Unfortunately, a plan participant cannot transfer ownership of plan balances out of his or her own name in an effort to reduce estate taxes, unless he or she makes withdrawals from the plans. Such withdrawals, however, may have adverse tax consequences of their own, such as the elimination of the income tax deferral and a 10% early withdrawal penalty (if the participant is under age 59 = at the time of withdrawal). IRC §§72(t).
In addition to the estate tax due on retirement plan balances at death, the beneficiary of retirement plan assets is usually subject to income tax on the distribution of such assets, since this property constitutes income in respect of a decedent ("IRD"). IRD is defined as income generated (or earned) by the decedent before his or her death that is not realized (or received) until after his or her death. IRC §691. The beneficiary of IRD property is subject to income taxes on such property, just as the decedent would have been if he or she was still alive. IRC §691. All qualified retirement plan and IRA benefits constitute IRD since the decedent had a right to receive such benefits at the time of death. Therefore, when retirement plan funds are withdrawn, the beneficiary is subject to income tax on the distribution, just as the decedent would have been.
The timing of distributions from retirement plans, therefore, determines when such income tax must be paid by the recipient of the funds. In general, if distributions have begun before the date of death, the remaining retirement plan funds must be distributed at least as rapidly as if the participant has survived. IRC §401(a)(9)(B)(i). If, on the other hand, the participant died before minimum distributions had begun, the plan balances must be distributed within five years of the date of death. IRC §401(a)(9)(B)(ii). If, however, the participant dies before his or her required beginning date (generally, April 1 of the year following the calendar year in which he or she reaches age 70 =) and he or she designates another individual as a beneficiary of the plan(s), the balances may be distributed over the lifetime of the designated beneficiary, as long as such distributions begin no later than one year after the participant's death. IRC §401(a)(9)(B)(iii).
Surviving Spouse as Beneficiary
If the surviving spouse is the designated beneficiary of a participant's retirement plan balances, a decedent may be entitled to a marital deduction on this property, thus excluding the retirement funds from estate tax liability.
Additionally, the surviving spouse may rollover the inherited retirement funds into his or her own IRA and postpone making required withdrawals, which would generate income tax, until his or her own required distribution date. IRC §§402(c)(9) and 401(a)(31). Then, at the surviving spouse's required beginning date for minimum distributions, he or she may begin withdrawing funds over the joint life expectancy of himself or herself and a younger beneficiary. IRC §§402(c)(9) and 401(a)(31). This option is beneficial if the surviving spouse is younger than the decedent as it will result in a longer deferral of distributions.
Alternatively, the surviving spouse may leave the funds in the decedent's plan until the decedent would have reached age 70 = and then make the required withdrawals. IRC §401(a)(9)(B)(iv). This option is beneficial if the surviving spouse is older than the decedent. This option is available to a trust for the benefit of the surviving spouse, such as a QTIP trust, as well.
It is important to note that although the surviving spouse will owe income tax on the distribution under IRC §691(a) when he or she withdraws the benefits, the amount of tax owed will only go to reduce the surviving spouse's future taxable estate.
Trusts as Beneficiary
In order for any trust to be named the designated beneficiary of retirement plan benefits, the "trust rules" of IRC §401(a)(9) must be complied with. First, the trust must be valid under state law. Also, all beneficiaries of the trust must be individuals. Next, the beneficiaries must be identifiable from the trust instrument. Finally, a copy of the trust instrument must be provided to the plan administrator.
In general, if a trust is named beneficiary of retirement plan benefits, the benefits must be distributed to the trust within five years of the participant's date of death. IRC §401(a)(9)(B)(ii). In certain instances, however, the oldest individual beneficiary of the trust may be treated as the designated beneficiary. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1). Therefore, this beneficiary's life expectancy may be used as the measuring period for determining minimum distributions to be paid to the trust. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1). A trust will qualify for this exception to the five-year rule if it meets the "trust rules" of IRC §401(a)(9), referred to above.
When IRD is paid to a trust, the income is taxed at the compressed trust income tax brackets. Thus, plan benefits paid to a trust will most likely result in the funds being taxed more heavily than if the benefits were paid to individuals and taxed at the individual rates.
Finally, any trust which is designated beneficiary which provides that the retirement funds pass as part of a pecuniary gift, which is typically found in pourover trusts with a pecuniary marital deduction formula, may result in the immediate realization of taxable income to the trust. PLR
9507008. Instead, the trust should use a fractional funding formula to avoid triggering this income tax. IRC §2056(b)(10); Regs. 1.691(a)-4(b)(2); PLR 9537005.
QTIP Trust as Beneficiary
There are several non-tax reasons to leave your retirement plan benefits to a QTIP Trust as opposed to outright to the surviving spouse. For instance, the plan participant may fear that, after the participant's death, the surviving spouse will remarry and divert the assets away from the participant's children from the first marriage. Alternatively, the surviving spouse may be unsophisticated in investing, or may be a spendthrift or may be incompetent. Since these are valid concerns, the participant must be sure that the QTIP trust qualifies for the marital deduction, that it complies with the "trust rules" so that the surviving spouse may be considered the "designated beneficiary" for purposes of the minimum distribution rules and that the trustee avoids triggering an income tax when funding the QTIP trust.
In order for retirement plans payable to a QTIP trust to qualify for the marital deduction, the trustee must be required to withdraw all income earned each year on the IRA property (or the minimum required distribution if greater) and to pay such amount to the surviving spouse on an annual basis. PLR's 9038015 and 9043054. Also, no person may have the power to appoint any of the principal to someone other than the surviving spouse during his or her lifetime. Id. The IRS has ruled that the beneficiary designation form itself should also contain similar marital deduction trust provisions. Rev. Rul. 89-89. In other words, the beneficiary designation form should state how benefits are to be withdrawn, in addition to naming the trustee of the QTIP trust as the beneficiary. Specifically, the trustee should be required to withdraw from the IRA each year, and place in the QTIP trust, all of the income earned by the IRA that year. Finally, it is important to remember that the executor needs to elect QTIP treatment for the benefits themselves as well as for the trust. PLR 9442032.
Making retirement plan benefits payable to a marital trust will generally result in much less income tax deferral during the surviving spouse's life than if the benefits were payable to the surviving spouse directly. This is because if the surviving spouse is individually designated beneficiary, he or she may roll the funds over into his or her own IRA, thus deferring distributions until he or she reaches the required beginning date for minimum distributions. IRC §§402(c)(9) and 401(a)(31). When a marital trust for the benefit of the surviving spouse is designated beneficiary, on the other hand, the minimum distribution rules most likely require annual distributions to the trust beginning the year after the decedent's death, which do not qualify for spousal rollover treatment. In this case, only the surviving spouse's own life expectancy can be used to measure the payout.
Credit Shelter Trust as Beneficiary
Naming a credit shelter trust as the designated beneficiary of retirement plan benefits will result in some estate tax savings on the surviving spouse's death due to the use of the unified credit by both spouses' estates, while still making some of the retirement plan benefits available for the surviving spouse during his or her lifetime.
One disadvantage of using a credit shelter as the designated beneficiary of retirement plan assets is that as the assets are withdrawn to fund the credit shelter trust, income taxes are due and are paid from those very assets, thus the estate is not receiving the full benefit of the unified credit.
Other Individual Beneficiaries
If only one person is named the designated beneficiary, then, under the exception to the five year rule, the beneficiary can withdraw the benefits "in accordance with regulations" over a period of time that does not exceed his or her life expectancy. IRC §401(a)(9)(B)(iii).
If there are several people who are jointly named the designated beneficiaries (i.e., "to my children who survive me"), then according to the proposed regulations, the benefits must be withdrawn over a period of time using the life expectancy of the oldest beneficiary. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1). In order for this exception to the five year rule to apply, all of the designated beneficiaries must be individuals. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1).
Please note that if the retirement plan is divided into separate accounts, each beneficiary may use his or her own life expectancy for his or her share of the benefits. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1).
Estate as Beneficiary
Since an estate cannot be a designated beneficiary, the participant who names the estate as beneficiary is limited to using his or her own life expectancy to calculate required minimum distributions. IRC §401(a)(9)(A)(ii). The time period over which these distributions must be made depends on whether the participant reached his or her required beginning date as of the date of death. If the participant has reached his or her required beginning date and has named his or her estate as beneficiary of the plan benefits, the funds must be distributed to the estate at least as rapidly as they would have been distributed to the participant had he or she survived. IRC §401(a)(9)(B)(i). If the participant was recalculating his or her life expectancy to calculate the required minimum distributions, the entire amount of the proceeds must be distributed to the estate by December 31 of the year following the date of death. Prop. Reg. 1.401(a)(9)-1, Q&A E-8(a). This is because the participant's life expectancy is reduced to zero in the year in which he or she dies. Prop. Reg. 1.401(a)(9)-1, Q&A E-8(a). If the participant was not recalculating his or her life expectancy for purposes of the minimum distributions, the estate may continue to use the participant's life expectancy to calculate the required minimum distributions.
If the participant has not reached his or her required beginning date as of the date of death, and the estate is the beneficiary of the retirement funds, the participant is deemed to have no designated beneficiary, and the five year rule applies for purposes of minimum distributions. IRC §401(a)(9)(B)(ii). That is, distribution of the entire amount of the benefits must occur by December 31 of the fifth calendar year following the participant's date of death. IRC §401(a)(9)(B)(ii).
Charity as Beneficiary
If a charitable organization is directly named the beneficiary of all or some of a participant's retirement plan balances at the participant's death, the amount given to the organization will generally be includible in the participant's estate for estate tax purposes. Rev. Rul. 67-242, 1967-2 CB 227; PLR 7827008. However, the estate may be entitled to a charitable deduction on the estate tax return for amounts passing to an organization described in IRC §501(c)(3). IRC §2055. The gift to charity will still be subject to the excise tax on excess accumulations, which would have to be paid by the estate or the charity, since this tax is considered a debt of the estate. However, the charitable organization will not recognize income when it receives distributions from a retirement plan. If a plan participant
designates a charitable organization as remainder beneficiary, payments are made to the participant over his or her own life expectancy, alone and no other individual's life expectancy may be used.
Alternatively, a charitable remainder trust may be the designated beneficiary of some or all of the retirement funds. In such a case, non-charitable beneficiaries would be entitled to an income stream during their lifetime and the remainder would pass to the charity. At the participant's death, the plan funds would be includible in his or her estate, but the present value of the charitable remainder interest would qualify for a charitable deduction on the participant's estate tax return. IRC §§2055(a) and 2055(e)(2)(A). Although the gift of income to the non-charitable beneficiaries would be taxable in the participant's estate, if the surviving spouse is the sole income beneficiary, the gift may qualify for the marital deduction, resulting in zero federal estate tax. IRC §2056(b)(8). Payments made to the non-charitable beneficiaries have the same character as they would have in the hands of the participant, that is such distributions are subject to income tax to the recipient as IRD. IRC §691(a)(1)(B). Although distributions from the retirement plans constitute IRD, a CRT is not subject to income tax on the IRD, unless the CRT has unrelated business taxable income. PLR 9237020.
In most instances, naming the participant's spouse as beneficiary results in the maximum amount of flexibility and tax savings. However, there are a variety of situations where naming the surviving spouse as beneficiary is undesirable. In such a case, a QTIP trust may be named as beneficiary.
The use of the marital deduction, whether in connection with a gift to the surviving spouse directly or the QTIP trust, for retirement plan benefits both minimizes estate taxes and postpones income taxes.
No matter who is actually named the designated beneficiary, careful attention should be paid to the tax consequences of such a designation since there are strict requirements that must be followed when designating the beneficiary of any retirement plan. Finally, due to the complexity of the law governing qualified retirement plans, estate planning practitioners should carefully review the law and plan documents before drafting any estate plan for a plan participant.