Many clients contribute to qualified retirement accounts (e.g., IRAs, Section 401(k) plans and Section 403(b) plans) for income tax planning and retirement planning purposes. In general, contributions into qualified retirement accounts appreciate income tax-free for as long as funds remain in the account. With the exception of Roth IRAs and Roth 401(k) plans, distributions to the account owner are subject to income tax when they are withdrawn.
To ensure that qualified retirement accounts are used by the account owner during their retirement years, tax laws require that required minimum distributions (RMDs) are distributed over the owner’s life expectancy. In general, the required beginning date (RBD) is the April 1 of the year following the year in which the owner turns 70 ½. If the RMDs are not withdrawn, then an excise tax is imposed.
If a client dies prior to the full distribution of the account, then the account is paid to whomever is named as the beneficiary. If the new beneficiary is an individual, then that person can withdraw those funds immediately, or they can be “rolled over” to an IRA of their own. The beneficiary then must make RMD withdrawals based on the beneficiary’s life expectancy under the single life table and the account value on the Dec. 31 of the prior year.
Where an owner of a qualified retirement account wishes to have those remaining funds managed for traditional estate planning reasons – for special needs beneficiaries, for benefit of a second spouse, for beneficiaries who are not yet able to manage funds, for spendthrift purposes, etc. – then a trust is a logical choice.
An important secondary consideration of making a trust the beneficiary is to maximize the distribution period of time to allow for asset appreciation and income tax deferral. If a trust is a “designated beneficiary,” then the trust can withdraw funds based on the oldest trust beneficiary’s life expectancy. For a trust to have a “designated beneficiary,” four requirements need to be met:
1. The trust is a valid trust under state law.
2. The trust is irrevocable or, will, by its terms, become irrevocable upon the death of the qualified retirement account owner.
3. The beneficiaries of the trust are identifiable.
4. A copy of the trust documents are provided to the plan administrator by Oct. 31 of the year immediately following the year in which the IRA owner died.
Attorneys should consider drafting trusts that qualify for “designated beneficiary” status. The IRS has identified several trusts that will meet the qualifications.
The first type of trust is a “conduit trust.” If the trust requires RMDs and any other amounts withdrawn from a qualified retirement account, to be distributed to the trust beneficiary “upon receipt by the trustee,” then the income beneficiary’s life expectancy can be used for determining the length of the distribution period. The life expectancy of the remainder beneficiaries is ignored.
Conduit trusts are not recommended for trusts with special needs beneficiaries, or in other situations where mandatory distributions are not advisable (e.g., trusts for minors, etc.). Frequently, conduit trusts are used when the beneficiary of the conduit trust is a second spouse and having an outright distribution to the second spouse might place the children from the first marriage at risk.
The second type of trust which qualifies as a designated beneficiary is an “accumulation trust.” In that case, all current and potential trust beneficiaries are considered for life expectancy purposes. The oldest beneficiary’s life expectancy is then used for the distribution period. As such, the trust agreement must prohibit trust distributions to a beneficiary who is older than the person whose life expectancy is used to calculate the RMD.
If the trusts provide the typical heirs-at-law contingent beneficiary clause, or to a charity, the trust will not be a designated beneficiary. It is important to note that only individuals may be beneficiaries. An estate, a charity or other institution cannot be named. The beneficiaries of the trust must be identifiable. If the remainder beneficiaries cannot involve a class capable of expansion or contraction, then the member with the shortest life expectancy will be used.
Where a trust does not have a designated beneficiary, then the qualified retirement account is treated as having no beneficiary for determining the life expectancy over which to pay the RMDs, and distributions will be distributed over a much shorter period of time, in one of two ways.
First, if the owner died before her RBD, then RMDs are calculated based on the “five year rule” – the account is to be paid out by Dec. 31 of the year containing the fifth anniversary of the owner’s death. Second, if the owner died after her RBD, then RMDs are calculated based on the owner’s theoretical remaining life expectancy.
In sum, naming trusts (rather than individuals) as beneficiaries of retirement plans is often desirable for a variety of reasons. But, in cases where account owners want to maximize the income distribution period, after their deaths, an appropriate trust form must be utilized.