Estate Planning: Pitfalls of Funding a Trust with Retirement Accounts
Retirement plan income is designated as “income in respect of the decedent.” The distributions are taxed to the beneficiary of an inherited plan as ordinary income. There is no step-up in tax basis at the death of the plan owner. This unfortunate aspect of inherited retirement benefits is becoming increasingly difficult to deal with, due to the increases in the lifetime exemption. For an increasing number of estates, retirement benefits are the largest asset in the estate. Many people are finding that they have insufficient assets to fund their credit shelter trust or the “QTIP” trust (marital) without using their retirement benefits.
Unfortunately, this means that the trust property ultimately going to the beneficiaries would be substantially less due to the income taxes that have to be paid. For example, a trust funded with a $2,000,000 Individual Retirement Account (IRA), when compared to one with $2,000,000 in stock, is not really worth $2,000,000, due to the income taxes that will have to be paid on the $2,000,000. The stock can grow tax-free and produce dividend income that, currently, is subject to a special reduced income tax rate of 15%, and the stock when ultimately sold, under current law, would be taxed at the special capital-gain rates and only on the gains incurred from the date of death forward. The IRA trust or its income beneficiaries will have to pay income tax at ordinary tax rates on the date-of-death balance and any growth since the date of death.
If a trust is a beneficiary of a retirement plan that does not qualify under the minimum required distribution rules, it will generally be subject to one of two payout options. If the owner died before his/her required beginning date for minimum distribution purposes, the trust will generally have to draw the entire balance of the account out within five years. (Keep in mind, the plan itself would have to allow you the five years to pay it out. Some company retirement plans do not allow you that option.) Ignoring state taxes, trusts in 2005 are taxed at the top 35% ordinary tax rate for income over $9,750, while single individuals are only taxed at that rate for income over $326,450. If the trust did not make any distributions to a beneficiary which passes the income tax burden along to them, a majority of the retirement income received by the trust would be taxed at the 35% tax bracket. Based on the previous example of a $2,000,000 IRA, the trust could incur over $680,000 in income tax. If the owner died after his required beginning date, the trust would have the option to continue to draw the benefits out over what would have been his/her remaining single life expectancy of the deceased and, hopefully, that would be longer than five years.
To qualify under the minimum required distribution rules that allow you to look through the trust to the trust beneficiary’s life expectancy, the trust has to meet very specific requirements. The trust must meet the four following requirements:
1) The trust must be valid under state law,
2) The trust has to be irrevocable or will, by its terms, become irrevocable upon the death of the participant,
3) The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the retirement plan have to be identifiable from the trust instrument. (This means that it must be possible to identify the oldest person who could ever possibly be a beneficiary of the trust. If there is a mere possibility that an older person could be added to the trust after the applicable date, the trust will not qualify. Example: If all my children have predeceased me, the property will be held in trust for my brother, then to his living issue. The mere possibility that the brother could inherit would disqualify the trust.)
4) Documentation has to be provided to the plan administrator, post-death
5) All the beneficiaries of the trust must be individuals. (Note that there are letter rulings that indicate if a trust instrument allows or directs the use of trust property to pay the participant’s debts, expenses or taxes. The estate is considered a beneficiary resulting in the “the no-designated-beneficiary” rule applying (the payout-within-five-year rule)
If you meet all these requirements, you can look through to the oldest trust beneficiary’s life expectancy for purposes of the minimum required distributions rules.
Additional steps should be taken to define fiduciary accounting income versus principal, etc. Otherwise, there is a high risk of paying tax at the highest income tax rate, due to the discrepancy in the income tax brackets applicable to trusts and those applicable to individuals. Additional income tax issues also arise due to differences in the definitions of trust accounting income and principal, retirement plan’s minimum required distributions, and federal taxable income, and they need to be addressed. The balance in the retirement account at the date of death is, by definition, principal of the estate. Distributions may or may not be “income” and/or “principal.” At one time, under South Carolina law, retirement income distributions were defined as 10% income and 90% principal. If a trust document called for income only to be distributed and provided no other definition of income, under this old 10/90 split rule, only 10% of the retirement distribution would have been income payable to the beneficiary. Example: A trust receives a $100,000 minimum required distribution in 2005. $10,000 would be distributable to the beneficiary and taxed at the beneficiary’s rates. The remaining amount, principal, would be subject to income tax within the trust. In this example, $90,000 would stay in the trust resulting in over $30,000 in income tax.
This is a very complicated area. There are even more complications that relate to use of pecuniary formulas and powers of appointment that can affect when the benefits are subject to tax and whether a trust can qualify under the minimum required distribution rules, etc. There are too many issues to address in one article. Just be aware if you are in a situation in which your retirement benefits represent a significant portion of your estate and your estate plan requires the funding of trusts with all or even a portion of your retirement benefits, it is highly recommended that you consult with attorneys, accountants, or retirement planners that are well-versed in the different areas of the laws that apply. It can make a large difference in how much the government gets in income taxes and how much ultimately flows to your beneficiaries.