1 Estate Planning for Retirement Benefits April Caudill, J.D., CLU, ChFC, AEP Senior Advanced Planning Attorney Advanced Financial Security Planning Northwestern Mutual The Northwestern Mutual Life Insurance Company Milwaukee, WI
2 Overview Estate Planning Making certain property is distributed after death according to the owner s wishes Minimizing estate and income taxes Taking into account Specific needs of beneficiaries Need for flexibility to adjust to changing circumstances Return of estate tax in 2011
3 Overview Special issues specific to qualified assets : Income in respect of a decedent (IRD): Impact of both income and estate tax Minimum distribution requirements and potential conflicts with planning objectives Retirement assets pass by beneficiary designation; many other assets pass by will Retirement assets can offer long-term income tax deferred growth (or tax-free growth for Roth assets)
4 Stretch Concept Stretch IRA Qualified assets subject to income tax, but not until distributed! What happens until they are distributed? Continued tax-deferred growth Or, tax-free in a Roth account Logical conclusion: let the assets grow! IRS says not so fast you have to at least take a little bit out each year.
5 Stretch Concept Stretch = make the IRA last as long as possible, take out only the minimum Youngest beneficiaries receive the most dramatic benefit amount received over their lifetime can be several times the initial account value inherited, depending on growth rate (assuming life expectancy fraction payout method is used) Use of trust can help assure the IRA remains intact, continues tax-deferred growth
6 Stretch Concept Stretch requirements Designated beneficiary status Named as beneficiary Taking under ERISA plan terms, such as spouse Trust special requirements Individual beneficiary: not estate or charity Big picture: long-term tax deferred growth can be a powerful wealth transfer tool Liquidity provided by an income tax free death benefit can help families optimize the tax advantages of qualified assets
7 Required Minimum Distributions Individual beneficiaries Nonspouse Single life payout Deadline for election 5-year rule or ghost life expectancy Spouse Rollover option Uniform lifetime table Maximum permitted delay Multiple individuals and separate accounts
8 Required Minimum Distributions Charitable beneficiaries Tax efficient planning Impact of charitable beneficiary on designated beneficiary status of other beneficiaries September 30 beneficiary determination date Estate beneficiaries No look-through No life expectancy Some PLRs allow spousal rollover
9 Required Minimum Distributions Planning objectives Make beneficiary designations that optimize achievement of client s goals Use the longest permitted measuring life so that income tax deferral or income tax-free growth is maximized Avoid potential exposure to 50% penalty Recognize the interaction (conflicts) between RMDs and other trust requirements or objectives
10 Marital Planning Number one IRA or QP beneficiary: spouse Objective: qualify for the unlimited marital deduction Four ways (if U.S. citizen) Leave assets to spouse outright by naming spouse as beneficiary Name a general power marital trust as beneficiary Name a QTIP trust as beneficiary Joint and survivor annuity
11 Marital planning Easiest: assets to surviving spouse outright by naming spouse as beneficiary Income tax advantages (versus trust) Simplicity Rollover dilemma for younger spouse Decision of whether to maximize stretch by rolling over to spouse s own IRA Alternative 1: leave funds in inherited IRA, start taking RMDs until age 59½ Alternative 2: roll over; hope funds are not needed Alternative 3: prevent dilemma with life insurance If it s already too late
12 Marital planning General power marital trust as beneficiary General power marital trust requirements: Surviving spouse must be entitled to all the income from the trust The spouse must be entitled to appoint the property to the himself or herself, or his or her estate, and No other person can have the power to appoint the property to someone other than the spouse Note these are broad powers, tantamount to outright ownership. Leaving benefits to spouse outright is simpler and avoids disadvantages of using a trust
13 Marital Planning General Power Marital Trust as beneficiary Note that certain plans require spousal consent to name beneficiary other than spouse Disadvantages of naming marital trust as beneficiary No ability to delay distributions until decedent would have reached age 70½ Unless benefit is rolled over to surviving spouse s own IRA (outside of trust), payouts use single life table (less deferral) Surviving spouse might not lose ability to make rollover of withdrawals in excess of RMDs; Depends on extent to which withdrawals are subject to a trustee s discretion, or otherwise restricted.
14 Marital Planning Qualified terminable interest property (QTIP) trust as beneficiary Allows account owner/participant to limit surviving spouse s access to principal, direct it to children or other heirs Spouse can be given any degree of access to principal or no access Spouse can be given limited power to appoint principal at death, or not Typically used to assure that children from a previous marriage receive principal after death of surviving spouse
15 Marital Planning Requirements for QTIP treatment: Spouse must be entitled to all the income from the trust, payable at least annually, No other person can have the power to appoint the property to anyone other than the spouse during the spouse s lifetime, and Executor must irrevocably elect QTIP treatment on the decedent's estate return for both the trust and the IRA
16 Marital Planning QTIP trust requirement: Entitled to All Income Trust terms should entitle the spouse to both the trust's and the plan's income annually Easiest way to satisfy is for trustee to calculate the "income" of the both trust and the IRA Trustee then withdraws from the IRA the greater of its income or the RMD amount Disadvantageous if RMD would have been much lower than income (e.g., young spouse)
17 Marital Planning QTIP trust requirement: Entitled to All Income Determination of income under state law varies IRS has approved use of unitrust amount (generally 3% to 5%) IRS approves of traditional method IRS disapproves of 10% rule where 90% of RMD amount is allocated to principal/10% to income. Note that some trusts/state statutes define income in this manner. Might not qualify for marital deduction. (See Revenue Ruling , IRB 939 )
18 Marital Planning QTIP Trust as beneficiary: Disadvantages Complexity: defining income, reconciling income with RMDs Might not accomplish goals if surviving spouse is near age of children. Perhaps acquire life insurance instead for surviving spouse and leave qualified assets to kids (or vice versa).
19 Marital planning Pecuniary Formula Marital Bequests What is this? Participant s will designates a specific dollar amount to go to the marital and credit shelter trust Executor allocates IRA to the trust in satisfaction of the bequest Potential taxation at the estate level on the IRA or plan proceeds Some PLRs have allowed spousal rollover in these circumstances Alternative is use of a fractional formula: e.g., ½ of my estate to each trust
20 Marital planning Noncitizen Spouse Deferred estate tax treatment available only for assets passing to qualified domestic trust (QDOT), unless modified by estate tax treaty Designed to prevent noncitizen surviving spouse from taking assets outside the U.S., escaping transfer taxes QDOT must meet other requirements for marital or QTIP trust plus additional ones
21 Marital Planning Additional requirements for QDOT trusts: Trustee should be a U.S. domestic corporation; No distributions of principal permitted without withholding of estate tax Trust must be maintained and administered under the laws of a state or the District of Columbia. Bonding requirements and limitations on the amount of foreign real property the trust can hold.
22 Marital Planning QDOT practical issues: QDOT can be named as beneficiary, or nonspouse beneficiary can have one created and roll over assets to it QDOT can also be structured as an IRA if maintained at a financial institution Requirement that no principal be distributed; deferred estate tax owed if RMD amount exceeds trust income Determination of income subject to same state law variations as with QTIP trust
23 Marital Planning Dealing With the QDOT requirements: Participant could leave the retirement assets to other beneficiaries and purchase life insurance in an ILIT to benefit the noncitizen spouse; Participant could forego the marital deduction and have executor pay the estate tax at the first death; Roth conversion could allow surviving spouse to avoid RMDs
24 Marital Planning Rollovers by Noncitizen Rollover to a plan in another country is a taxable distribution (10% penalty might also apply) unless authorized by a tax treaty Tax treaty might allow noncitizen to leave funds in existing plan but have them taxed upon withdrawal only in the other country Money from other countries typically cannot be rolled into U.S. accounts; not considered a tax-free rollover.
25 Planning Issues for Trusts Other trust planning issues: Look-through trust requirements Credit shelter trust as beneficiary Special needs trust Trusts for multiple beneficiaries
26 Planning Issues for Trusts Trust beneficiaries Requirements for look-through treatment All beneficiaries are individuals Valid under state law Documentation requirement Trust must be irrevocable Beneficiaries must be identifiable Which beneficiaries count for purposes of requirement that all must be individuals?
27 Planning Issues for Trusts Conduit trust: Income/RMDs paid out to beneficiaries each year: Only Primary beneficiaries counted Example: to my children with remainder to my grandchildren children are only ones counted. Accumulation trust: income/rmds can be held in trust instead of distributed All beneficiaries counted Example: to my children with remainder to my grandchildren all are counted.
28 Planning Issues for Trusts Special Needs Trust Normally an accumulation trust: trustee has complete discretion to retain assets or make distributions Result is that all beneficiaries counted: individual with special needs, as well as any remainder beneficiaries Negative results if remainder beneficiary is an estate or charity: no designated beneficiary status; faster payout, taxed at trust s income tax rates Planning strategy: if funding special needs trust with qualified assets, remainder beneficiaries need to be individuals near same age for optimal tax results Alternative: fund special needs trust with life insurance, leave retirement assets to spouse and/or other children
29 Planning Issues for Trusts Credit Shelter Trust as beneficiary Most basic planning strategy for individuals potentially subject to estate tax All other trust requirements discussed previously apply If no other assets available, credit shelter trust useful to protect retirement assets from estate tax Retirement and other IRD assets are a wasting asset Some of credit shelter is used up by income tax liabilities and RMDs An asset that receives stepped-up basis is preferable
30 Planning Issues for Trusts Credit shelter trust as beneficiary: If spouse is beneficiary of credit shelter trust, consider trade-offs Credit shelter trust saves estate tax but at the cost of short-term flexibility for the surviving spouse Trust as beneficiary triggers other disadvantages -- requirements for designated beneficiary status, potentially higher income taxes Alternative strategy: name surviving spouse as beneficiary and credit shelter trust as contingent beneficiary. Spouse can disclaim if so desired.
31 Planning Issues for Trusts Multiple beneficiaries General rule: use shortest life expectancy i.e., life expectancy of oldest beneficiary Bad deal if one much older beneficiary and others are younger payout to younger beneficiaries is much faster, much less longterm growth. Multiple beneficiaries taking through one trust do not get to use their own life expectancies, even if separate accounts are established
32 Planning Issues for Trusts Example: Tom is widowed, has a $3 million IRA. His will names his sister Joan, age 59 as guardian for his two children, Dan (8) and Ann (21). Tom names Joan, Dan and Ann as outright beneficiaries of his IRA. First year payout if they can establish separate accounts and receive payouts over their life expectancies (i.e., they are not taking through a trust): Joan $1M/26.1=$38,314 Ann $1M/62.1= $16,103 Dan $1M/74.8 = $13,369
33 Planning Issues for Trusts Example (cont d): If Tom named a trust instead of naming Joan, Dan and Ann individually. Result: now all three must take distributions based on Joan s life expectancy Potential solutions: Separate trusts, where each is a named beneficiary One master trusts with multiple little trusts that are each an IRA/plan beneficiary Separate IRAs Disclaimer or payout to Joan before September 30 of year after death
34 Income Tax Issues Income in respect of a decedent (IRD) Definition: income to which decedent was entitled but had not yet been taxed No stepped up basis Subject to income tax as all ordinary income Taxed only when distributed thus, stretch strategies important
35 Income Tax Issues Income tax deduction for beneficiary; available for estate tax paid on IRD (IRC Sec. 691(c)) Designed to mitigate impact of double taxation Calculates how much of estate tax was attributable to IRD assets, then each person receiving IRD receives a proportionate amount of the deduction
36 Income Tax Issues IRD Deduction Example: Julie dies in 2011 leaving $1 million IRA and $5 million of other assets. Assume that the amount of federal estate tax attributable to the IRA is $350,000. If Julie s two children are equal beneficiaries of the IRA, each receives a 691(c) deduction in the amount of $175,000. Deduction is an itemized deduction, but not subject to the 2% floor.
37 Income Tax Issues Charitable beneficiary: Advantage: Very efficient tax planning tool, since charity does not pay income tax; full amount of plan balance benefits the charity. Advantage: IRA going to charity escapes estate tax due to estate tax charitable deduction. Disadvantage: Existence of a charity as a beneficiary at the beneficiary determination date (September 30 of year after death) means that no beneficiaries have designated beneficiary status. Result: if charity is one of multiple beneficiaries, special planning is necessary.
38 Income Tax Issues Charitable beneficiary of retirement assets Methods: Name charity as one of several beneficiaries Beneficiary of a specified fraction Beneficiary of a specified dollar amount Name a trust as beneficiary and provide for a charity as beneficiary of some portion of the trust Name a trust as beneficiary and a charity as a remainder beneficiary Name charity as the sole beneficiary of IRA or plan
39 Income Tax Issues Method: Name charity as one of multiple beneficiaries of IRA Beneficiary of a specified fraction: OK idea -- allows for separate account treatment and possible payoff of charity before beneficiary determination date Example: 20% to the Boy Scouts of America Beneficiary of a specified dollar amount: bad idea -- more difficult to create a separate account for the charitable gift under the separate account rules. Example: $10,000 to United Way
40 Income Tax Issues Method: Name a trust as beneficiary and provide for a charity as beneficiary of some portion of the trust Bad idea: use of qualified assets to satisfy charitable bequest might result in taxation of the IRA/plan funds at the trust level, especially if trustee has a choice of assets with which to satisfy the charitable bequest.
41 Income Tax Issues Method: Name a trust as beneficiary and a charity as a remainder beneficiary OK so long as trust is a conduit trust and does not accumulate distributions. Bad idea if trust is an accumulation trust: trust will be treated as having no designated beneficiaries. This means no stretch opportunity for beneficiaries.
42 Income Tax Issues Method: Name a trust as beneficiary of a fractional share of the account and a charity as beneficiary of another fractional share OK idea: just need make sure separate accounts are created prior to September 30 deadline.
43 Income Tax Issues Method: Name charity as the sole beneficiary of IRA or plan Best idea for larger charitable bequests Avoids issue of charity potentially disqualifying other beneficiaries from designated beneficiary status For smaller bequests, consider use of will (and other assets) instead of qualified assets, to avoid potentially jeopardizing a stretch strategy.
44 After Death Clean-up Strategies: After IRA owner/plan participant has died Distributions to undesirable beneficiaries prior to September 30 of year after death Can remedy existence of older or charitable beneficiaries, especially where separate accounts not available Qualified disclaimer: refusal to accept an inheritance Allows IRA or qualified plan benefit to go to contingent beneficiary Does not constitute a gift by disclaimant Useful when one of multiple beneficiaries is much older or otherwise defeats stretch objectives.
45 After Death Requirements for qualified disclaimer Must be in writing For qualified assets: must be received by Executor and/or plan trustee or account custodian by 9 months after date of death Note that person disclaiming does NOT have until September 30 of the year after death
46 After Death Requirements for qualified disclaimer (cont d) Person disclaiming cannot have accepted the interest or any of its benefits Acceptance of RMD for decedent s year of death does not constitute acceptance of the entire plan Partial disclaimer might be possible even if beneficiary has received additional amounts
47 After Death Requirements for qualified disclaimer (cont d) Interest must pass without any direction on the part of the person disclaiming Property must pass to someone other than the person disclaiming, unless the person disclaiming is the decedent s spouse.
48 After Death Separate accounts Requires pro rata allocation of post-death gains, losses, contributions and forfeitures among beneficiaries Allows each outright beneficiary to use own life expectancy (if not taking through a trust) if established by 12/31 of year after death Deadline of 12/31 applies only for purposes of determining whether separate account holders can use their own life expectancies.
49 After Death Separate accounts If deadline is not met, separate accounts can still be established but oldest beneficiary s life expectancy will be the measuring life Separate accounts allow beneficiaries to choose different investments, avoid interacting, etc. Might result in each beneficiary being responsible only for his/her own RMDs
50 After Death Rollover by surviving spouse Allows spouse to treat IRA or plan account as his/her own; delay distributions Spouse can also leave account intact and receive RMDs beginning in year after death or when decedent would have reached 70 ½ Spouse can convert to a Roth account: Compelling long-term stretch wealth transfer strategy No RMDs are required to owner of a Roth IRA
51 After Death Rollover (direct transfer) by nonspouse beneficiary Qualified plan assets can be rolled over to inherited IRA titled in decedent s name for benefit of beneficiary Requires direct transfer, no 60-day rollover IRA assets can be retitled in same manner Nonspouse beneficiary has option to convert qualified plan account to an inherited Roth account Nonspouse cannot convert an inherited IRA to a Roth account
52 After Death Qualified Plan 5-year trap Nonspouse beneficiary of qualified plan might have 5 years under plan to decide how to receive funds However, choice of a life expectancy payout must be made by December 31 of the year after death Nonspouse beneficiary who waits longer than the December 31 deadline can still make a nonspouse rollover, but distributions will have to be completed within 5 years.
53 After Death Qualified Plan 5-year trap Spouse beneficiary who does not roll over to his/her own IRA could normally wait until decedent would have been 70 ½ If funds left in plan, default could make the entire account become an RMD in 5 th year after death Surviving spouse would no longer have ability to roll over to his/her own IRA
54 After Death Net Unrealized Appreciation Special treatment available if decedent s qualified plan account held appreciated employer stock During decedent s lifetime: could take distribution of stock as part of lump sum distribution, be taxed only on basis, defer income tax on gain until sold. Executor can make NUA election Beneficiary receives the same treatment, provided he takes a lump sum distribution of the benefit. Note that NUA opportunity lost if benefit is transferred to an IRA
55 After Death 4 Critical after-death deadlines: Qualified disclaimer deadline: 9 months after date of death Beneficiary determination date: September 30 of year after death Trust documentation deadline: October 31 of year after death Deadline for creating separate accounts and for electing a lifetime distribution payout: December 31 of year after death
57 Circular 230 Statement: These teaching materials: do not constitute legal or tax advice; are not intended to (and cannot) be used to avoid tax penalties; are not written to promote or market or recommend a transaction or arrangement.