Complex Planning with IRAs

Transcription

1 2013 Advanced Elder Law Review: November 5-6 Washington, DC Complex Planning with IRAs Materials Prepared by: Stephen C. Hartnett, J.D., LL.M. (in Taxation); Dennis Sandoval, CELA Updated and Presented by: November 6, 2013

2 Overview of Retirement Assets What are Retirement Assets? Individual Retirement Accounts (IRAs) SEP-IRAs / Simple Plans / Keoghs 403(b) Plan 457 Plan Qualified Plans Money Purchase Profit Sharing 401(k) Plan 2

3 Overview of Retirement Assets Income in Respect of a Decedent (IRD) No step-up in basis under IRC Taxed to beneficiary as ordinary income when distributed from a retirement plan. Most heavily taxed assets, with double or triple taxation possible: Income, Estate, GST. 3

4 Income Tax Objective: Defer Income Tax as Long as Possible The typical income tax objective with respect to retirement accounts is to defer and to reduce the amount of distributions as much as possible in order to generate investment income on the deferred income taxes. 4

5 Income Tax Objective: Defer Income Tax as Long as Possible (cont.) For example, if there is $100,000 in a traditional IRA, then if the entire account is liquidated in a single year there could be a combined federal and state income tax liability of $40,000 from the taxable distribution, leaving the individual with just $60,000 to invest after taxes. Had the distribution not been made, the $40,000 would remain in the IRA and would generate investment income for the IRA owner. 5

6 Income Tax Objective: Defer Income Taxes as Long as Possible (cont.) If, instead, the IRA Owner had a $100,000 Roth IRA, then a complete distribution would not trigger any income tax liability because distributions from Roth accounts are generally tax-exempt. Still, there is a significant cost of liquidating a Roth account. 6

7 Income Tax Objective: Defer Income Taxes as Long as Possible (cont.) Once the $100,000 leaves the Roth account, the investment income earned on the $100,000 is generally taxable whereas it would have been tax-exempt had it been earned in the Roth account. Thus, with either a traditional IRA or a Roth IRA, the income tax objective is to keep the balance at $100,000 inside the IRA and to avoid an early distribution. 7

8 Required Beginning Date For Account Owner A participant must begin taking Required Minimum Distributions (RMDs) from his retirement assets by his Required Beginning Date or RBD. The RBD is April 1 st of the calendar year AFTER the calendar year in which the participant reaches age 70½. 8

9 Required Beginning Date For Account Owner (cont.) There is an exception for QUALIFIED PLANS only if the participant is not retired at age 70½ and the participant is not a five percent or greater owner in the business in which he or she works, RBD can be postponed until April 1 st of the year after the participant actually retires. RMDs from an IRA cannot be postponed beyond age 70½, even if the participant is continuing to defer distributions from the qualified plan. 9

10 Roth IRAs Roth IRAs are exempt from mandatory lifetime distributions. Individuals who have a Roth 401(k) or Roth 403(b) account do not have this advantage, but they can easily obtain it by making a tax-free rollover of the account to a Roth IRA. 10

11 Required Beginning Date Bob is born on 6/30/1942. Bob turns 70 on 6/30/2012. Bob turns 70 ½ on 12/30/2012. Bob s RBD is 4/01/2013. Jane is born 7/1/1942. Jane turns 70 on 7/1/2012. Jane turns age 70 ½ on 1/1/2013. RBD is 4/1/

12 Required Lifetime Distributions After Age 70 ½ General Rules Unless you are married to someone who is more than ten years younger than you, there is one and only one- table of numbers that tells you the portion of your IRA, 403(b) plan or qualified retirement plan that must be distributed to you each year after you attain the age of 70 ½. 12

13 Required Lifetime Distributions After Age 70 ½ (cont.) The only exception to this table is if (1) you are married to a person who is more than ten years younger than you and (2) she or he is the only beneficiary on the account. In that case the required amounts are even less than the amounts shown in the table. To be exact, the required amounts are based on the actual joint life expectancy of you and your younger spouse. 13

14 Required Lifetime Distributions After Age 70 ½ (cont.) Two Simple Steps: Step 1: Find out the value of your investments in your retirement plan account on the last day of the preceding year. For example, on New Years Day look at the closing stock prices for December 31. Step 2: Multiply the value of your investments by the percentage in the table that is next to the age that you will be at the end of this year. This is the minimum amount that you must receive this year to avoid a 50% penalty. 14

15 Required Lifetime Distributions After Age 70 ½ (cont.) Example: Ann had $100,000 in her sole IRA at the beginning of the year. By the end of this year, she will be age 80. She must receive at least $5,350 during the year to avoid a 50% penalty (5.35% times $100,000). 15

16 Overview of Retirement Assets Age RM D Age Uniform Table RM D Age RM D Age RM D Age RM D

17 Overview of Retirement Assets Age s Selected Excerpt from Joint Table

18 Penalties Penalties 50% penalty for failure to take RMD. IRC % penalty for taking a distribution before age 59½. IRC 72 18

19 Exceptions to 10% Penalty Distributions due to death or disability; Distributions for payment of unreimbursed medical expenses that exceed 7.5% of AGI; Distributions for the payment of health insurance premiums for certain unemployed individuals; Distributions for the payment of qualified higher education expenses; Distributions payments; consisting of substantially equal periodic Distributions to a qualified first-time homebuyer; and Distributions due to an IRS levy on the IRA. If you do not meet one of the above exceptions, you can avoid paying the 10% penalty tax if you redeposit the early distribution amount within 60 days of the distribution. 19

20 Required Distributions After Death Terminology (cont.) Beneficiaries versus Designated Beneficiary ( DB ) A beneficiary is any person or entity that is entitled to receive benefits from a QRP or IRA account after the account owner s death. By comparison, a designated beneficiary is an individual who is entitled to the benefits of the IRA or QRP account upon the death of the employee/participant/ira owner (hereafter account owner ). Neither a charity nor the decedent s estate will qualify as a DB since neither has a life expectancy. If certain criteria are met, a trust may be the beneficiary of an IRA or QRP and distributions will be based on the beneficiaries of that trust (an eligible trust ). 20

21 Required Distributions After Death Terminology (cont.) Determination Date The date when the beneficiaries must be determined is September 30 of the calendar year that follows the calendar year of the account owner s death. Example: Sarah died on April 29, The determination date for her IRA and QRP accounts will be September 30, The minimum distributions will be computed based only on the beneficiaries who still have an interest on the determination date. If a beneficiary s interest is eliminated between the time that the account owner died and the determination date for example by a cash out or a disclaimer then that beneficiary will not have any impact on the required minimum distributions. 21

22 Distributions at Death For Spouse Spouse as Beneficiary Rollover Option Spouse must be sole beneficiary of IRA. No RMDs until age 70 ½. Use Uniform Table. Spouse can name new beneficiaries to take IRA at death. 22

23 Spousal Rollover In order for the spouse to rollover the inherited retirement assets, he or she must be the sole beneficiary of the retirement asset. So, if an IRA named a spouse and child as beneficiaries, spouse would only be the sole beneficiary of half of the IRA. Therefore, the spouse could rollover half of the IRA into an IRA in her name and child could take the other half as an inherited IRA. 23

24 Spousal Rollover (cont.) If the beneficiary of the retirement asset was a trust whose sole beneficiary was the spouse and where spouse is the trustee or has withdrawal power over the trust assets, then spouse could roll over the retirement assets to an IRA in her name. If however, the trust named spouse as income beneficiary and spouse and descendants as discretionary beneficiaries of principal for health, education, maintenance and support then spousal rollover would not be available. 24

25 Distributions at Death Spousal Inherited IRA Death Before RBD Surviving spouse can take distributions based on his or her life expectancy, but can delay taking distributions until the deceased spouse would have reached age 70 ½. Use Single Life Expectancy Table. Recalculate each year. 25

26 Distributions at Death (cont.) Spousal Inherited IRA Death After RBD Distributions based on the longer of spouse s or participant s life expectancy. Can delay taking distributions until the deceased spouse would have reached age 70 ½. Use Single Life Expectancy Table. If using spouse s life expectancy, recalculate each year. If using participant s life expectancy, then find age at date of death, then subtract one each year. 26

27 When Rollover is Not Recommended When spouse is younger than age 59 ½. Second Marriage. Estate Tax Planning. Creditor and Management Concerns. 27

28 Distributions at Death Inherited IRA (Beneficiary Other Than Spouse) Death Before RBD Option 1: Distributions based on beneficiary s life expectancy; Must take first distribution by December 31st of year after participant s death; Use Single Life Expectancy Table; Find age of beneficiary at date of death of the account owner, then subtract one each year, or Option 2 Five-Year Rule. 28

29 Distributions at Death (cont.) Inherited IRA (Beneficiary Other Than Spouse) Death After RBD Option 1: Distributions based on longer of beneficiary s life expectancy or the life expectancy of the participant as of the year of death; Must take first distribution by December 31st of year after participant s death; Use Single Life Expectancy Table, or Option 2 Five-Year Rule. 29

30 Calculating RMDs for a Beneficiary If the beneficiary is 58 when the participant dies, the factor to determine the beneficiary s RMD is 27. The following year, the beneficiary factor to calculate RMD is 26 (27-1). If the participant was 50 when he died, the beneficiary could use a factor of 34.2 (the participant s factor) for calculating RMDs. 30

31 Overview of Retirement Assets Single Life Expectancy Table for Inherited IRAs Age RMD Age RMD Age RMD Age RMD Age RMD

32 Overview of Retirement Assets Single Life Expectancy Table for Inherited IRAs Age RMD Age RMD Age RMD Age RMD Age RMD

33 Distributions at Death Proper Titling for Inherited IRA John Doe (Deceased) IRA fbo Mary Doe. John Doe (Deceased) IRA fbo Mary Doe, Trustee under the John Doe Trust dated January 1, John Doe (Deceased) IRA fbo Mary Doe, Trustee of the Jane Doe Trust created under the John Doe Trust dated January 1, NOT Mary Doe (unless rollover). 33

34 Distributions at Death No Designated Beneficiary Named? No beneficiary designated by participant Estate Charity Distributions at Death Non-Qualified Trust 34

35 No Designated Beneficiary Five year rule applies: Under the five year rule, the entire balance of the retirement plan must be distributed to the beneficiary no later than December 31 of the calendar year five years from the participant s death. Not required to make distributions equally over the five year period. 35

36 Reasons to Name a Trust as Beneficiary of Retirement Assets Protect Retirement Assets Minor beneficiaries Special needs beneficiaries Spendthrift beneficiaries Asset Protection Children from a Previous Marriage Under-funded Credit Shelter or Bypass Trust 36

37 Multiple Beneficiaries and the Separate Account Rule If you can divide each beneficiary s share into a separate account then each beneficiary can use own life expectancy. You must contact the custodian and physically divide the accounts. Must be completed by December 31 of the year following the participant s death. 37

38 Separate Account Rule and Trusts Note the separate account rule does NOT apply to multiple beneficiaries who take their interest through a trust. Several PLRs ruled that if a trust was to be divided into sub-trusts for each beneficiary after the settlor s death, every sub-trust must calculate RMDs based upon oldest beneficiary of the original trust. 38

39 IRA accounts and Trust Rules If you are an elder law attorney This entire discussion is about Required Minimum Distributions (RMDs). If you are a trust and estate lawyer, do not confuse taxable income to a trust or a beneficiary with income for SSI purposes. They are not the same. 39

40 DB and RMD Rules for Trusts First Step: If a participant names a qualified trust as the beneficiary of an eligible retirement plan, then the trust beneficiary will be treated as the beneficiary of the account for purposes of determining whether there is a designated beneficiary and who it is. Second Step: Once the trust qualifies as a qualified trust and a beneficiary is identified as a designated beneficiary, then you must determine the applicable measuring life. 40

41 Qualified Designated Beneficiary Trust To be a Qualified Trust - Trust must be is valid under state law. Trust must be irrevocable or becomes irrevocable by participant s date of death. All beneficiaries are identifiable under the terms of the trust. A copy of the trust document is provided to the plan administrator or IRA custodian by no later than October 31 of the calendar year after the death of the participant. 41

42 Deadlines Deadline for meeting requirement is October 31 st of the year following the plan participant s death. Deadline for providing plan documentation is September 30 th of the year following the plan participant s death. Documents required to be furnished: Either a copy of trust documents and all amendments, or A list of all trust beneficiaries, including contingent and remainder beneficiaries and a statement as to the circumstances under which they will take. 42

43 Conduit Trust With a conduit trust the trustee is required, by the terms of the trust, to pass all plan distributions to the individual trust beneficiary. The IRS considers the conduit beneficiary as the sole beneficiary of the trust. Remainder beneficiaries are disregarded for purposes of calculating RMDs even if remainder beneficiaries are not DBs. 43

44 Conduit Trust (cont.) Example: A creates a trust for the benefit of his wife. The terms of the trust provide that wife must receive all income. Trustee has discretion to distribute principal for wife s health, education and support. Upon wife s death all property passes to A s siblings. If a sibling predeceases then passes to charity. Since Conduit trust only look at wife s life expectancy to determine RMD s. Do not need to look at A s siblings or charity. 44

45 Accumulation Trust With an accumulation trust, the trustee has the discretion to distribute income and principal to the beneficiary. With an accumulation trust, must look at life expectancy of all remainder beneficiaries to determine measuring life for RMD purposes. A special needs, or a discretionary support trust would be examples of an accumulation trust. 45

46 Accumulation Trust Power to Appoint to Charity A creates a trust that provides discretionary income and principal to son B. Upon B s death, the remaining principal and income is paid to a class of beneficiaries consisting of B s issue and any charity as appointed by B in his will. Since B s power to appoint includes a power to appoint to a nonindividual, the trust would not have a DB for RMD purposes. If the terms of the trust did not provide a power of appointment to charity, then B s life expectancy would be used because all of B s issue must be younger in age. 46

47 Qualified Designated Beneficiary Trust Look through beneficiaries CAUTION: Atom Bomb Beneficiaries Solution Limit to younger beneficiaries for purposes of distributing retirement assets CAUTION: Powers of Appointment Solution Limit powers of appoint to younger beneficiaries for purposes of appointing retirement assets 47

48 Qualified Designated Beneficiary Trust (cont.) Look through beneficiaries. CAUTION: Using retirement assets to pay trustor s debts, estate taxes or administration expenses = paying to estate of the trustor, i.e., no designated beneficiary. Solution: Prohibit use of retirement assets to pay for debts, estate taxes or administration expenses, unless these payments can be made prior to September 30 of year after the trustor dies. 48

49 Calculating RMDs for an Accumulation Trust Father establishes a SNT for his special needs son A and designates the SNT as the primary beneficiary of his IRA. The father s IRA has a $1,000,000 balance at the time of his death. Upon A s death, the balance of the assets of the SNT go to A s siblings, B and C. A is 20, B is 40, and C is 45 at their father s death. In this case, the RMD rules require A, B, and C to be considered as beneficiaries. C s life expectancy is used to determine RMDs because C is the oldest. 49

50 Calculating RMDs for an Accumulation Trust (cont.) The factor for C at age 45 is Using a factor of 38.8 creates a RMD for the initial year of the trust of $25, ($1,000, ). If RMDs are based on A s life expectancy, a factor of 63 is used. A factor of 63 decreases RMDs to $15, ($1,000,000 63). By naming C as a remainder beneficiary, the RMD increased by $9,

51 Evaluating the Impact of RMDs If the beneficiary has considerable expenses and the trustee will use all RMDs to pay for the beneficiary s care or other needs, then an increase of RMDS is probably not significant. If beneficiary does not have significant expenses and RMDs will accumulate in trust, then trust will pay income tax on accumulated income. ). Although similar tax rates (15%, 25%, 28%, 33%, and 35%) apply to both individuals and trusts, the tax brackets for a trust are more compact than for an individual. In 2013, a trust with taxable income over $11,950 is taxed at a 39.6%-rate bracket. In contrast, an unmarried individual must have taxable income over $400,000 to reach the 39.6% rate bracket for 2013 (or taxable income of $450,000 for married individuals filing joint returns. Falling under the 5 year rule would be a costly mistake for most beneficiaries. 51

52 Options to Consider Drafting Charitable Remainder Trust Disclaimers Decanting 52 Reformation

53 Drafting When all of the beneficiaries of an accumulation trust are relatively close in age, RMDs will not be significantly impacted. Nonetheless, the attorney should understand that payments from the inherited IRA to a trust after the death of the account owner will be taxable income to the trust. If it is likely the trust will distribute all current income to or for the benefit of the trust beneficiary, then there will be minimal income tax consequence to the trust. If RMDs are significantly higher due to the ages of the remainder beneficiaries or a non-designated beneficiary is involved, the drafting attorney should consider dividing the trust into two separate subtrusts. 53

54 Charitable Remainder Trust Planning Another option that should be considered is a lump-sum distribution of all or a portion of a taxable retirement account to a charitable remainder trust (CRT) that may first benefit the surviving spouse, then other beneficiaries (such as children), and then a charity. The principal income tax advantage is that a CRT is a taxexempt trust, so there will be no income tax liability when it receives the income from the retirement plan account. 54

55 Charitable Remainder Trust Planning (cont.) The IRS addressed the issue on whether the terms of the CRT making distribution to another trust must be limited to a term of 20 years or the life of the beneficiary in Revenue Ruling Revenue Ruling provides that CRT distributions can be made to a second trust, for the life of an individual who is financially disabled under three situations. The ruling states that an individual shall be determined to be financially disabled if the individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment which can be expected to result in death, or which has lasted or can be expected to last for a continuance period of not less than 12 months. 55

56 Disclaimers of Retirement Benefits A disclaimer is the refusal to accept a gift or inheritance. Federal tax law recognizes that a person cannot be forced to accept a gift or inheritance. Therefore a disclaimer itself (provided it meets the requirements of 2518) is not treated as a taxable transfer. For tax purposes, the person making the disclaimer never accepted the property in the first place, he never owned it and therefore could not have given it away. For SSI/Medicaid purposes, a disclaimer will be treated as a transfer of assets. 56

57 Disclaimers of Retirement Benefits (cont.) Disclaimers of inherited retirement benefits can be very useful in post mortem planning even when dealing with special needs planning. However, the order of who disclaims and when will be critical. For example, you will create a period of ineligibility or be forced to create a first party pay-back trust if you named the beneficiary with a disability as your primary beneficiary and then disclaimed. Even if your contingent beneficiary was a special needs trust, a disclaimer by the disabled beneficiary to his or her special needs trust would create a period of ineligibility. 57

58 Disclaimers of Retirement Benefits (cont.) Conversely, a disclaimer is an effective means to eliminate an older beneficiary, power of appointment or charitable beneficiary that impacts RMDs for the special needs beneficiary. Acceptance of required minimum distributions ( RMDs ) by the primary beneficiary of retirement accounts following the participant s death prevents the beneficiary from disclaiming both the RMDs and the income attributable to the RMDs. However, the beneficiary may validly disclaim the balance of the retirement accounts. 58

59 Decanting Decanting may be an option to remove an older beneficiary or a nondesignated beneficiary provided the impermissible or problem beneficiaries are removed by the September 30 th deadline. Currently, there are no rulings by the IRS on whether decanting is an effective means to correct an existing trust with older or nondesignated beneficiaries. Additionally, it is unclear whether a state Medicaid office would take the position that a decanting of an existing third party SNT constitutes a transfer without consideration by the SNT beneficiary. 59

60 Reformation Private Letter Rulings have discussed a court s modification of a trust or beneficiary designation made by the settlor of a trust or the IRA owner with varying results, depending on the specific facts of the case. In PLR , the IRS refused to recognize a retroactive beneficiary designation made by the court when the decedent failed to name a contingent beneficiary (although there was no disagreement that the decedent intended to name one) after a new IRA custodian began administering the IRA. 60

61 Reformation (cont.) The same year as the surviving spouse died, the Trustees sought and obtained an order from the State Court modifying the trust to provide, among other things, that descendents of the decedent couple born before 1955, contingent beneficiaries, and charities could not be named as potential appointees of a beneficiary s lifetime power of appointment. 61

62 Reformation (cont.) The Trustees realized that there was a problem - the trust document clearly reflected the grantors intent that the trust qualify as a see-through trust, thus avoiding the requirement that distribution of an IRA must be made within five years and instead uses the life expectancy of the oldest beneficiary to calculate the required minimum distributions from the IRA. 62

63 Reformation (cont.) Despite the court order, the IRS refused to give effect to the retroactive reformation because charities were potential contingent beneficiaries of the trust and only individuals can be designated beneficiaries for the purpose of satisfying 401(a)(9). The IRS reasoned that generally, the reformation of a trust instrument is not effective to change the tax consequences of a completed transaction. 63

64 Some Benefits Cannot be Transferred Some benefits available through certain retirement systems cannot be assigned to a trust. These prohibitions are sometimes found in the public service sector for professionals including, but not limited to, firefighters, police officers, and EMTs. Consider, for example, the unpublished case of Saccone v. Board of Trustees of the Police and Firemen s Retirement System. Mr. Saccone was a retired firefighter; there were certain death benefits available to Mr. Saccone s wife and son, who was disabled. 64

65 NAELA 2013 Advanced Elder Law Review November 2013 Overview of IRA s and Retirement Plans Materials Prepared by: Stephen C. Hartnett, J.D., LL.M. (in Taxation) & Dennis Sandoval, CELA Updated and Presented by: Bradley Frigon, JD, LLM, CELA, CAP 1. Overview of Retirement Assets What are Retirement Assets? Individual Retirement Accounts SEP-IRAs Simple Plans Keoghs 403(b) Plan 457 Plan Qualified Plans o Money Purchase o Profit Sharing o 401(k) Plan Retirement Assets Are Income in Respect of a Decedent. Retirement Assets are income in respect of a decedent. 1 Income in respect of a decedent, or IRD, are all items of taxable income of a decedent that are not properly taxable to the decedent on his or her last or prior income tax returns. In addition to retirement assets, income in respect of a decedent can include compensation, bonuses, benefit plan distributions, partnership income, interest, dividends, annuities and installment obligations. IRD items are not entitled to a step-up in basis under IRC Therefore, IRD items are often the most heavily taxed assets in a decedent s estate, always subject to income tax and sometimes also subject to estate and generation-skipping transfer taxes as well. The income tax on IRD assets is paid by the beneficiary of the IRD asset. Where an estate is taxable, the recipient of IRD assets may be eligible for an offsetting IRD deduction for the federal estate taxes attributable to the IRD. 2 The deduction is taken as a Schedule A itemization in an amount equal to the percentage of the IRD being brought into taxable income in any given year (i.e., if 50% of IRD assets are distributed in the current year and subject to income taxation, then 50% of the allowable IRD deduction can be taken in the current year, with the balance carried forward to future years when additional IRD assets are distributed). The amount of the IRD deduction is calculated by determining the federal estate tax of the 1 IRC 691(a). 2 IRC 691(c) Stephen C. Hartnett 1

66 decedent with IRD assets included and with IRD assets excluded. The IRD deduction is the difference between the two. 3 For example, an unmarried participant dies in 2013 with an IRA of $350,000, plus $5,600,000 in other assets. The participant s total federal and state estate tax is approximately $122,500. The entire estate tax is attributable to the IRA account because, if that account were not included in the participant s gross estate, there would be no estate tax. (The entire estate tax would have been absorbed by the available applicable credit amount.) When the IRA account is distributed to the participant s beneficiaries, all amounts distributed are included in the gross income of the beneficiaries. Taking into account the special deduction allowed under IRC 691(c), and assuming the participant s beneficiaries have an average rate of income tax of 25%, the total income tax on the date of death IRA plan balance will be $48,125. This is calculated as follows: IRC 691 income: $350,000 Less IRC 691(c) deduction: $122,500 Taxable amount: $227,500 25% tax: $56,875 The total effective rate of tax (both income and estate) on the IRA account after the IRC 691(c) deduction is 60%. In the real world, the $691(c) deduction can be very complicated to calculate. A decedent s estate will have many different items of IRD, including accrued interest and dividends paid after the date of death. Additionally, IRD is often received over a period of years and not all at once. The deduction is often overlooked by the accountant unless the attorney administering the estate alerts the beneficiaries to the deduction. Remember, the IRC 691(c) deduction is not available if the IRD is not subject to estate tax. Options for Distributions from Retirement Plans There are a variety of distribution options available for qualified plans (although the participant s spouse will generally need to consent to the option chosen, as described more thoroughly below). The most common options are: Joint and Survivor Annuity This option provides for a monthly annuity to the participant for life. Upon the participant s death, a percentage of the initial annuity amount (up to the whole thereof, but usually 50%) is paid to the participant s spouse for his or her life, assuming the spouse survives the participant. 3 Treas. Reg (c)-1(a) Stephen C. Hartnett 2

67 Single Life Annuity This option provides for an annuity payment to be made only for the life of the participant. Because the payments are made for only one life expectancy, they are greater than the amount paid under a joint and survivor annuity option. Oftentimes, financial planners will recommend choosing the option and using a portion of the greater cash flow to pay the premiums on a life insurance policy, annuity or long term care policy on the participant. Of course, the effectiveness of this strategy depends on the age and health of the participant, and well as the performance of the annuity or life insurance policy selected. Period Certain or Term Certain Annuity When this option is selected, an annuity payment is made for a specified number of years regardless of whether the participant is alive or not. If the participant dies before the period expires, then the annuity payments continue to be made to the remainder beneficiary. If the participant outlives the period certain, then he or she will be without a retirement income for the balance of her life. Lump Sum Under this option, the distribution is made in a single sum. The Retirement Equity Act, or REA, requires that distributions from a qualified plan in which the participant is married must be paid in the form of a joint and survivor annuity. The annuity must provide payments to the spouse of the participant for such spouse s life that are equal to at least fifty percent of the amounts payable to the participant during his or her life. 4 After the participant has attained age 35, he or she may waive the requirement for a joint and survivor retirement annuity under REA if the participant s spouse consents to such waiver. Rollover Options Most types of distributions from a qualified plan or individual retirement account can be rolled over into the same or a different qualified plan or individual retirement account without being subject to income taxation or penalty, if done within sixty days. Examples of distributions from qualified plans and individual retirement accounts that are NOT eligible for rollover treatment include: One of a series of payments taken over a single or joint life expectancy; One of a series of payments received for a specified period often years or more; A Required Minimum Distribution, or RMD 5 (explained infra). A rollover distribution from a retirement plan or IRA is subject to a 20% federal income tax withholding requirement. The withholding requirement can cause forced income taxation of a 4 IRC 417(a)(7)(B). 5 IRC 402(c)(1) and (4) Stephen C. Hartnett 3

68 portion of the distribution where the participant does not have an alternative source to replace the 20% of the distribution withheld for taxes. For example, a participant requests a distribution of $100,000 from her IRA, intending to roll it over before the expiration of sixty days to another IRA custodian. The original IRA custodian withholds $20,000, as required under federal law, and distributes $80,000 to participant. Participant does not have $20,000 from alternative sources and so is only able to deposit $80,000 with the new IRA custodian. Participant will have $20,000 of taxable income to report. Under certain circumstances the IRS can waive the sixty-day requirement and allow a valid rollover even if beyond sixty days. See Rev. Rul ; IRC 40(d)(3)(I). A method to avoid tax withholding is to use a trustee to trustee transfer rather than an IRA rollover. Because the money is never distributed directly to the participant, a trustee to trustee transfer is not subject to the otherwise mandatory withholding requirements. Required Beginning Date A participant must begin taking RMDs from his or her retirement assets by his or her Required Beginning Date or RBD. The RBD is April 1 st of the calendar year AFTER the calendar year in which the participant reaches age 70½. There is an exception for QUALIFIED PLANS only if the participant is not retired at age 70½ and the participant is not a five percent or greater owner in the business in which he or she works, RBD can be postponed until April 1 st of the year after the participant actually retires. RMDs from an IRA cannot be postponed beyond age 70½, even if the participant is continuing to defer distributions from the qualified plan. Example: Bob is born on 6/30/1942. Bob turns 70 on 6/30/2012. Bob turns 70 ½ on 12/30/2012. Bob s RBD is 4/01/2013. Jane is born 7/1/1942. Jane turns 70 on 7/1/2012. Jane turns age 70 ½ on 1/1/2013. RBD is 4/1/2014. Required Minimum Distributions Once a participant has reached his RBD, then he must begin taking annual RMDs based on the Uniform Table. The only exception to use of the Uniform Table by the participant is when the participant s spouse is more than ten years younger than the participant, in which case the participant has the option to use the Joint Life Expectancy Table. The Uniform Table is reproduced as Appendix A. A portion of the Joint Table is reproduced at Appendix B. To use the Uniform Table, find the age of the participant for the calendar and determine the factor to be used. For instance, the factor at age 73 is The factor is then divided into the balance of the participant s retirement plan(s) as of December 31 of the previous calendar year. This result is the RMD for that year. NOTE: Where a participant has multiple IRA accounts, it is not necessary that a prorated portion of the RMD be taken from each IRA. The total RMD can be taken from one IRA and the other 2007 Stephen C. Hartnett 4

69 IRAs can be left to accumulate tax-deferred. Where the participant has different types of retirement plans, however, such as an IRA, 401(k) and profit sharing plan, the RMD may not be aggregated it must be taken on a pro rata basis from each type of retirement plan. Take, for instance, the example of a participant who has two IRAs totaling $50,000 and a 401(k) with a value of $50,000. If the participant is age 73, the RMD would be $4,049 ($100,000 / 24.7). The distribution must come one-half from the 401(k) plan and one-half from either one or both of the IRAs. CAUTION: If the first RMD is postponed until April 1 of the calendar year after the participant turns age 70½, then two RMDs must be made in the first year one by April 1 to cover the RMD for the previous calendar year in which the participant turned 70½ and a second by no later than December 31, to cover the RMD for the current calendar year. Only one RMD would be required for each year thereafter. To avoid this result, the participant must take her first RMD in the year she turns age 70½, and not in the following calendar year. Penalties The penalty for failing to take a RMD is 50% of the amount of the RMD. 6 The IRS, in limited cases, may waive the penalty where reasonable cause is shown. There is also a 10% penalty for taking distributions from an IRA or qualified plan prior to age 59½ (premature withdrawal penalty). 7 There are several exceptions to the application of this penalty, including: Distributions due to your death or disability; Distributions for payment of unreimbursed medical expenses that exceed 7.5% of your AGI; Distributions for the payment of health insurance premiums for certain unemployed individuals; Distributions for the payment of qualified higher education expenses; Distributions consisting of substantially equal periodic payments; Distributions to a qualified first-time homebuyer; and Distributions due to an IRS levy on the IRA. If you do not meet one of the above exceptions, you can avoid paying the 10% penalty tax if you redeposit the early distribution amount within 60 days of the distribution. 6 IRC IRC Stephen C. Hartnett 5

70 2. Distributions at Death Determination of Beneficiary The determination of the identity of the beneficiary of a retirement plan is often critical as to what distribution options are available, as will be discussed further below. The beneficiary of an IRA or retirement plan must be determined by no later than September 30 of the calendar year after the participant s death. This means that the participant can change beneficiaries during his lifetime and his RMD will not change, because it will be calculated using the Uniform Table in almost all events. The only exception would be if the participant changes the beneficiary designation to a spouse who is more than ten years younger than the participant and the participant chooses to use the Joint Table. The period between date of death of the participant and September 30 of the following calendar year is sometimes referred to as the shake-out period. The nickname arose because during that period the beneficiary can be changed (such as by disclaimer) or an undesirable beneficiary can be removed in order to maximize stretch distributions. For example, the devise to an undesirable beneficiary can be removed from consideration by satisfying the devise prior to September 30. This time period can also be used to create separate accounts where there are multiple beneficiaries designated under the IRA or retirement plan. In some circumstance, the creation of separate accounts allows for the age of each beneficiary to be used in determining RMDs from his or her share. The concepts of stretch distributions and separate shares are discussed further below. Spouse as Beneficiary When a spouse is named as the beneficiary of an IRA or retirement plan, the spouse has many options. Rollover A spouse may rollover an inherited retirement asset into an IRA in his or her own name. In order for the spouse to rollover the inherited retirement assets, he or she must be the sole beneficiary of the retirement asset. So, if an IRA named a spouse and child as beneficiaries, spouse would only be the sole beneficiary as to half of the IRA. Therefore, the spouse could rollover half of the IRA into an IRA in her name and child could take the other half as an inherited IRA. If the beneficiary of the retirement asset was a trust whose sole beneficiary was the spouse and where spouse is the trustee or has withdrawal power over the trust assets, then spouse could roll over the retirement assets to an IRA in her name. If however, the trust named spouse as income beneficiary and spouse and descendants as discretionary beneficiaries of principal for health, education, maintenance and support then spousal rollover would not be available. If a spouse elects to rollover an inherited IRA, she can defer taking distributions until she reaches her RBD. If the surviving spouse is under age 59 1/2, rolling over the IRA may not be an appropriate option if the surviving spouse needs any of the IRA funds for the surviving spouse s support before reaching that age. If distributions are taken, IRC 72 may impose a 10% penalty tax may be imposed because the surviving spouse will be treated as an owner and not a 2007 Stephen C. Hartnett 6

71 beneficiary after the rollover. When RMDs begin, they will be based on the Uniform Table. She can name new death beneficiaries to her IRA. Also if the surviving were to die before reaching age 70 ½, the surviving spouse would be treated as the IRA owner, rather than as a beneficiary. Thus, if he or she has not designated a succeeding beneficiary of the IRA, the IRA will be distributed after the surviving spouse s death as if there were no beneficiary (i.e. to his or her estate). The MRDs will be higher in this situation and the assets will be subject to the surviving spouse s creditors. In addition to when the surviving spouse is under 59 ½, another situation in which allowing a surviving spousal rollover might not be desirable is where the participant is in a second plus marriage and would like assurance that the retirement assets will benefit children from a prior marriage after the death of the surviving spouse. A QTIP trust is usually the recommended method to make sure the retirement account will eventually pass to the deceased spouse s children. Although a QTIP trust will ensure that property is left to the children of the deceased spouse, the income tax benefits from designating a QTIP trust as a beneficiary will usually be less than what can be achieved from a rollover to a surviving spouse. Additionally, a rollover might not be desirable if the combined estates of the husband and wife might be subject to estate tax at the death of the surviving spouse. This situation may require using all or part of a spouse s retirement account to fund a credit shelter trust. Inherited IRA Death Before Required Beginning Date Another option is for the spouse to treat the IRA as an inherited IRA. If this option is chosen and the participant died before his or her RBD, then the surviving spouse will take distributions from the IRA based on her life expectancy using the IRS Single Life Expectancy Table (see Appendix C ). To use the table, the spouse will find the factor associated with her age at the date of the participant s death and use that factor. She is the only death beneficiary that is allowed to recalculate when using the Single Life Expectancy Tables, so she will return to the tables each year to determine her RMD. For instance, if the spouse is age 65 when the participant dies, the factor for determining the first RMD (payable by December 31 of the first calendar year after the calendar year of the participant s death) would be 21. The following year the spouse would look at the table again and determine the factor is In the third year the factor is In an exception to the rule that all inherited retirement assets must begin distributing to beneficiaries no later than December 31 st of the calendar year after the year of the participant s death, where the participant dies before his or her RBD (i.e. deceased spouse was 65 at date of death), a surviving spouse who elects to treat the participant spouse s retirement asset as an inherited retirement may defer taking his or her first RMD until the deceased spouse would have been required to take his or her first RBD. Inherited IRA Death After Required Beginning Date If the participant died after his or her RBD, and the spouse wants to treat the IRA as an inherited IRA, then she will have the option of taking distributions from the IRA based on the 2007 Stephen C. Hartnett 7

72 greater of her life expectancy using the IRS Single Life Expectancy Table (recalculated), or the life expectancy of the participant (but in this case the life expectancy would not be recalculated instead the life expectancy for the participant would be determined as of his year of death and one would be subtracted from the number each year thereafter). For instance, if the participant died at age 75, then the first RMD would be The following year s distribution would be calculated using a factor of , or Accordingly, the IRA would be fully distributed at the end of 14 years. All Other Qualified Beneficiaries Before the Pension Protection Act of (PPA), non-spouse beneficiaries were only allowed to authorize a plan-to-plan transfer from one IRA inherited from a participant to another inherited IRA in the name of the same participant and payable to that same beneficiary. 9 After the PPA, non-spouse beneficiaries may also rollover a distribution from an eligible retirement plan to an IRA, thereby allowing a non-spouse to defer distributions. This new non-spousal rollover must be completed by a direct trustee-to-trustee transfer. The same minimum distribution rules that apply to an inherited IRAs will apply to rollover IRAs for a non-spouse. The recipient IRA is treated as an inherited IRA that must be titled in the name of the participant, and the non-spouse beneficiary must qualify as a designated beneficiary. Transfers may also be made to inherited IRAs that are held by trusts for the benefit of a non-spouse beneficiary. 10 Inherited IRA Death Before Required Beginning Date Option 1 Distributions Over Beneficiary s Life Expectancy When the participant dies before the RBD and the beneficiary is other than the surviving spouse, RMDs are based on the beneficiary s life expectancy using the Single Life Table (see Appendix C ). To use the table, the beneficiary will find the factor associated with his or her age at the date of the participant s death, and then simply subtract one from the factor every year thereafter. For instance, if the beneficiary is age 55 when the participant dies, the factor for determine the first RMD would be The following year the beneficiary would subtract one and the beneficiary s new factor for determining RMD for that year would be 28.6 (29.6 1). The Inherited IRA would be fully distributed in year 30. Distributions must begin no later than December 31 of the calendar year after the year in which the participant died. Failure to take distributions by that would, in effect, be an election by the beneficiary to use option 2 the five year rule. Option 2 Five-Year Rule Under the five-year rule there is no set schedule of distributions, but the retirement assets must be fully distributed to the beneficiary no later than December 31 of the calendar year five years from the death of the beneficiary. For instance, under the five-year rule the beneficiary could withdraw 20% of the retirement assets in year one, 25% in year two, 33.3% in year three, 8 Pub. L (August 17, 2006) 9 PLR IRC 402(c)(11); see also Notice , , I.R.B Stephen C. Hartnett 8

73 half the remaining balance in year four and the remainder in year five. Alternatively, the beneficiary could decide to take no distributions for the first four years and instead withdraw the entire balance on at the end of year five. Inherited IRA Death After Required Beginning Date Option 1 Distributions Over Greater of Beneficiary s or Participant s Life Expectancy When the participant dies after the RBD and the beneficiary is other than the surviving spouse, RMDs are based on the greater of the beneficiary s or the participant s life expectancy using the Single Life Table. (See Appendix C ). To use the table, the beneficiary will find the factor associated with his or her age at the date of the participant s death (or the age of the participant, if younger), and then simply subtract one from the factor every year thereafter. For instance, if the beneficiary is age 55 when the participant dies, the factor for determine the first RMD would be The following year the beneficiary would subtract one and the beneficiary s new factor for determining RMD for that year would be 28.6 (29.6 1). The Inherited IRA would be fully distributed in year 30. Distributions must begin no later than December 31 of the calendar year after the year in which the participant died. Failure to take distributions by that would, in effect, be an election by the beneficiary to use option 2 the five-year rule. Option 2 Five-Year Rule No Designated Beneficiary In some circumstances, the IRS considers that there is no designated beneficiary named for purposes of being able to determine RMDs. The first circumstance when this occurs is when the participant in fact fails to name a beneficiary for his or her retirement asset. Four less obvious events where the IRS considers there to be no designated beneficiary are when the participant names a beneficiary, but the beneficiary is one of the following: Estate Charity Non-Qualified Trust Other Entity (such as corporation or partnership) The IRS considers there to be no designated beneficiary in these events because it is not possible to determine the life expectancy of an estate, charity, non-qualified trust or other entity. What are the distribution requirements when no designated beneficiary is named? Here again, there are two scenarios Stephen C. Hartnett 9

74 Participant Dies Before RBD If the participant dies before his required beginning date without having designated a beneficiary, then the retirement asset must be withdrawn under the five-year rule. Participant Dies After RBD If the participant dies after having reached his RBD without having designated a beneficiary, then the recipient of the retirement assets has two withdrawal options: o Take RMDs over Participant s Life Expectancy The recipient of the retirement assets could take RMDs based on the remaining life expectancy of the participant using the IRS s single life expectancy table. For example, if the participant dies at age 73, his factor for that age under the Single Life Expectancy Table is The recipient of the retirement assets would need to take an initial RMD by December 31 of the calendar year after the participant s death equal to the value of the retirement asset divided by The following year, the recipient would take a second RMD using a factor of 13.8 (14.8-1), so that the retirement asset would be fully distributed over fifteen years, or o Five-Year Rule The recipient of the retirement assets could take distributions from the retirement asset under the five-year rule. Proper Titling of an Inherited Retirement Asset Many practitioners and financial professionals erroneously believe that title to an inherited retirement asset should be taken in the name of the beneficiary. This is not correct. Distributing the assets from a retirement plan (or liquidating the assets and then distributing them) to the beneficiary or an IRA in the name of the beneficiary would be considered a taxable distribution by the IRS, requiring that income taxes be paid on the full amount in the year of distribution. Instead, an inherited IRA should be titled in the name of the deceased participant, but for the benefit of the beneficiary. Following are some examples: John Doe (Deceased) IRA fbo Mary Doe John Doe (Deceased) IRA fbo Mary Doe, Trustee under the John Doe Bypass Trust dated January 1, 1995 John Doe (Deceased) IRA fbo Mary Doe, Trustee of the Jane Doe Trust created under the John Doe Living Trust dated January 1, Stephen C. Hartnett 10

75 3. Naming a Trust as Beneficiary of Retirement Assets Reasons to Name a Trust as Beneficiary of Retirement Assets Protect Retirement Assets o Minor Beneficiaries Retirement assets should not be paid outright to a minor beneficiary. In some states, the payment of substantial retirement assets to a minor beneficiary would require the establishment of a guardianship of the minor s estate, whether or not the minor had a natural guardian at that time. o Special Needs Beneficiaries Direct payment of retirement assets to a special needs beneficiary could disqualify the special needs beneficiary from receiving government assistance programs such as Medicaid, In Home Supportive Services, and SSI. In such instances, retirement assets should be made payable to a third party Special Needs Trust. o Spendthrift Beneficiaries Where the participant wants to preserve the inheritance of a spendthrift beneficiary and give control of that beneficiary s inheritance to a third party trustee, retirement assets should not be made payable directly to the spendthrift beneficiary. o Asset Protection for Beneficiaries Where a beneficiary has tax problems, judgment creditors, an unstable marriage, or engaged in a high liability profession, retirement assets can be made payable to a third party discretionary trust to provide asset protection for the beneficiary. Children from a Previous Marriage Retirement assets can be made payable to the Bypass or Marital QTIP Trust of a revocable living trust or testamentary trust in order to provide the current spouse with income during her life, but shelter the retirement assets for the children from a previous marriage, who are the remainder beneficiaries under the trust. Under-funded Credit Shelter or Bypass Trust Naming a spouse as the beneficiary of a retirement plan may cause estate tax at the death of the surviving spouse that could otherwise have been avoided. For example, assume H has an IRA worth $1 million and all of the couple s other assets, worth $6 million, are titled in the name of a revocable living trust as tenants in common or community property, as applicable. W is the beneficiary of H s $1 Million IRA. At H s death, the Bypass Trust is funded with $3 Million (half the assets in the joint trust) and the Survivor s Trust is funded with the other $3 Million in trust assets. W rolls over the $1 Million IRA. W now has $4 Million in assets. Depending on the 2007 Stephen C. Hartnett 11

76 amount of the Applicable Exclusion Amount at W s death, W s estate may be subject to estate tax. An alternative would be to use disclaimer planning to fully fund the Bypass Trust with $5,250,000 in assets, the amount that can be passed free from estate tax in 2013, otherwise known as the Applicable Exclusion Amount. Fully utilizing the Applicable Exclusion Amount maximizes estate tax savings to the couple. 11 H s IRA $1 million Living Trust $6 million $500,000 Disclaimed W Rollover $500,000 Disclaims $500,000 to RLT Bypass Trust $4.5 Million + $500,000 disclaimed = $5 million Survivor s Trust $1.5 Million 4. Qualified Designated Beneficiary Trust Look-Through to Trust Beneficiaries A Qualified Trust allows the trust to be disregarded, and allows a look-through to the beneficiaries of the trust for purposes of determining life expectancy for RMDs. A qualified trust must have the following four attributes: Trust is valid under state law; Trust is irrevocable or becomes irrevocable by the participant s date of death; There are beneficiaries that are identifiable under the terms of the trust; and 11 The portability of the applicable exclusion amount between spouses made permanent effective January 1, 2013, may impact the need to create and fund a by-pass trust Stephen C. Hartnett 12

77 A copy of the trust document is provided to the plan administration or retirement plan custodian by no later than October 31 of the calendar year after the death of the participant. 12 Calculating RMDs for Trust Beneficiaries. When calculating the RMD for a retirement asset that is made payable to a trust, you would use the life expectancy of the trust s oldest beneficiary. 13 Therefore, if a retirement asset were made payable to or disclaimed to the Bypass Trust, the age of the oldest beneficiary of the Bypass Trust (usually the surviving spouse) would be used to determine the RMDs that need to be distributed by the retirement asset custodian to the trustee of the Bypass Trust. Who is the Oldest Beneficiary of a Trust? Caution should be exercised in drafting a trust that will have retirement assets paid to it to avoid inadvertently including a beneficiary who is older than the intended beneficiary. For instance, in PLR , a trust was named beneficiary of an IRA. The trust provided that it was for three beneficiaries that were then minors. The assets of the trust were to be held in trust for the minors until each minor reached age 35, at which time the trustee was to distribute that minor s share to him or her, outright and free of trust. While the trust was in existence, the trustee was mandated under the trust document to accumulate income and only make distributions of income and/or principal of the trust for health, education, maintenance and support of the minors. In the event the minors died prior to reaching age 35, the trust would be distributed to an uncle who was age 67 at the date of the participant s death. The IRS held that because it was possible that uncle could have the trust assets distributed to him if the minor beneficiaries did not survive to age 35, he was the oldest beneficiary under the trust and RMDs must be calculated based on his life expectancy. The solution to this problem is to limit contingent beneficiaries of retirement assets paid to a trust to only those beneficiaries younger than the intended beneficiary, or to use a conduit trust. A conduit trust is a trust that simply passes through any RMDs paid to the trustee of the trust onto the intended beneficiary under the trust and has no provision to accumulate distributions from a retirement asset which is paid to the trustee of the trust. In the exercise of caution, the drafting attorney should look out for the following traps: Watch out for powers of appointment granted under the trust which could allow a trust beneficiary to appoint trust retirement assets to an appointee older than the intended trust beneficiary. 12 A copy of the trust document would need to be provided during the life of the participant only if lifetime RMDs from the trust are being calculated using the joint life expectancy table. If RMDs are being calculated using the Uniform Table, a copy need only be provided after death. 13 Treas. Reg (a)(9)-4 Q & A-5(c) provides that the separate account rules of 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, but see PLR Stephen C. Hartnett 13

78 Limit the ultimate remainder beneficiaries to those heirs at law who are younger than the intended beneficiary. 14 Be especially cautious where a charity is intended as the ultimate remainder beneficiary. 15 Do not name as charity as one of several primary beneficiaries under a trust, if it is intended that RMDs from retirement assets allocated to other non-charity beneficiaries are to be taken over the life expectancy of such beneficiaries. 16 Do not allow the use of trust retirement assets to pay for the debts and expenses of the decedent, except to extend the payment of the debts and expenses can be made prior to September 30 of the calendar year after the participant s death. 17 Do not allow the use of trust retirement assets to pay the estate taxes of the participant, except of the payment can be made prior to September 30 of the calendar year after the participant s death As with PLR , if the trust was not a conduit trust and a potential heir at law was older than the intended beneficiary, it is possible the IRS could take the position that the RMDs must be based on the age of the oldest heir at law as of the date of death of the participant. 15 Because a charity has no life expectancy, it would be considered the oldest beneficiary under the trust and distributions from a retirement asset to the trust would be limited to the five-year rule. 16 Because the trust must use the life expectancy of the oldest beneficiary to determine RMDs for all its trust beneficiaries and the charity has no life expectancy, distributions from the retirement asset would be limited to using the five-year rule. 17 The IRS considers the payment of the participant s debts and expenses by the trust to be the same as naming the participant s estate as a beneficiary of the trust. Therefore RMDs would have to be calculated using the five-year rule. 18 The IRS considers the payment of the participant s estate taxes by the trust to be the same as naming the participant s estate as a beneficiary of the trust, therefore RMDs would have to be calculated using the five year rule Stephen C. Hartnett 14

79 Other Precautions for the Drafting Attorney Funding Formula The IRS treats a pecuniary gift 19 that is satisfied with an asset as though the trustee had sold the asset and given cash to the beneficiary. Therefore, caution should be used in allocating retirement assets within a trust that uses a pecuniary marital formula 20 or pecuniary exemption formula 21. A provision should be added to the retirement provisions of the trust that all retirement assets should be allocated using a fractional formula A pecuniary gift is a gift of a designated amount such as I give $100,000 to my son at my death. A pecuniary formula gift defines an amount rather than expressing it is dollar terms such as allocating the amount that can pass free of estate taxes at death to the Bypass Trust. 20 An example of a pecuniary marital formula is allocate to the Marital Trust (or QTIP Trust) the minimum amount of the trust estate that qualifies for the marital deduction necessary to reduce estate taxes to zero. 21 An example of a pecuniary marital formula is allocate to the Bypass Trust the maximum amount of the trust estate that can pass free of federal estate tax. 22 An example might be Upon the death of a Participant who is the Deceased Trustor, notwithstanding any other provision in this trust, the Trustee shall first allocate to the Bypass Trust all of the Trust Estate that is not properly characterized as Retirement Assets, until such trust is fully funded. To the extent the Bypass Trust is not fully funded using only assets that are not characterized as Retirement Assets, the Trustee shall next allocate to the Bypass Trust the smallest fractional share of any Retirement Assets which are under the control of the Trustee necessary to fully fund the Bypass Trust (which fraction, depending on the circumstances, may result in some, all or no Retirement Assets being allocated to the Bypass Trust). To the extent any Retirement Assets are not needed to fully fund the Bypass Trust, and subject to the exceptions designated in the paragraph immediately below, the Trustee shall distribute such Retirement Assets to the Surviving Trustor, outright and free of trust. If the Surviving Trustor disclaims this outright distribution, any Retirement Assets so disclaimed shall be allocated to the Marital Trusts Stephen C. Hartnett 15

80 Uniform Principal and Income Act The Uniform Principal and Income Act ( UPAIA ) treats distributions from a retirement plan as coming ten percent from income and ninety percent from principal. 23 This is intended to preserve trust assets to the greatest extent possible. However, this allocation may not be congruent with the wishes of the participant (especially with regard to distributions to the surviving spouse). Depending on how the trust is drafted, it may prevent the trust from qualifying as a conduit trust, if that is what is intended. If the default definition of income from a retirement plan under the UPAIA is not in accord with the intent of the participant, a special definition of income should be added to the trust provisions See for example, California Probate Code 16361(e). 24 One alternative is to define income as the actual amount of income earned by the retirement plan. Take, for example, a RMD received by the trustee in the amount of $75,000. If the retirement plan had a value of $1 million and earned 5%, then $50,000 of that $75,000 RMD would be characterized as income and $25,000 would be characterized as principal. A sample of such allocation language is: The Trustee shall allocate to income that portion of Retirement Assets that equals (a) the amount of Inside Income that my Trustee reasonably determines has occurred since the Trustee has acquired a right to receive the Retirement Assets; reduced by (b) the amount of prior Retirement Assets from the same contractual, custodial, or trust arrangement that was allocated to trust income. The Trustee shall allocate the balance of the Retirement Assets, if any, to principal. The term Inside Income with respect to each contractual, custodial, or trust arrangement, refers to that portion of the Retirement Assets that are characterized by the payor as interest, dividends, or a dividend equivalent. To the extent any portion of Retirement Assets are not so characterized by the payor, Inside Income shall consist of any amounts that would be allocable to income under applicable state law governing the allocation of principal and income for trusts, if said statutes were applied to a trust holding the assets that fund all Retirement Assets to which this Trust is entitled under such arrangements. If the Trustee cannot identify the character, amount, or nature of said assets, the Trustee may reasonably estimate the character, amount and nature of such assets Stephen C. Hartnett 16

81 Appendix A IRS Uniform Table for Calculating RMDs Age RMD Age RMD Age RMD Age RMD Age RMD Appendix B Selected Excerpt from IRS Joint Table Ages Stephen C. Hartnett 17

82 Appendix C Single Life Expectancy Table for Inherited IRAs Age RMD Age RMD Age RMD Age RMD Age RMD Stephen C. Hartnett 18