Retire Secure!

KEY IDEA

Setting up a trust for the beneficiary of a retirement plan and/or IRA can be an excellent method of protecting the beneficiary. Creating trusts for minors, for spendthrifts, and for spouses can be appropriate under certain circumstances.

There are many types of trusts, and each one serves a particular purpose. As I mentioned earlier, many good estate attorneys routinely create trusts for adult children. Though I think this practice has merit, for responsible older adult children without marital problems, I believe the simplicity of leaving money outright outweighs some of the risks that the trust protects against. Remember, though, you should never name your estate as your beneficiary because that makes it subject to probate, which is a time consuming and expensive process, and which accelerates the income tax that would have been due on the retirement account.

Please remember the basics. Your beneficiary designation, not your will, controls the distribution of your IRA at your death. Therefore, you need to make sure that the beneficiary designation of your retirement plan is completed correctly.

You can either submit a correctly worded beneficiary designation form, or name as the beneficiary a qualifying trust that complies with the five conditions listed in Chapter 13. Assuming that it is done correctly, you will have the same result using either option. If the beneficiary form is completed incorrectly or if the terms of the trust do not meet the five conditions described in Chapter 13, then we have enormous problems. Please refer back to Chapter 16 for details on actually filling out the beneficiary forms.

I do not allow my clients to fill out beneficiary change forms for their IRAs or retirement plans. Granted, it takes additional time for us to do it, and requires even more work if there are many IRAs and retirement plans in different investment companies, all of which are likely to have their own beneficiary change form. I have seen enough instances where the client and/ or his attorney were cavalier about the IRA beneficiary form, and the form was filled out incorrectly. I have also seen situations where the attorney’s directions to the client were not clear or, worse yet, the client didn’t follow the attorney’s instructions. With large IRAs or retirement plans, there is too much at stake to allow errors.

In my office, we draft a special document to be used as the retirement plan or IRA beneficiary designation. Within that long document (see Lange’s Cascading beneficiary Plan), we draft a special trust or, more often, a series of trusts to be used as the beneficiary of the IRA. Currently, we typically refer to the will or a revocable trust that contains all the details. The trust within the will or revocable trust, however, always meets the five conditions required for the trust or beneficiary to stretch the IRA.

With large IRAs or retirement
plans, there is too
much at stake for inadvertent
errors; get help from a
competent attorney who
understands how to draft
IRA beneficiary designations.

My original intention was to include detailed sample language with this book, but after thinking it through, realized that with large IRAs or retirement plans, there is too much at stake for inadvertent errors; get help from a competent attorney who understands how to draft IRA beneficiary designations.

The attorney should understand your entire financial situation and have the requisite technical knowledge of the law and the forms before being asked to properly fill out the forms. This is one instance when I think paying an attorney is money well spent. Other financial professionals may be competent to perform this task, but please make sure that filling out a beneficiary form is not incidental to a sale but rather a task taken seriously by whoever is performing it.

Let’s start with these basic assumptions. An IRA or a 403(b) or 401(a) participant owner dies. A trust is the primary beneficiary, or it becomes the beneficiary because the surviving spouse, who had been named as the primary beneficiary, disclaims and the trust is the secondary beneficiary.

We have discussed the Required Minimum Distribution (RMD) rules for the inherited IRA owned by the trust both during the life of the surviving spouse and after the surviving spouse dies. What perhaps is not clear is the mechanics of how the account should be handled after death in order to avoid a massive acceleration of income taxes—which would happen if all the money in the IRA were disbursed to the beneficiary.

After death, the inherited IRA will be retitled to something like “Bob Jones, deceased, for the benefit of Sam Jones, Trustee of the Bob Jones Plan benefits Trust.” However, the money is not actually transferred to the trust at that point. The name of the account is retitled, but that is not an income taxable event.

The money sits in this newly named account held by the plan administrator. The RMD rules for a spouse who inherits an IRA are based on his or her life expectancy. If, for example, the surviving spouse has a 20-year life expectancy, we would divide 20 into the account balance as of December 31 of the year the IRA owner died in order to calculate the RMD. In subsequent years, the life expectancy factor would be 19, then 18, and so on. Even after the death of the surviving spouse, children would still have to take withdrawals based on the surviving spouse’s remaining life expectancy according to the tables, if any money remains.

When any trust is the beneficiary of an inherited IRA, whether the end beneficiary is a trust for children or the spouse, income taxation generally occurs when the money is transferred from the inherited IRA to the trustee of the trust. To minimize the taxes, I generally recommend that the transfers happen only on a RMD basis. The trustee will receive the check from the plan administrator and deposit it into a checking account in the name of the trust. If the money is kept in the trust, the trust must pay income taxes on the distribution at trust income tax rates. More commonly, the trust will pay out 100 percent of the RMD it receives to the trust beneficiary, the surviving spouse. The reason for paying the RMD (or whatever amount is withdrawn) to the beneficiary, rather than keeping the money in the trust, is to avoid the higher income taxes imposed on the trust (which are usually higher than an individual’s income tax rate).

Here is an example of how it happens in our office. We calculate the annual RMD early in January. We have a monthly automatic transfer of one-twelfth of the RMD from the inherited IRA to a separate trust checking account. Then we have an automatic transfer from this trust account to the bank account of the surviving spouse. At the end of the year, the plan administrator issues a Form 1099 (or multiple 1099s) to the trust. The trustee files a tax return called a Form 1041 reporting the distribution it received as income, and deducts the amount it paid to the surviving spouse as a distribution deduction, via a Schedule K-1. Since the deductions equal the income exactly, the trust pays no tax. The surviving spouse includes the Schedule K-1 income (which is the amount distributed from the inherited IRA) on her own Form 1040 for the year and pays the income tax accordingly.

Therefore, what you may have heard in the past—that when the money goes to a trust it becomes taxable—is accurate. However, it is important to understand that after the death of the IRA owner, the money is transferred into an inherited IRA account and not the trust account until minimum distributions or other distributions are deposited into the trust account. Simply renaming the account to the name of the trust is not a withdrawal of the entire IRA (which would generate a huge tax bill).

Tom fills out his beneficiary form with wording provided by the Human Resources Department where he works: “My grandchild Junior, in trust.” Tom does have a will that includes a trust for Junior, but there is no specific reference to that will in this beneficiary designation. The result is that Junior may not be able to reach this money when he is 21 because, in effect, there is no trust as a beneficiary specific to the beneficiary designation. Less technically, that means that the words Tom used on his beneficiary form were too vague, and the IRA custodian will delay releasing the funds while they try to figure out which trust Tom was talking about. And while Junior’s parents (or their lawyers) may eventually be able to argue that the trust mentioned in Tom’s beneficiary designation is definitely the same one as the trust mentioned for Junior’s benefit under Tom’s will, considerable time and expense could have been saved if Tom had had good advice and knowledgeable help to complete the beneficiary designation properly.

Let’s consider another example. Tom fills out the beneficiary form with “The Tom Family Trust for Grandchildren, found in my will.” Assuming the trust in the will meets all five requirements, the money will pass as intended, in trust. Let’s review the five requirements again:

If, on the other hand, the trust in the will violates one of these five conditions, then we do not have a qualifying trust as a beneficiary. If that is the case, the income from the IRA is accelerated and Junior loses the ability to stretch the proceeds of the IRA for as long as possible.

Therefore, it is critical that the five conditions are met for all trusts with the potential to become beneficiaries of IRAs and/or retirement plans.

The most prudent way to
leave money to a young
beneficiary is through
a trust.

This example provides a reasonable starting point, but is not the only way to draft a trust for young beneficiaries.

It is easy to vary the terms of the trust according to your personal preferences. The type of trust I described works well when the beneficiaries are young, usually for grandchildren when it is unclear how they will turn out as young adults. If the beneficiary is already in his or her late teens or early twenties, you can alter the terms as seems prudent to you. Some 25-year-olds are perfectly capable of handling money without the need for a trust, but I’ve also met 35-year-olds who were nowhere near ready for that type of responsibility. If your beneficiaries are old enough for you to assess their level of responsibility, and you have confidence in their judgment, then you don’t have to rely on the general language recommended above.

Most of the trusts for minors that we draft are for the benefit of a grand-child (or grandchildren). The trust takes effect when the IRA owner dies and the first beneficiary (often the IRA owner’s child) has either predeceased the grandchild or chooses to disclaim to his or her children.

Tom Smith, a retired IRA owner, has one son, Joe, and one grandson, Junior, age 3. He fills out his beneficiary form as follows:

Tom dies. Joe doesn’t want or need the money and, as his father had asked him to, he disclaims his right to the IRA. The money will then go to Junior, who is the contingent beneficiary. Since his grand-father did not establish a trust for his benefit, Junior will have complete access to the IRA money when he reaches 21 (younger in some states). Tom’s legacy might be a Corvette and a year of drunken partying for Junior.

As Tom’s will states, he has already drafted a trust for Junior. With this structure, his son, Joe, can be much more comfortable. Joe can disclaim his inheritance to the trust that he knows has reasonable restrictions for Junior, rather than disclaiming the assets outright to him. Now Junior will not have access to all of the money at 21, but if he has legitimate needs—education, for example—they can be met by the trust. Joe could even be named trustee. By going to the trouble of drafting the trust, Tom protected the money from premature taxation and frivolous spending. The trust also protects Junior’s inheritance from his creditors, who may range from a bank or credit card company, to someone suing him for damages in an automobile accident, and even to his future spouse if their marriage goes sour.

This type of trust may also be referred to as a forced prudence trust, or, and this is my personal favorite, the “I don’t want my no good son-in-law getting one red cent of my money” trust.

The basic spendthrift trust is usually drafted because not every child, even those beyond 35 years old, will have developed sufficient maturity or sense of fiscal responsibility to make wise choices after the death of his or her parent or parents. It is also possible that parents may feel their children will never be financially responsible so the parents want to control from the grave for the remainder of their child’s life. Since the greatest value of an inherited IRA is to stretch the benefits for as long as possible, it would be a financial disaster to have an inappropriate and premature withdrawal of these funds.

A spendthrift trust will put a trusted relative, friend, or financial institution in control of the beneficiary’s money and will ensure that the inherited IRA is used as a lifetime fund rather than an “I want a brand new Porsche fund.” In more severe cases, where drug addiction or alcohol abuse comes into play, I often recommend additional special provisions. Spendthrift trusts typically also include creditor protection language, and even though such language does not offer the beneficiary perfect protection, it does go a long way toward protecting the beneficiaries not only from themselves but also from their creditors or potential creditors. One set of potential creditors for your children that you may not have thought about are your children’s spouses in the event that they divorce. Other times, even without a divorce, a child’s spouse may be pushing the child to act irresponsibly with the inherited funds. In some cases, a trust can be used to protect a child from his or her spouse’s irresponsibility.

Our law firm is experiencing an ever-growing number of clients who love their kids, but who don’t trust their kids’ spouses.

One of life’s greatest mysteries is how the boy who wasn’t good enough to marry your daughter can be the father of the smartest grandchild in the world.

— Proverb

A couple came into my office, and the first thing the husband said was, “I don’t want my no good son-in-law to get one dime of my money.” Only after discussing this issue could we proceed with providing for his wife, his other children, his grandchildren, and saving taxes. What we ended up with was, basically, leaving any money that his daughter might inherit to a trust for the benefit of the daughter. We named an independent trustee whose job is to make sure the money is protected from the son-in-law, even if the daughter wants to give her husband money. In terms of actual drafting, the language is similar to a traditional spendthrift trust.

Although I have no qualms in drafting a trust when the client thinks there is a significant need to protect the beneficiary, other practitioners go much farther in the direction of controlling from the grave. For some children, spendthrift trusts are certainly justified, and it is far more prudent to leave money to a child in trust. Some practitioners see leaving money for adult children in trust as the norm rather than the exception. Personally, I am a cheap-skate, and I like to keep things simple if I can. Therefore, my default is not to draft a trust for an adult beneficiary.

One noted expert who recommends using a trust for an adult child as the rule instead of the exception advocates putting virtually all of an adult child’s interest from an inherited IRA into a trust. As he correctly points out, this forces the child to stretch the benefits over his or her lifetime and protects the child from creditors. He claims that the adult children are happy with this arrangement. Many financial firms offer boilerplate trusts as beneficiaries of the IRA. I generally do not like this approach.

I prefer the simplicity of trusting the adult child’s judgment unless there is a reason not to. The idea of forcing the adult child to stretch the IRA for as long as possible and not permitting anything other than mandatory withdrawals is a reasonable idea under some circumstances, especially if the child needs the maximum protection possible from creditors. If you do use a trust (even in a spendthrift situation), the trust should have a provision allowing for distributions beyond the Required Minimum Distribution (RMD) from the IRA. It should also have a provision for distributions for health, maintenance, support, education, and so on.

A relevant issue when naming a trust as a beneficiary of an IRA is whether the drafter wishes to treat the RMD as income, or part income and part principal for the trust’s accounting purposes. Pennsylvania and some other states in accordance with the Uniform Principal and Income Act of 1997 (UPAIA) have adopted tracing rules which require the trustee to allocate a portion of the RMD as income and the remainder of the RMD as principal. If the income portion of the RMD cannot be traced, the UPAIA states that a RMD payable to a trust will be treated as 90 percent principal and 10 percent income for trust accounting purposes. Accordingly, if the objective is for the income beneficiary of the trust to pay the income tax due on the RMD (my usual preference because the income tax rates for individuals are lower than the rates for trusts), drafters should opt out of the UPAIA by mandating that RMDs payable to the trust be treated as income and paid out to the income beneficiary.

In years past, it was common to see the B trust, or the Unified Credit Shelter Trust, named as the contingent beneficiary of the retirement plan. This type of trust gave the surviving spouse all of the trust income and the trustee the flexibility to distribute principal for the health, maintenance, and support of the surviving spouse. The surviving spouse was also often given a “5 and 5 power,” meaning that each year the surviving spouse could withdraw the greater of an additional five percent of the corpus (assets excluding Profit and interest) of the trust, or $5,000. At the death of the surviving spouse, the trust proceeds generally went to the children equally. The main purpose of this type of trust was to ensure that, for federal estate tax purposes, the proceeds of the trust would not be included in the estate of the second spouse to die.

Currently, federal estate taxes are not a concern for most taxpayers, and so avoiding estate taxes should not be the reason for establishing (or keeping) this type of trust. The Applicable Exclusion Amount has been increased to a level ($5.43 million in 2015) that far exceeds the estates of most couples. In addition, the estate of the first spouse to die can now elect to transfer any unused Applicable Exclusion Amount, to the estate of the surviving spouse. This concept, known as portability, brings the amount of a married couple’s assets that are completely exempt from federal estate tax to well over $10 million.

Married couples whose estates are not likely to ever exceed $10 million, who still have this type of trust as part of their estate plan, should have their documents reviewed by a competent estate planning attorney immediately. Please read “The Cruelest Trap of All” in Chapter 11 to find out why.

I hate to see QTIP trusts (qualified Terminal Interest Property) and/or B trusts as beneficiaries of retirement plans and IRAs and, in my practice, use them only as a last resort. But since it is not unusual to see QTIP trusts in second marriages, I will give you a brief overview of how they work. Basically, the trust says to pay the surviving spouse an income for life, but at the second spouse’s death, have the principal revert to the children of the first marriage.

The terms of the QTIP trust have provisions for the surviving spouse that are similar to the provisions for the surviving spouse in a B trust. Like a B trust, it provides income to the surviving spouse and the assets revert to the children at the surviving spouse’s death. The purpose of the QTIP trust, however, is not to avoid estate taxes at the second death. Rather the purposes are to provide an income to the surviving spouse, to preserve a marital deduction at the death of the first spouse, and to preserve the assets for the children from the decedent’s first marriage. The marital deduction allows the first estate to escape federal estate taxation on the assets transferred to the QTIP trust. But unlike the B trust, the balance of the QTIP trust is included in the estate of the second spouse to die. As a result, there are no estate tax savings with the QTIP trust.

It is natural to want to protect your second spouse and then have the money revert to children from your first marriage. For after-tax assets, QTIP trusts, though not a perfect solution, are often the best solution. In reality, for IRA owners using this type of plan, the biggest question in my mind is who will be most unhappy: the surviving spouse, the children of the first marriage, or the poor trustee.

This type of trust accelerates income taxes by forcing both the surviving spouse and the children of the first marriage (generally the ones who inherit the remainder of the trust at the second death) to take RMDs based on the surviving spouse’s age. Because QTIP trusts are usually the primary beneficiaries and the interests of both spouses are usually different because frequently they each have their own set of children, there are few disclaimer opportunities providing alternative ways to reduce income taxes.

As a result, during the surviving spouse’s life, minimum distributions are accelerated faster than if the surviving spouse had been named outright. When the surviving spouse dies (assuming the surviving spouse predeceases the children), the children of the first marriage will also have an accelerated RMD schedule based on the life expectancy of their stepparent, not their own life expectancy (the same situation as the RMD of a Unified Credit Shelter Trust). (See Mini Case Study 14.1).

For example, if the value of an income stream for a 65-year-old surviving spouse based on a six percent rate of return is worth roughly 58 percent of the principal of the IRA (based on the life expectancy of the surviving spouse and depending on what tables you use), then it is simpler and preferable in the vast majority of cases to leave the surviving spouse 58 percent of the IRA and the children 42 percent of the IRA.

Upon the death of the IRA owner, the surviving spouse takes his or her share and rolls it into an IRA. Until the surviving spouse reaches 70½, there is no RMD. When he or she reaches 70½, he or she will take RMDs based on the Uniform Life Table (see the appendix). The children take their shares as an inherited IRA and stretch distributions based on their own life expectancies. Clean. Simple. Cheap. No trusts, no fuss, no muss.

This solution may not fit with the IRA owner’s goal of making sure the surviving spouse always has an income. In some circumstances, particularly for an older and less sophisticated beneficiary spouse, it may be prudent to direct the executor to buy an annuity that will guarantee the second spouse an income for life (see Chapter 8).

With more frequency, we are using Charitable Remainder Unitrusts (or CRUT) as contingent beneficiaries of IRAs. If a CRUT is established and is named as the beneficiary, the descendant’s IRA is paid as a lump sum into the CRUT. Distributions can be paid to income beneficiaries of the trust (usually the children) for years, possibly even for the duration of their lifetimes, but there is a specific amount that eventually must be turned over to the charity that is named as the final beneficiary. The amount that can be paid to the income beneficiaries is calculated yearly, using a complex formula required by the IRS. There are no taxes due at the time the IRA is moved to the CRUT because the final distribution is to a charitable entity, and the trust can take a tax deduction for the charitable contribution even though the contribution doesn’t get paid until the trust is dissolved. However, the annual distributions made to income beneficiaries are subject to income tax.

Even if they have generously donated to charity over the course of their lifetimes, many of my clients have done a double take when I’ve brought up the idea of leaving their large IRA to a charitable trust. Understandably, they’re concerned about how their children will react when they find out that they aren’t the beneficiary. But once they understand how the CRUT works, then the idea begins to make sense. Often the benefit of the deferred incoming growing inside the CRUT exceeds the amount of the final payout to the charity.

Margaret, a retired IRA owner, has no children of her own. She wants to leave her IRA, valued at $1 million, to her sister’s only child, Thomas, who is 57 years old. As you know from reading Chapter 5, in the absence of proper planning, Thomas will be required to with-draw all of the money from his aunt’s IRA within five years, causing a maximum acceleration of income taxes. Is there anything that Margaret can do to minimize Thomas’ tax bill, while at the same time maximizing the amount he receives from her IRA?

The answer is yes. Margaret can establish a Charitable Remainder Unitrust that names her nephew as the income beneficiary, and her favorite charity (or charities) as the final beneficiary. Because the beneficiary form on her IRA was completed correctly, the account will be transferred to the trust at her death. Thomas reinvests all of the distributions he receives into a brokerage account, until his death at age 84. The value of his account at his death if he received the distributions from the IRA is $3,299,558. The value of his account at his death if he had received the distributions from the CRUT is $3,798,384 – and her favorite charity also receives

The income tax consequence of removing all of the money from the tax shelter of the IRA within five years is significant. If Congress does limit the number of years that a beneficiary can make withdrawals from an inherited IRA, the CRUT can serve as an alternative method to “stretch” the proceeds of the IRA for longer than five years, possibly for the lifetime of the beneficiary. In addition, naming the spouse as the primary beneficiary of the IRA and the CRUT as the contingent beneficiary allows maximum flexibility, because the spouse can access the money if she needs it, and disclaim to the trust if she doesn’t.

A Key Lesson from This Chapter

Establishing a trust as a beneficiary is most successful for protecting minors and spendthrifts. B trusts and QTIP trusts, though sometimes an interesting option, are usually not best for IRA and retirement plan beneficiary designations. Charitable Remainder Unitrusts should be considered if the IRA owner is charitably inclined.

17

Trusts as Beneficiaries of Retirement Plans

Put not your trust in money, but put your money in trust.

— Oliver Wendell Holmes

One of life’s greatest mysteries is how the boy who wasn’t good enough to marry your daughter can be the father of the smartest grandchild in the world.

— Proverb