires, make each situation unique. Sometimes it may be possible to balance the various estate- and tax-planning considerations; at other times a client may have to decide among competing considerations. Naming a Spouse as Beneficiary For most married people, the spouse is usually the first choice as beneficiary. Although this is often the result of factors not involving estate planning or tax planning, such a choice has certain tax-planning advantages. A spouse, as an individual, qualifies as a designated beneficiary and has the opportunity to benefit from the continued tax-deferred growth of the account. If a client has selected his or her spouse as the designated beneficiary, the spouse may choose to begin distributions from the IRA by Dec. 31 of the year following the year of the client s death. If the spouse is the sole beneficiary, he or she may also take an RMD over his or her recalculated single life expectancy, beginning when the account owner would have turned age 70½, or Dec. 31 of the year after death. A spouse also has the ability to roll over the deceased client s IRA to the spouse s IRA with no immediate income tax consequences. There 6

9 are several advantages to a spousal rollover. First, the spouse can defer distributions from the IRA until he or she attains age 70½, as opposed to beginning distributions by the end of the year following the year of the client s death. Second, the surviving spouse s RMDs are calculated under the Uniform Lifetime Table, which provides for smaller distributions, as opposed to calculation under the surviving spouse s single life expectancy if distributions were taken from the decedent s IRA. Finally, the spouse can name his or her own beneficiary, allowing additional opportunity for tax-deferred growth and for the spouse to consider changed circumstances following the client s death. Following the surviving spouse s death, RMDs are calculated based on the life expectancy of the beneficiary, as opposed to distributions based on the remaining life expectancy of the surviving spouse. If a spouse is the sole beneficiary, he or she also has the opportunity to treat the IRA as his or her own, or to delay distributions until such time as the deceased client would have attained age 70½. Delaying distributions until the client would have turned 70½ may be a benefit when the client is younger than the beneficiary spouse. As discussed in more detail below, the client should review this designation and contingent beneficiaries if circumstances change, such as in the event of separation, divorce or special health concerns. Naming a Nonspouse Individual as Beneficiary As in the case of naming a spouse as beneficiary, naming a nonspouse individual as the beneficiary of an IRA is a simple form of beneficiary designation. As long as he or she is alive, an individual qualifies as a designated beneficiary, so he or she has the opportunity to benefit from continued tax-deferred growth within the account by receiving distributions over a life expectancy. Some financial professionals may prefer to name an individual as beneficiary because naming an individual, rather than a trust, often minimizes the potential for a client or professional to inadvertently cause the beneficiary to lose the tax-deferral opportunity. Although a trust may be drafted in such a manner as to qualify as a designated beneficiary, the likelihood of inadvertently losing the tax-deferral opportunity increases due to the complex rules for qualifying a trust as a designated beneficiary. The client should revisit this designation if the named individual develops health issues, and should plan for the possibility that the named individual beneficiary might predecease the client. The client should name a contingent beneficiary and review with his or her advisors the default beneficiaries that would receive the assets if an individual were deceased. These default beneficiaries are often determined by the plan documents. For example, a client might provide that the IRA is divided equally among his three surviving children. However, if a child predeceases the client, under the plan documents or applicable law, that child s share might pass to his or her descendants or to the other children of the client. 7

10 Naming a Charity as Beneficiary If a client is charitably inclined and has an IRA, he or she may want to consider naming a charity as the IRA beneficiary. If the charity is qualified as a tax-exempt entity under Internal Revenue Code (IRC) Section 501(c)(3), it can take an immediate distribution of the IRA balance without having to pay any income taxes. This may allow for a greater benefit to the client s intended recipients. Example A client dies in 2016 with $1 million in a regular brokerage account and $1 million in an IRA. The client wanted half of her assets to go to charity and the other half to go to her son. If she named a charity as the sole beneficiary of her IRA, and her son as the sole beneficiary of her brokerage account, each beneficiary receives $1 million in after-tax dollars. If she named the charity and her son as equal beneficiaries of both accounts, the charity receives $1 million, and her son receives $800,000 in after-tax dollars (assuming a 40% total income tax liability applied to the son s portion of the lump-sum IRA distribution). Unfortunately, circumstances are usually more complicated than this example. Often, the charity is one of several beneficiaries because the client s planning goals are more complex or the nature of the client s assets requires it. Under the multiple beneficiary rule, all beneficiaries of an IRA must be designated beneficiaries to allow for the life expectancy payout option. To ensure that the individual beneficiaries can benefit from this option, the client can establish a separate IRA during his or her lifetime for the amount desired to be distributed to charity. However, this is often not practical because the value of the IRA may change over time as investments increase in value and as RMDs are taken by the client, while the client may want a fixed amount, or an amount calculated under a predictable formula, to be distributed to the charity. For example, a client may wish to calculate charitable gifts based on his or her total assets. The client may wish to name a revocable trust as beneficiary of the IRA in order to gather all of those assets, including the IRA. The trustee can then make any adjustments and distributions from that trust. However, even if the terms of the trust specify that the trustee is to distribute IRA proceeds to a charity, it is uncertain whether the distribution would have the same tax advantages as an outright bequest to the charity. Although the term charity may initially evoke thoughts of large public charitable organizations, a charitable remainder trust (CRT) is also a tax-exempt entity under special provisions of the IRC. Depending on the client s goals, a CRT may be a useful estate-planning technique. The trustee of a CRT could take a complete distribution from an IRA without any immediate income tax consequences and then reinvest the proceeds for the benefit of an individual during his or her lifetime, with the remainder distributed to a charity. In addition to the IRA rules and regulations, professionals should be well acquainted with the rules and regulations governing CRTs, including the special four-tier accounting rules, before using this technique. Complications can arise when a charity is a potential beneficiary of any trust named as an IRA beneficiary, as discussed later in the brochure. In sum, if a charity is named as a potential beneficiary of a trust, the client may need to rely on postmortem planning to save the tax deferral for the other beneficiaries. The postmortem planning may involve distribution of the charity s complete share by the designation date or through the use of the separate account rules. 8

11 Naming a Trust as Beneficiary Many people have named their revocable trusts as the beneficiaries of their IRAs to allow for comprehensive administration of all assets upon their deaths. At first glance, this may seem like a good idea. However, a number of complications can arise by naming a trust as an IRA beneficiary. Consequently, unless a client has other estate-planning reasons, it may be more appropriate to name individuals directly. If other estate-planning reasons, such as a second marriage, a spendthrift child or a need to fund a credit shelter trust, warrant naming a trust as the beneficiary, the attorney handling the client s affairs should take care in drafting the trust. To ensure that a trust can take advantage of the benefits of continued income tax deferral inside the IRA, it must meet certain requirements. This allows the trustee to look through the trust as if the trust beneficiaries were named directly as the IRA beneficiaries for RMD purposes. The requirements are as follows: 1. The trust is a valid trust under state law, or would be but for the fact that there is no corpus. 2. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the participant. Generally, revocable living trusts become irrevocable upon the client s death, thereby satisfying this requirement. However, joint revocable trusts should be carefully reviewed by a professional to ensure that the joint revocable trust, or a trust established under that document, would meet this requirement. A testamentary trust also meets this requirement, despite the fact that it is not yet in existence at the time of the client s death. 3. The trust beneficiaries are identifiable from the trust document. The beneficiary does not need to be specified by name; the members of a class of beneficiaries capable of expansion or contraction are treated as being identifiable if it is possible to identify the class member with the shortest life expectancy. As discussed in more detail below, there is some uncertainty regarding the extent to which future beneficiaries would be considered a part of this group. If the trust is not drafted carefully, the group of beneficiaries might be indeterminate, and it might be impossible to determine the beneficiary with the shortest life expectancy, meaning the beneficiaries are not identifiable as required. 4. Certain trust documentation is provided to the plan administrator. A copy of the trust document, or a summary listing all beneficiaries, must be delivered to the IRA trustee or custodian by Oct. 31 of the year following the year of the client s death. 5. All beneficiaries of the trust are individuals. A trust with a charity or an estate as a beneficiary does not meet this requirement. The requirements above are often more complex than many clients or professionals may imagine. A professional should carefully review each provision of a trust document to ensure that it does not inadvertently fail to meet these requirements. The relevant question is who may potentially receive IRA distributions. Answering that question should include identifying those who may receive distributions immediately upon receipt from the IRA, as well as those who may eventually receive distributions accumulated inside the trust or the earnings generated from those accumulations. Consequently, a professional should review the remainder beneficiaries as well as current beneficiaries. Examples of common trust provisions that could cause problems include the following: A provision allowing for the payment of expenses or debts of the estate A power of appointment provision that includes a charity in the class of potential appointees A power of appointment provision that allows appointment to individuals older than the current beneficiaries 9

12 The first two provisions may allow for IRA proceeds to be distributed to an estate or a charity, while the third provision may make it impossible to identify the beneficiary of the trust with the shortest life expectancy, thereby disqualifying the trust as a designated beneficiary. To avoid such a problem, a professional may want to consider adding provisions to the trust that prohibit the use of IRA proceeds for the payment of estate expenses; prohibit the payment of such expenses after the designation date; limit the class of potential appointees under a power of appointment to individuals; and limit the class of potential appointees under a power of appointment to individuals with life expectancies that are longer than those of the current beneficiaries. The identity of the trust beneficiaries is also relevant for determining the life expectancy factor to be used by the trust. As discussed earlier, the life expectancy of the oldest trust beneficiary is used for the RMD rules applicable to the trust. Currently, regulations are somewhat unclear regarding who should be considered a beneficiary to determine the life expectancy factor. The regulations provide that a mere potential successor beneficiary should not be considered. That raises the question: Who is considered a mere potential successor beneficiary? For example, should contingent remainder beneficiaries be considered? To address this issue, the client s attorney should review the provisions of the trust regarding how much of the IRA is required to be distributed to current beneficiaries. The ability to accumulate assets of the IRA in trust for later beneficiaries may affect whether a future beneficiary is included in the group of beneficiaries for purposes of determining the tax treatment of the IRA. Example A grandmother, age 65, names her trust as the beneficiary of her IRA. Article II of her trust provides that upon her death, the trust assets are divided into three shares: one share for her son, age 40; one share for her grandson, age 10; and one share for her granddaughter, age 8. The share for her son is held in a separate trust to be administered under Article III of the trust. The share for her grandson is held in a separate trust to be administered under Article IV of the trust. The share for her granddaughter is held in a separate trust to be administered under Article V of the trust. Because the grandmother named her trust as the beneficiary of her IRA, for purposes of determining the applicable life expectancy of each trust for her son and grandchildren, the beneficiaries include the son. Even though the grandchildren are substantially younger than the son, each grandchild s trust must make determinations based on the life expectancy of the oldest beneficiary the son because the undivided trust itself was named as beneficiary of the IRA. This could result in a substantial loss of tax savings for the shares of the IRA held in the grandson s and granddaughter s trusts. As an alternative, the beneficiary designation of the IRA could provide that upon the grandmother s death, the IRA is divided into three shares: one for the son, to be distributed to her trustee and held under Article III of her trust agreement; one for the grandson, to be distributed to her trustee and held under Article IV of her trust agreement; and one for the granddaughter, to be distributed to her trustee and held under Article V of her trust agreement. Because each of these sub-trusts is named directly in the beneficiary designation, and because the beneficiaries of these sub-trusts are a subset of the beneficiaries of the entire trust, each trust may be able to take distributions based on the respective life expectancies of the son, grandson and granddaughter. However, as noted above, designating beneficiaries of an IRA is an important and technical exercise that can have substantial tax implications, and the client should consult with an advisor. 10

13 Trust Principal and Income Rules If a trust is to be named as beneficiary of an IRA, a professional should review the applicable principal and income rules to determine the manner in which RMDs will be treated under the trust accounting rules and ensure that they are consistent with the client s intentions regarding distributions. The principal and income rules may be expressly delineated in the trust agreement, or they may be referenced under applicable state statutes. It may be possible under the principal and income rules applicable to the trust for only a small portion of an RMD to be considered trust income for distribution to the income beneficiary. For example, under many state statutes, only 10% of a distribution from an IRA is considered income available for distribution to the income beneficiary. This result might run counter to many clients expectations, since most of the distribution from an IRA will be considered taxable income and subject to income tax. Distributing only 10% of an RMD may not provide the level of support the client intended. As noted in more detail below, such a limit on income might interfere with the ability of a trust to qualify for a marital or charitable deduction. Example A client creates an income-only trust for the benefit of a child because the client has concerns regarding the child s management of money. The bulk of the client s assets are held in an IRA naming the trust as beneficiary. After the client s death, the trust qualifies as a designated beneficiary and begins taking RMDs based on the child s life expectancy. Unfortunately, only 10% of each RMD is considered income and distributed to the child under applicable law an amount far below what the client had intended. Although the trustee could take distributions larger than the RMD, only 10% of such distributions would be distributable to the child. The remaining portion would be considered trust principal and retained in the trust. This would also have the disadvantage of realizing income tax liability earlier than necessary and trapping that income tax liability inside the trust at potentially higher rates due to the compressed tax brackets applicable to trusts. Of course, the outcome of the above example can be avoided by carefully reviewing the interaction of all trust provisions. A professional can modify the definition of trust income in a trust agreement or provide for discretionary principal distributions to a child. Again, each situation is unique, so the provisions of each trust agreement must be reviewed in light of the client s situation. Funding a Credit Shelter Trust In many instances, married clients hold the bulk of their net worth in IRAs, and it may be necessary to use a portion of their IRA assets to fund a credit shelter trust for estate tax planning. Although the use of IRA assets to fund credit shelter trusts should generally be avoided because they do not provide the most tax-efficient transfer of assets, the breakdown of a couple s assets may simply make it necessary. If this is the case, a professional should consider the use of a fractional marital formula to divide the account between the credit shelter trust and the marital trust (or outright distribution to a spouse). Credit Shelter Trust Funding with a Disclaimer A disclaimer can be an effective tool for postmortem planning. One common technique is to name a spouse as the primary beneficiary of an IRA and a credit shelter trust as the contingent beneficiary. The spouse, with assistance from a professional, can then disclaim the least amount necessary to fund the credit shelter trust in the most tax-efficient manner. This technique can 11

14 be especially advantageous if there is uncertainty regarding the future of the estate tax exemption amount. The disadvantage of this technique is the risk that the surviving spouse may not disclaim as the decedent intended, because he or she is unaware of the implications, unable to do so due to illness or unwilling to do so for other reasons. Consequently, in many situations, such as a client with second (or multiple) marriage concerns or a spendthrift spouse, a disclaimer probably should not be relied on to achieve the client s estate- and tax-planning goals. Marital Trusts If a client does not have any estate-planning concerns, such as children from a prior marriage or a spendthrift spouse, naming a spouse as beneficiary outright is probably preferable to naming a marital trust. Naming a spouse outright is a simpler approach that provides more options to the spouse and less chance to inadvertently lose qualification as a designated beneficiary. However, if estate-planning factors exist that merit naming a marital trust as beneficiary, a professional must ensure that the marital trust also complies with the requirements necessary to qualify for the marital deduction. Two types of trusts typically meet the requirements to qualify for the marital deduction: a general power of appointment marital trust and a qualified terminable interest property (QTIP) trust. Due to its ability to allow the grantor to control the disposition of the trust s assets following the death of the surviving spouse, the QTIP trust is often used in this context. Requirements for both types of marital trusts are found in IRC Section One requirement is that a surviving spouse must be entitled to all of the trust income during his or her lifetime. As noted above, a professional should carefully consider the interaction of this requirement with the RMD rules and the principal and income rules, so as not to interfere with any claim for a marital deduction. Conduit Trusts Many professionals consider a conduit trust to be a valuable estate-planning tool. A conduit trust is drafted specifically to receive RMDs and immediately distribute them to the trust beneficiary. By its design, a conduit trust avoids many of the potential obstacles inherent in other types of trusts. If clients wish to create a trust with multiple beneficiaries for the purpose of receiving the proceeds of their IRA, professionals may want to consider creating and naming multiple conduit trusts in order to receive similar treatment as individuals using the separate account rule. Careful document review is still required to ensure that a conduit trust meets all the necessary requirements of a qualified trust. Conclusion No standard IRA beneficiary designation can be advised for all clients. Rather, the IRA beneficiary designation should be part of a comprehensive estate plan, unique to each individual, that considers the client s estate-planning goals and the interaction of those goals with the rules and regulations governing IRAs. Professionals should carefully consider their clients estate plans in light of these sometimes complex rules and strive for an appropriate balance, if necessary, between competing estate- and tax-planning interests. 12

15 How Edward Jones Can Help Edward Jones is committed to a team approach when it comes to meeting client needs. Edward Jones financial advisors collaborate with our clients CPAs, attorneys and others to work toward a common objective: helping people preserve, manage and distribute their wealth while meeting their financial goals. Working in concert with tax and legal professionals, an Edward Jones financial advisor can help mutual clients develop retirement goals and implement strategies, using traditional IRAs and other investment options, to pursue those goals, as well as objectives such as preparing for the unexpected, planning legacies and paying for education. To learn more about how this team approach can help you serve your clients best interests, contact an Edward Jones financial advisor today. How Edward Jones Trust Company Can Help Since 1996, Edward Jones Trust Company has provided a truly unique combination of personal service and dedicated resources. Each account administered by Edward Jones Trust Company is overseen by an experienced team of trust and financial professionals. Edward Jones Trust Company serves as trustee, co-trustee or managing agent, supporting clients with: Professional asset management Income and expense assistance Fiduciary record keeping, accounting and tax reporting Administrative and distribution services Comprehensive principal and income statements Estate and trust settlement services About Wolters Kluwer: Wolters Kluwer Tax & Accounting is one of the world s leading providers of tax, accounting and audit information, solutions and services. Wolters Kluwer integrates deep local knowledge with leading workflow technology solutions to deliver insightful, industry-leading resources, as well as step-by-step guidance on a wide variety of tax and accounting issues. To learn more, please visit This publication is for educational and informational purposes only. It is not intended, and should not be construed, as a specific recommendation or legal, tax or investment advice. The information provided is for tax and legal professionals; it is not for use with the general public. Edward Jones, its financial advisors and its employees cannot provide tax or legal advice; before acting on any information herein, individuals should consult a qualified tax advisor or attorney regarding their circumstances. 13 CPA-2485E-A EXP 30 JUN 2018