Among the most heavily taxed assets of an estate are the accrued benefits of a qualified retirement plan and the account balances of an individual retirement account (IRA). For purposes of this article, a qualified retirement plan includes profit-sharing plans, stock bonus plans, 401(k) plans, money purchase pension plans, defined benefit plans and other plans satisfying the definitions of Section 401 1 and the service’s related regulations. An IRA includes any account meeting the definitions of Section 408 and the related regulations. 2
For the purposes of this article:
1. The benefits of a qualified retirement plan and the account balance of an IRA will be referred to as the plan or plan benefit.
2. The participant in a qualified retirement plan and the owner of an IRA will be referred to as the plan owner.
3. The beneficiary of a qualified retirement plan or an IRA will be referred to as the plan beneficiary.
Estate Taxation of Plan Benefits
Upon the death of the plan owner, all plan benefits are subject to the federal estate tax. 3 In addition, a state transfer tax may apply depending upon the plan owner’s state of domicile. 4 the 15 percent federal excess accumulations excise tax has been repealed and no longer applies for decedents dying after December 31, 1996.
A plan benefit payable to a spouse, will not attract the federal estate tax (or state transfer tax) until the death of that spouse. 5 The federal estate tax (and state transfer tax) is not imposed upon plan benefits passing to a charity. 6 If any of the plan benefit is paid to an individual or entity, other than a spouse or charity, then upon the plan owner’s death, the plan benefit is subject to the federal (and possible state) estate taxes, unless the plan benefit is protected by the estate tax exemption equivalent amount. 7
Income Taxation of Plan Benefits
A plan owner must begin receiving distributions on April 1 of the calendar year following the year in which he or she attains age 70 (the required beginning date). A 50 percent excise tax is imposed on that portion of a required distribution that is not in fact received by the plan owner (or a beneficiary). 8
The required distribution amount (minimum distribution) is computed by dividing the December 31 account balance of the previous calendar year by the payout period (i.e., the time period over which distributions must be made). 9
The payout period is determined pursuant to the rules of Section 401(a)(9)(A) and the corresponding proposed regulations (subject to the terms and conditions of the plan document), which provide that distributions must be made over the life expectancy of the plan owner or the joint life expectancy of the plan owner and his or her “designated beneficiary.” 10
The phrase “designated beneficiary” is a term defined in the Code and proposed regulations to mean an individual and certain “qualified trusts.” 11 Only the life expectancy of a designated beneficiary can be used to determine the payout period. Thus, if an estate, entity, organization or non-qualified trust is named as a beneficiary, then the plan owner is treated as not having a designated beneficiary for the purpose of computing the minimum distribution amount. In that event, only the life expectancy of the plan owner can be utilized to determine the payout period. 12
While the naming of a designated beneficiary provides an additional life over which payments can be made, the plan owner may also elect to either:
(1) have the payout period recalculated annually based upon the then-applicable life expectancy or joint life expectancy of the plan owner and his or her designated beneficiary (the recalculation method), or
(2) simply reduce the initial life expectancy or joint life expectancy (determined in the year in which the plan owner attains age 70) by one for each year which has lapsed (the term certain method). Only the life expectancy of the plan owner and his or her spouse may be recalculated. 13
Recalculating life expectancies in each succeeding year generally results in a smaller minimum distribution than would otherwise be required under the term certain method. However, the recalculation method is risky, since the recalculated life expectancy of an individual becomes zero in his or her year of death. Thus, the premature death of the plan owner or his or her spouse may accelerate the required minimum distributions in the years following the death.
The Code establishes two sets of rules for determining the minimum distribution amount for a plan beneficiary. If the plan owner dies before the required beginning date, the general rule is that the entire plan benefit must be distributed within five years after the plan owner’s date of death. However, the following exceptions apply:
1. If the plan benefit passes to a “designated beneficiary” other than the spouse for the plan owner, distributions can be made over a term certain not to exceed the list expectancy of the designated beneficiary, provided distributions begin no later than one year following the plan owner’s death; or
2. If the plan benefit passes to the spouse of the plan owner, distributions can be made over the life expectancy (or term certain not to exceed the life expectancy) of the spouse beginning in the year in which the plan owner would have attained age 70. 14
If the plan owner dies after the required beginning date, then the minimum distributions must continue to be made at least as rapidly as the payout period in effect at the plan owner’s death.
While the distributions received by a beneficiary are subject to the income tax, a deduction for “income in respect of a decedent” is available under Section 691(c) of the Code for the federal estate tax attributable to the plan benefit.
Generally the Section 691(c) deduction is computed by determining the federal estate tax with and without the plan benefit. The difference is the federal estate tax attributable to the plan benefit., and hence the income tax deduction. For example, assume client A has a taxable estate of $1,900,000, of which $880,000 consists of plan benefits. The federal estate tax with and without the plan benefit is approximately $450,000 and $130,000 respectively. Thus, up to $320,000 ($450,000-$130,000) can be taken as an income tax deduction against the $880,000 plan benefit as distributions are made to the plan beneficiary. 15
Use of Trusts to Minimize Estate Tax Burden and Maintain Income Tax Deferral
Designating a trust as a beneficiary of plan benefits may be advisable for estates with insufficient assets, outside of plan benefits, with which to fully utilize the plan owner’s federal estate tax exemption amount. While trusts may be named as a beneficiary of plan benefits, the trust must satisfy specific qualification requirements of the proposed regulations to meet the definition of a designated beneficiary for purposes of determining the minimum distribution amount. 16
If the trust meets the qualification requirements of the proposed regulations, then the life expectancy of the trust beneficiary and the plan owner can be utilized for purposes of determining the payout period. On the other hand, if the trust does not meet those requirements, only the plan owner’s life or life expectancy may be utilized to determine the payout period.
In this event, if the plan owner dies before his or her required beginning date, then the entire plan benefit must be distributed (and hence taxed) within five years of the account owner’s death. If a plan owner dies after his or her required beginning date, then the plan benefit will be distributed over the plan owner’s remaining life expectancy only. If the plan owner had been recalculating his or her life expectancy, then the remaining life expectancy is zero and the entire account balance must be paid out (and taxed) within one year of the plan owner’s death.
The beneficiary or beneficiaries of a trust will be treated as a designated beneficiary for minimum distribution purposes, if the trust satisfies the following requirements on the date the trust is named as a beneficiary, or the plan owner’s required beginning date, whichever is later:
1. the beneficiaries of the trust are identifiable from the trust instrument.
2. The trust is a valid trust under state law, or would be except for the fact that there is no corpus.
3. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the participant. (The trust need not become irrevocable “by its terms: if it becomes irrevocable under state law on the plan owner’s death).
4. The plan owner provides a copy of the trust document (and any amendments thereto) to the plan administrator. Alternatively, the plan owner may provide a list of all beneficiaries of the trust (including contingent and remainder beneficiaries with a description of the conditions on heir entitlement) certifying that, to the best of the plan owner’s knowledge, the list is correct and complete. The plan owner must also agree to provide any changes to the list ant to provide a copy of the trust instrument upon demand. Within nine months of the plan owner’s date of death, the trustee must provide to the plan administrator either a list of all the beneficiaries of the trust (including contingent and remainder beneficiaries with a description of the conditions on their entitlement) or a copy of the actual trust document. 17
Also, if a portion of an IRA is to pass to the trust, care should be taken to utilize a fractional formula and not a pecuniary amount to avoid an inadvertent (an unintended) acceleration of the income tax consequence.
While estate tax savings can be achieved with credit shelter trust planning, consideration should be given to the income tax consequences, particularly if the client’s primary objective is to maximize the funds available to his or her spouse. Generally, distributions passing to the trust are allocable to principal and may not carry out distributable net income. Therefore, such distributions could be taxed at the trust level where the income tax rates reach higher brackets at significantly lower income levels.
QTIP Trust as Beneficiary
If a plan owner wishes to provide for the needs of his or her spouse, but desires to retain control over the ultimate disposition of the benefits, the plan owner should consider designating a qualified terminal interest property (QTIP) trust as the beneficiary of his or her plan benefit. If the plan owner has children from a prior marriage and wishes to preserve pan benefits for his or her children, this option is particularly effective in securing the plan owner’s goals.
When naming a QTIP trust as the beneficiary of plan benefits, the trust should be designed to meet the definition of a designated beneficiary. In addition, the spousal consent rules (if applicable) and the QTIP eligibility rules must be addressed.
The Code and the regulations require spousal consent to name a trust as the beneficiary of a qualified retirement plan under the rules of Sections 401(a)(ii) and 417. 18 Spousal consent is not required for an IRA.
No federal statute or regulation specifically addresses qualification for QTIP treatment in the case of plan benefits. Certain revenue rulings and private letter rulings give guidance to qualifying a trust for QTIP treatment. rev. Rul. 89-89 19 held that a decedent’s executor could elect to treat the decedent’s IRA as QTIP property and, thereby, obtain a full marital deduction. In this ruling, the conclusion of the IRS was based on certain criteria including:
1. a determination of whether the spouse would be entitled to all income earned by the IRA on an annual basis; and
2. the QTIP election having been made for both the IRA and the QTIP trust.
Letter Ruling 9704029 provides a clear road map for satisfying the QTIP requirements for plan benefits.
Common among all rulings is the importance of the “income” requirement. Section 2056 provides that the trust must give the surviving spouse a “qualifying income interest for life” for the trust to obtain QTIP status. 20 the Code provides that a surviving spouse had a “qualifying income interest for life” if he or she is entitled to all income from the property payable annually or at more frequent intervals. In addition, no person can have a power to appoint any part of the property to any person other than the surviving spouse.
To ensure that the surviving spouse has a qualifying income interest for life, the beneficiary designation form and trust document should provide that the greater of the income generated by the plan benefits or the required minimum distribution amount must be paid to the trust annually. The trust instrument should also provide that all plan benefits received by the trust are allocable to trust income. 21 To be certain that the requisite income is paid to the spouse, the trustee of the QTIP trust should have the right to require the plan trustee or IRA sponsor to convert non-income-producing assets into productive assets. The trustee should also be given the right to withdraw a portion of the IRA balance in an amount equal to the income that should have been produced if the assets were productive.
The rulings suggest that a QTIP election b made regarding both the QTIP trust and the plan benefit itself. However, an argument can be made that a QTIP election need not be made with respect to property interests that are held by a QTIP trust (i.e., the plan benefit). As Revenue Ruling 89-89 indicates, the IRS may be concerned that if a QTIP election is not made for the plan benefit itself, then the possibility arises that upon the surviving spouse’s death, the plan benefits would not be included in the spouse’s estate. Therefore, to ensure the marital deduction, a QTIP election should be made for both the trust and the plan benefit.
A fractional share formula should be used to allocate plan assets to a QTIP trust (or any trust). The pecuniary bequest of plan benefits could accelerate the income tax liability under Section 691(a)(2).
Proper planning for the distribution of plan benefits can result in significant income tax deferral and, in some instances, estate tax reduction. Accomplishing these objectives requires a full understanding of a client’s objectives and a clear understanding of the options and planning opportunities associated with plan benefits. Once a client’s goals are outlined and the intricacies of the law understood, creative solutions can be established to meet those objectives.
Endnotes 1 All section references herein are to the Internal Revenue Code of 1986, as amended (the “Code”) and the regulations thereunder.
2 An individual retirement account also includes a “Roth IRA” as defined in Section 408A. Note, however, that the minimum distribution rules discussed in this article apply to a Roth IRA only upon the death of the Roth IRA owner and his or her spouse. During the lifetime of the owner and his or her spouse, no minimum distributions from a Roth IRA are required. For Section 403(a) and 403(b) “Tax Sheltered Annuity” contracts, a beneficiary should give special consideration to the rules of Code Section 72(h) and 72(s).
3 For Retirement Accounts passing to “skip persons”, the generation-skipping transfer tax must be considered.
4 For example, New Jersey imposes an estate and inheritance tax. The New Jersey estate tax is equal to the federal estate tax credit for death taxes reduced by succession taxes actually paid to New Jersey or any other state. The New Jersey estate tax applies only to resident decedents. NJSA 54:38-1. If an estate is subject to both the New Jersey estate tax and the New Jersey inheritance tax, then if the inheritance tax paid to New Jersey or any other state is less than the federal estate death tax credit, the New Jersey estate tax is equal to the difference. If the inheritance tax paid to New Jersey or any other state is greater than the federal estate death tax credit, then no New Jersey estate tax is due. For New Jersey inheritance tax purposes, a taxable class of beneficiaries includes Class C and Class D beneficiaries. A Class C beneficiary includes a brother and a sister, a wife or widow of a son of the decedent and a husband or widower of a daughter of a decedent. A Class D beneficiary includes any other transferee is not a Class A, C or E beneficiary.
5 The Plan Benefit passing to a spouse is eligible for the marital deduction, and is taxable to the surviving spouse upon his or her death. Section 2056 and 2044. Caution should be taken to assure eligibility for the marital deduction when designating a QTIP Trust as the beneficiary of the Plan Benefit. See, e.g., PLR 9704029.
6 Section 2055(a).
7 The Section 2010(c) “applicable credit amount” provides for a 1999 exemption of $650,000. This amount will increase to $1,000,000 by the year 2006.
8 Section 4974(a). Note that Section 72(t), subject to numerous exceptions, imposes an additional tax for distributions made prior to age 59-1/2.
9 prop. Treas. Reg. Section 1.401(a)(9)-1 Q&A F-5(A). For payments received in the form of an annuity contract, see Prop. Treas. Reg. Section 1.401(a)(9)-1 Q&A F-1(A)(e).
10 Life expectancies are determined under Annuity Table V (for individual lives) and Annuity Table VI (for joint lives) set forth in Regulation Section 1.72-9 utilizing the age of the Plan Owner and his or her designated beneficiary in the year in which the Plan Owner attains age 70-1/2.
11 Section 401(a)(9)(E); Prop. Treas. Reg. Section 1.401(a)(9)-1, Q&A D-5 and D-6.
12 Prop. Treas. Reg. Section 1.401(a)(9)-1 Q&A D-2A(A)(b).
13 Prop. Treas. Reg. Section 1.401(a)(9)-1 Q&A E-8(A)(b).
14 Section 401(a)(()(B)(iv)(I). Alternatively, the spouse can accomplish a spousal rollover. In the case of any rollover from a Qualified Plan, the 20% automatic withholding rule should be considered. That rules does not apply to individual retirement accounts.
15 The Section 691(c) deduction must be claimed as an itemized deduction against gross income. However, the Section 691(c) deduction is not subject to the 2% floor, nor is it a tax preference for AMT purposes.
16 Section 401(a)(9)(E).
17 Proposed Regulation 1.401(a)(9)-1D(Q&A D-5 and D-6). This Proposed Regulation now allows the beneficiaries of a revocable trust to be treated as a “designated beneficiary”. The language of the Proposed Regulation is not clear on the issue of whether the rule applied to a testamentary trust. However, informal talks with IRS suggest that there was no intent to exclude testamentary trusts from this rule. The cautious practitioner should continue to use inter vivos trusts for this purpose pending further guidance on the issue. When naming a trust as the Plan Beneficiary, caution should also be taken to assure that all of the trust beneficiaries are “designated beneficiaries”. If any beneficiary (with a vested interest) of a Plan Benefit fails to meet the definition of a “designated beneficiary”, then none of the beneficiaries can qualify as a designated beneficiary. Proposed Treasury Regulation 1.401(a)(9)-1, Q&A E-5A(a). Thus, is a trust provides for an income interest to spouse, remainder to charity and the charitable interest is vested, the regulations will presumably disqualify the surviving spouse as a “designated beneficiary”, even if the trust has satisfied the full requirements of the Proposed Regulations.
18 Under the joint and survivor annuity rules, a married participant who retires under a defined benefit plan or certain defined contribution plans must receive the benefit in the form of a qualified joint and survivor annuity which would be paid over the life of the participant, then over the life of the spouse. Section 417(a)(2). A participant may waive the right to receive benefits in the form of a qualified joint and survivor annuity; however, the waiver will only be effective if it is accompanied by the spouse’s consent. Section 401(a)(II)(i). Furthermore, if the married participant dies before his or her annuity starting date, then the defined plan benefits must be paid to the surviving spouse in the form of a qualified pre-retirement survivor annuity. Section 417(a)(2). Similar to the qualified joint and survivor annuity, the participant may waive the right to receive benefits in the form of a qualified pre-retirement survivor annuity, but only if the spouse consents to such a waiver. To be effective, spousal consent to a waiver of either a qualified joint and survivor annuity or a qualified pre-retirement survivor annuity must be in writing; it must designate a beneficiary (or a form of benefits) that may not be changed without spousal consent (unless the consent expressly permits designations by the participant without any requirement of further consent); the consent must acknowledge the effect of the participant’s waiver; and it must be witnessed by a plan representative or notary public. Section 417(a)(2)(A).
19 Section 2056(b)(7)(B)(ii); Revenue Ruling 89-89, 1989-2 CB 231. See also PLR 8351097, 8728011, 9038013, 9043054, 9052015. Compare PLR 922007 which denied QTIP treatment since the trust agreement did not guarantee that all income would be paid to the spouse at least annually.
21 This provision anticipates income tax consequences that may arise where state law characterizes part or all of a Plan Benefit as principal instead of income.
This article is reprinted with permission from the January 2000 issue of the Real Property, Probate and Trust Law Section Newsletter .