Estate Planning for IRAs, 401(k)s, and other Retirement Plan Assets

Estate Planning for IRAs, 401(k)s, and other Retirement Plan Assets

Our Attorneys Kevin B. Rack, J.D., LL.M. [TAXATION] Nathan R. Olansen, J.D., CPA, LL.M. [TAXATION] Jennifer L. Moccia, J.D., LL.M. [ESTATE PLANNING] Trey T. Parker, Esq. Of Counsel Michelle ReDavid Rack, Esq.

Areas of Practice Estate Planning Elder Law Fiduciary Services Taxation Estate and Tax Litigation Charitable Entities

Overview Qualified plans, IRAs and other tax-deferred retirement plans often constitute a significant portion of a person s wealth. Without careful planning, the value of a retirement plan may be eroded by heavy taxation, spendthrift beneficiaries, creditors, and predators. Selecting and designating the Plan beneficiary must be coordinated with the rest of the owner s estate plan.

Typical Beneficiary Designations None Estate Spouse (elective or statutory) Non-spouse individual Trust Charity

Why Having a Properly Designated Beneficiary is Important Stretching distributions only individuals may receive benefits payable over their life expectancy. An estate, charity, or trust (other than a see through trust ) is subject to the 5-year payout rule. Benefits payable to a designated beneficiary avoid probate and its associated costs and fees. Benefits pass without regard to the Participant s Will and other estate planning documents.

No Beneficiary Designation If P fails to designate a beneficiary or the beneficiary predeceases P and there is no contingent beneficiary then the IRA account or Qualified Plan agreement will name a default beneficiary. If an IRA it is P s estate. If a Qualified Plan (ERISA qualified) it is P s surviving spouse then his estate.

The Estate as the Beneficiary What happens if P s estate is the beneficiary? The retirement plan must go through probate and is subject to probate taxes, executor, and professional fees. If payable to the estate, distributions cannot be stretched out over the beneficiary s life expectancy (exception: when the spouse is sole beneficiary of the estate). A spousal rollover is not available (without a PLR) even if spouse is sole beneficiary of estate.

The Estate as the Beneficiary (contd.) Minimum Required Distributions ( MRDs ) must begin by 12/31 of the year following P s death. Distribution period varies: If P dies before his Required Beginning Date ( RBD ) then distributions must occur over a period not exceeding 5 years. If P dies after his RBD then distribution period is P s remaining life expectancy using the single life table. Income taxes on distributions exceeding $11,650 a year are paid at the highest marginal individual income tax rate (35% Fed & 5.75% VA).

The Spouse as Designated Beneficiary Naming P s spouse as designated beneficiary of a retirement plan provides great flexibility - the surviving spouse can: Rollover the retirement account into a preexisting IRA or elect to treat the IRA as her own (spouse must be sole beneficiary). Take her interest as an inherited IRA. Disclaim, in whole or part, her interest in the IRA.

The Spouse as Designated Beneficiary: Rollover IRA If the spouse rolls over or treats the IRA as her own: Spouse names new or additional designated beneficiaries. Delay MRD until April 1 of the year after she turns 70 ½ (pre 59 ½ distributions subject to 10% penalty). Aggregate distributions from rollover IRA with their regular IRA accounts.

The Spouse as Designated Beneficiary: Rollover IRA (contd.) If the spouse rolls over or treats the retirement account as her own: Convert the rollover IRA to a Roth IRA. Maintain IRA creditor & bankruptcy protection offered under state & federal law. $1,000,000 for IRA rollovers. Unlimited for qualified plan rollovers, if segregated from regular IRA accounts.

The Spouse as Designated Beneficiary: Inherited IRA If the spouse elects to receive the IRA as an inherited IRA: MRD must begin by 12/31 of the year following P s death. No penalty for pre age 59 ½ distributions. Distributions are made over the life expectancy of the surviving spouse (recalculated each year). Cannot aggregate distributions from the inherited IRA. Usually not available for qualified plans.

The Spouse as Designated Beneficiary: Inherited IRA (contd.) If the spouse elects to receive the IRA as an inherited IRA: Can rollover or elect to treat as own IRA at a future time. Cannot convert to a Roth IRA (until rollover or future election to treat as own is made). May lose IRA creditor & bankruptcy protection offered under federal and state law outside VA.

The Spouse as Designated Beneficiary: Disclaiming an Interest Spouse may disclaim her interest in the retirement account. All Percentage Formula clause If disclaimed, the surviving spouse is treated as if she predeceased P, and the interest in the account passes to the named contingent beneficiary. If no contingent beneficiary named, then the account will pass to the default beneficiary under the terms of the contract. P s estate P s spouse P s next of kin

Non-Spouse Individual as Designated Beneficiary No rollover option or election to treat as beneficiary s own IRA available to non-spouse individual. MRD s must begin no later than 12/31 of the year following P s death. Distributions are made over the beneficiary s life expectancy determined as of 12/31 of the year following P s death, reduced by 1 for each year thereafter (different than spouse). No penalty for pre age 59 ½ distributions. May lose IRA creditor protection offered under state and federal law.

Multiple, Non-Spouse Individual as Designated Beneficiaries Identity of the beneficiaries determined as of 9/30 of the year following P s death. MRD s must begin no later than 12/31 of the year following P s death. If all of the beneficiaries are Designated Beneficiaries then distribution period for ALL beneficiaries is the life expectancy of the oldest beneficiary determined as of 12/31 of the year following P s death, reduced by 1 for each year thereafter. Solution 1: Establish separate accounts for each beneficiary by 12/31 of the year following P s death allowing use of each individual beneficiary s life expectancy in determining the distribution period. Not available to multiple beneficiaries of a single trust. Solution 2: Remove beneficiaries (cannot add) through disclaimer, distribution or litigation, so that only the desired beneficiaries exist on 9/30.

Separate Account Example IRA of $2 million Eldest DB 35 years old Life expectancy 48.5 years Youngest DB 25 years old Life expectancy 58.2 years In multiple account scenario, IRA is split 50:50 8% total pre-tax return $60 $50 $40 $30 $20 $10 Postmortem IRA Distribution Comparison in $Millions 40% tax rate on distributions 20% tax rate on growth outside IRA $0 Single Account Two Accounts

Trust as Designated Beneficiary: Single Trust Beneficiary Provides P greater testamentary control and asset protection than outright bequests. If the following requirements are met, the IRS will consider the trust a see through trust and treat the trust beneficiaries as the designated beneficiaries of P s IRA: Trust is valid under state law; The trust is irrevocable or becomes irrevocable at P s death; The beneficiary of the trust is identifiable; The beneficiary of the trust must be an individual; and Certain trust information must be furnished to the plan administrator, trustee, custodian, etc.

Trust as Designated Beneficiary: Single Trust Beneficiary (contd.) If the see through trust rules are met, then the post mortem distribution rules applicable to individuals apply. If spouse is the beneficiary: MRD s must begin no later than December 31 of the year following P s date of death. Distributions may be stretched out over the spouse s life expectancy determined as of 12/31 of the year following P s death, and recalculated each year thereafter. If non-spouse is the beneficiary: MRD s must begin no later than December 31 of the year following P s date of death. Distributions may be stretched out over the individual's life expectancy determined as of 12/31 of the year following P s death reduced by 1 for each year thereafter.

IRA Stretch-Out to Trust IRA of $2 million DB 35 years old Life expectancy 48.5 years $40 $35 Wealth Transfer Comparison In $Millions 8% total pre-tax return 40% tax rate on distributions $30 $25 $20 $15 $10 20% tax rate on growth $5 outside IRA $0 Immediate Liquidation Trust Stretch Out

Trust as Designated Beneficiary: Multiple Trust Beneficiaries Special care must be taken when designating a trust, with multiple beneficiaries, as the beneficiary of an IRA. Treasury Regulations state that plan benefits payable to a multiple beneficiary trust are not split into separate shares. Life expectancy of oldest trust beneficiary used to determine post mortem MRDs. Loss of significant income tax deferral if there is a large disparity in age of the trust beneficiaries.

Trust as Designated Beneficiary: Multiple Trust Beneficiaries (contd.) Solution 1: Account is split into separate trust shares via a custom beneficiary designation. Solution 2: Separate sub-trusts are named as the beneficiaries. Solution 3: Separate trusts (Designated Beneficiary Trusts) are named as the beneficiaries.

QTIP Trust as Beneficiary Rules governing both MRD s and qualified spousal interests for estate tax purposes apply. MRD s RBD Life expectancy No spousal rollovers permissible QTIP The surviving spouse is entitled to all the income from the property payable annually or at more frequent intervals; and No person has a power to appoint any part of the property to any person other than the surviving spouse.

QTIP Trust as Beneficiary (contd.) Advantages P maintains testamentary control of the asset, ensuring residual distribution to heirs. Creditor and predator protection is enhanced. Estate-tax deferral via unlimited marital deduction. Disadvantages Potential sacrifice of income-tax deferral relative to spousal IRA rollover. Increased complexity. Increased administrative costs. Limitations on principal distributions.

Credit-Shelter Trust as Beneficiary Retirement accounts are not ideal assets for funding credit-shelter trusts. Inefficient use of estate-tax exemption as asset naturally depreciates. Income tax burden reduces the real value of the bequest (exception: Roth IRA). Worth considering if other assets are insufficient to fully fund Credit- Shelter Trust. Pecuniary funding formula may accelerate tax. Generally, the credit-shelter trust has the surviving spouse as a beneficiary which will cause MRD s to be made over her life expectancy regardless of other beneficiaries. Consider funding as contingent beneficiary to surviving spouse disclaimer.

Funding Charitable Bequests Retirement accounts are ideal assets for funding charitable bequests. Charities are tax-exempt so no diminution in value for income tax. Full value of assets entitled to basis allocation or step-up, can pass to family. Dollar-for-dollar reduction in value of taxable estate.

Funding Charitable Bequests (contd.) Types of gifts to charity: Sole beneficiary Fractional share Formula bequest Leave benefits through trust Leave benefits through estate Disclaimer activated gift

IRA-to-CRT Example IRA of $2 Million DB 35 years old Life expectancy 48.5 years 6.275% CRT payout ($125,500 per year / 20 years) $60 $50 Wealth Transfer Comparison in $Millions 8% total pre-tax return 40% tax rate on distributions 20% tax rate on growth outside IRA (DB only) $40 $30 $20 $10 Value to DB Value to Charity Total 3.40% 7520 rate $0 Stretch Distribution IRA- to- CRT

Qualified Disclaimer Consider a full or partial qualified disclaimer of the retirement plan assets, allowing either the contingent or default beneficiaries to take. Written, irrevocable and unqualified refusal to accept the property. Must be received by transferor (custodian) within 9 months of: The day on which the transfer creating the interest in such person is made (date of death), or The date the person turns age 21. Cannot accept any interest in or benefits of the disclaimed property. The property passes without direction on the part of the disclaimant to: The surviving spouse, or A person (a see through trust is ok) other than the disclaimant.

Disclaimer Examples I, Jane Doe, hereby disclaim 100% of my beneficial interest in Fidelity Individual Retirement Account number 123456. I, Jane Doe hereby disclaim 50% of my beneficial interest in Fidelity Individual Retirement Account number 123456. I, Jane Doe, Trustee of John Doe Family Trust U/A dated January 1, 2009 (the Trust ), hereby disclaim 100% of the Trust s beneficial interest in Fidelity Individual Retirement Account number 123456.

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