Use of Disclaimers

Estate planning attorneys prepare wills and trust agreements for the purpose of minimizing federal estate tax. The most common plan for a married couple involves the preparation of a credit shelter trust and marital deduction trust for both husband and wife. This is commonly known as an AB plan. The AB plan allows the couple to presently use two unified credits⁽¹⁾ and shelter up to $1,300,000 following the death of the second to die.

Once the plan is prepared, the attorney will then work with the couple to fund their estate plans. This process requires the clients to retitle their assets and redesignate their insurance policies and qualified retirement assets.⁽²⁾ In most situations, the couple will need to determine the primary and contingent beneficiaries of their qualified retirement assets. The couples non-qualified retirement assets⁽³⁾ will determine the importance of the beneficial designation for the qualified retirement assets. If the couple has non-qualified retirement assets that exceed twice the unified credit, then the beneficial designation is less important. If the couple does not have non-qualified retirement assets that exceed twice the unified credit, then the beneficial designation is more important.

This article will discuss the prototype estate plan for couples that have assets that exceed one unified credit which include qualified retirement assets. The article will then discuss the estate tax and income tax issues as they apply to the qualified retirement assets. The article finally will propose a preferred method to designate the beneficiaries of the qualified retirement assets in order to maximize both income tax and estate tax planning.

Disclaimer

A disclaimer is a tool used by estate planning attorneys to redirect property at the death of an individual. The person who makes the disclaimer must make it within nine months of the death⁽⁴⁾ of the decedent in order to be a qualified disclaimer for federal estate tax purposes. In addition, the individual who disclaims the property cannot receive any benefits from the property prior to making the disclaimer. If the disclaimer is properly made, then the individual who made the disclaimer will be deemed to have predeceased the decedent and the property will go to the next beneficiary.

The use of a disclaimer for estate planning needs to be properly planned so that the surviving spouse will choose to execute the plan including the use of the disclaimer. In the context of qualified retirement assets, disclaimers typically are used to maximize an AB estate plan. The following case example demonstrates the planning for the use of a disclaimer.

Case Example

Jim and Sally Smith meet with you to discuss estate planning. Jim is 55 years old and is currently working. Sally is 53 years old and is currently working. The Smiths have three children ages 18, 23 and 25. They own a house with a fair market value of $300,000 and no mortgage. They have a joint stock portfolio of $350,000 and joint bank accounts of $200,000. Jim's 401(k) is worth $750,000 and Sally's 403(b) is worth $450,000. The Smiths do not own any life insurance and they are uninsurable due to their health. They wish to leave their estate equally to their three children, utilize revocable trusts in their planning and shelter the maximum amount from federal estate tax.

The estate planning attorney prepares an AB estate plan based upon their needs utilizing revocable trusts, wills and durable powers of attorney⁽⁵⁾ for both Jim and Sally. The terms of the revocable trusts provide for a credit shelter trust and a marital deduction trust. In connection with executing the Smiths' estate plan, the attorney advises the Smiths that the house should remain titled as tenants by the entireties for homestead purposes. The stock portfolio and bank accounts should be divided such that one-half will be titled in Jim's trust and one-half titled in Sally's trust.

The discussion then turns to the 401(k) and 403(b) plan. The Smiths ask who should be the primary and contingent beneficiaries for the plans. In addition, they are concerned with the estate and income tax issues.

Funding the Smiths' AB Plan and Estate Tax Issues

The Smiths' assets present a problem for most estate planning attorneys. Their assets would typically be divided as follows:

The above charts demonstrate that either Jim's 401(k) or Sally's 403(b) must be used to shelter both unified credits. If Jim died first, then the following assets totaling $1,175,000 would be included in his federal gross estate: (1) 401(k) $750,000, (2) stock portfolio $175,000, (3) bank account $100,000 and one-half interest in house $150,000. The house would qualify for the marital deduction leaving $1,025,000 to fund the credit shelter trust. The non-qualified retirement assets total $275,000, therefore, $375,000 of the 401(k) is needed to fully utilize the balance of the credit shelter amount. If Sally dies first, then the following assets totaling $875,000 would be included in her federal gross estate: (1) 403(b) $450,000, (2) stock portfolio $175,000, (3) bank account $100,000 and one-half interest in house $150,000. The house would qualify for the marital deduction leaving $725,000 to fund the credit shelter trust. The non-qualified retirement assets total $275,000, therefore, $375,000 of the 403(b) is needed to fully utilize the balance of the credit shelter amount.

The estate planning attorney must assist the Smiths in determining the beneficiaries of the 401(k) and 403(b) plans to maximize the benefit of the unified credit amounts. The first question that the estate planning attorney must address is should the spouse or trust ⁽⁶⁾ be the primary beneficiary. If the spouse is the primary beneficiary, then the next question is should the children or a trust be the contingent beneficiary.

Income Tax and Estate Tax Issues For Qualified Retirement Assets

Qualified retirement assets are defined as assets in Sections 401 through 408 of the Internal Revenue Code. They include: 401(k) plans, Individual Retirement Account ("IRA"), Simple IRA, TSP Plans, 403(b) plans and Keough Plans. Each plan requires the owner to begin withdrawing the monies April 1^st of the year following the year the owner attained age 70 1/2 under the minimum distribution rules which is commonly referred to as the account owner's required beginning date.⁽⁷⁾ The modes for withdrawing the monies are based upon four methods: (a) single and non-recalculating,⁽⁸⁾ (b) single and re-calculating,⁽⁹⁾ (c) joint and non-recalculating⁽¹⁰⁾ and (d) joint and re-calculating.⁽¹¹⁾ The method must be selected on or before the account owner's required beginning date and will determine when the monies will be withdrawn.⁽¹²⁾

The single and non-recalculating method allows the account owner to withdraw the account over a fixed period of time. For example, if the account owner is 71 and has a life expectancy of 15.3 years, then the account will be withdrawn over 15.3 years. The account owner will reduce his life expectancy by one year and then divide the balance by his current life expectancy.⁽¹³⁾ The account owner will continue to use this method until the entire account is withdrawn at the end of the 15.3 year term.

The single and recalculating method allows the account owner to withdraw the account based upon his life expectancy for that year.⁽¹⁴⁾ For example, if the account owner is 71 and has a life expectancy of 15.3 years, then he will withdraw an amount by dividing the account balance by his life expectancy for that year. In subsequent years, the account owner will continue to recalculate his life expectancy in order to determine the minimum distribution for that year.

The minimum distribution rules for both non-recalculating and recalculating for joint life expectancies have special rules depending on whether the account owner's spouse is the beneficiary. If the spouse is the beneficiary, then the account owner and spouse will use their actual ages to determine their joint life expectancy.⁽¹⁵⁾ For instance, if the account owner is 71 and his spouse is 50, they will use both ages. If the account owner's beneficiary is someone other than his spouse, then for purposes of determining life expectancy, the beneficiary will be deemed not more than ten years younger than the account owner.⁽¹⁶⁾ For instance, if the account owner and the beneficiary's ages are 71 and 50, then the rules state that while the owner is alive the person who is 50 will be deemed to be age 61 for purposes of calculating their joint life expectancy. If there are multiple beneficiaries, the beneficiary with the shortest life expectancy will be used to determine the joint life expectancy.⁽¹⁷⁾ In addition, should the beneficiary die and a replacement beneficiary is used to determine joint life expectancy, then the substitute's age cannot extend the original beneficiary's life expectancy.⁽¹⁸⁾ For instance, if the beneficiary is age 64 when she dies and the new beneficiary is age 60, then the account owner will continue to use the joint life expectancy based upon the 64 year old.⁽¹⁹⁾ Conversely, the life expectancy can be shortened.⁽²⁰⁾ For example, if the beneficiary died at age 66 and the new beneficiary is age 69, the account owner will use his age and the 69 year old age to calculate life expectancy.

In the event the account owner died prior to the required beginning date, the designated beneficiary can either (a) withdraw all the money and pay the income tax⁽²¹⁾ or (b) withdraw the money over a five year period.⁽²²⁾ However, special rules apply, if the owner's spouse is the designated beneficiary. In this case, the spouse may (a) withdraw all the money and pay the income tax,⁽²³⁾ (b) withdraw the money over a five year period,⁽²⁴⁾ (c) wait until the date that the account owner would have attained the age of 70 = and begin withdrawing the account⁽²⁵⁾ or (d) rollover the account to the spouse's IRA.⁽²⁶⁾

In the event that the account owner died subsequent to the required beginning date, the withdrawal of the funds depends upon whether the designated beneficiary is a spouse or non-spouse. If the beneficiary is the surviving spouse, then the spouse has three options: (a) withdraw all the money and pay the income tax,⁽²⁷⁾ (b) rollover the account to the spouse's IRA⁽²⁸⁾ or (c) continue to withdraw the monies using the same schedule that the owner was using prior to his or her death.⁽²⁹⁾ However, if the designated beneficiary is a person other than the surviving spouse, then the person can either (a) withdraw the account and pay the income tax⁽³⁰⁾ or (b) withdraw the money based upon a schedule using the recipient's age and accounting for the number of years that the decedent received monies after he attained age 70 1/2.⁽³¹⁾ If the beneficiary is not a natural person and is not a qualified trust agreement, then the beneficiary can (a) withdraw the money and pay the income tax⁽³²⁾ or (b) withdraw the monies over a five year period.⁽³³⁾ If the beneficiary is a qualified trust, then the beneficiary can either (a) withdraw the money and pay the income tax⁽³⁴⁾ or (b) withdraw the monies over a period based upon the oldest beneficiary of the trust agreement.⁽³⁵⁾

Returning to the Smiths, the estate planning attorney suggests that Jim and Sally select each other as the primary beneficiary and their children as the contingent beneficiary of their 401(k) and 403(b). The estate planning attorney explains that Sally, thereby, will have five options at Jim's death depending on whether he reached his required beginning date: (1) rollover Jim's 401(k) into her IRA, (2) withdraw the money over a five year period, (3) delay withdrawing the money until the year that Jim would have become age 70 =, (4) continue to take the money out based upon Sally and Jim's life expectancy until Sally dies, or (5) disclaim a portion of Jim's 401(k) so that the children will receive it as the contingent beneficiaries.

The estate planning attorney informs the Smiths that a rollover of the 401(k) will reduce Jim's credit shelter trust by $375,000. He further states that this will result in additional estate tax of $166,750 at the death of Sally.⁽³⁶⁾ He also tells the Smiths that Sally will lose control and use of any monies that she disclaims, but that the use of the disclaimer will eliminate the additional estate taxes which would be due.

The Smiths ask what will happen if they designate the trust as the primary beneficiary of their qualified retirement assets. Designating the trust as the primary beneficiary allows the complete use of the credit shelter trust, however, Jim or Sally may lose their ability to rollover the amount which exceeds the credit shelter trust and thereby may lose the benefit of the additional period of deferment of the payment of income tax.⁽³⁷⁾ In this case, Jim may be required to continue to use Sally's distribution schedule on $75,000,⁽³⁸⁾ and Sally may be required to continue to use Jim's distribution schedule on $375,000.⁽³⁹⁾

The estate planning attorney finally recommends that the Smiths designate each other as the primary beneficiary and their trusts as the contingent beneficiary of their 401(k) and 403(b). Designating the trust as the contingent beneficiary allows the complete use of the credit shelter amount⁽⁴⁰⁾

by allowing Jim or Sally to disclaim the portion of the 401(k) or 403(b) that is needed to utilize the balance of the credit shelter trust, if that result is desirable at the death of the first spouse. The balance of the 401(k) or 403(b) could then be rolled over to either Jim or Sally's IRA so that they could select a new primary beneficiary.

Interplay between Income Tax and Estate Tax for Qualified Retirement Assets Using Trust Agreements

A non-grantor irrevocable trust⁽⁴¹⁾ is taxed pursuant Subchapter J of the Internal Revenue Code. The rules provide a conduit method for paying income taxes. Trusts have a compressed tax brackets and reach the 39.6 percent tax bracket over $8,350 of taxable income.⁽⁴²⁾ In addition, trusts are subject to the same capital gains tax rates as individuals. If the trust distributes all of its income to the beneficiaries for the current tax year, then the trust receives a deduction equal to the distribution, and therefore it does not pay income tax on that amount.⁽⁴³⁾ If the trust does not distribute all of its income to the beneficiaries, then the trust will pay the income tax on the monies.⁽⁴⁴⁾ For example, if the trust earns $50,000 of income in 1999 and distributes 100% to the beneficiaries, then the beneficiaries will pay the tax and the trust will pay nothing. If the trust only distributes $10,000 of income to the beneficiaries and retains $40,000 of income, then the beneficiaries will pay the income tax on the $10,000 and the trust will pay income tax on the $40,000.⁽⁴⁵⁾ If the beneficiaries are in a lower income tax bracket than the 39.6 percent tax bracket for trusts generating income in excess of $8,350, it generally is beneficial to distribute the income to them instead of paying the tax at the trust's income tax bracket.

Qualified retirement assets which are either owned by or designated to a non-grantor irrevocable trust have unique income tax issues. The monies that are paid from the qualified retirement asset to the trust pursuant to the minimum distribution rules are deemed to be income for federal income tax purposes.⁽⁴⁶⁾ The actual distribution will be allocated to income and principal for fiduciary accounting purposes. This creates an inherent conflict between preservation of the principal of the credit shelter trust and distributing monies to the surviving spouse to reduce the income tax burden.

In the event that Jim died first, Sally would disclaim $375,000 of Jim's 401(k) to the credit shelter trust created in Jim's trust agreement and Sally would also rollover the $375,000 balance of Jim's 401(k) to her IRA. In the event that Sally died first, Jim would disclaim $375,000 of Sally's 403(b) to the credit shelter trust created in Sally's trust agreement and Jim would also rollover the $75,000 balance of Sally's 403(b) to his IRA. Under either situation, $375,000 of either Jim or Sally's qualified retirement assets would thereby make up part of the credit shelter trust.

Jim's credit shelter trust will begin receiving distributions from the 401(k) pursuant to the minimum distribution rules at the time of his death. The trust will pay income tax based upon the monies that are earned by the trust and the distributions that are made by the 401(k). If the taxable income of the trust, including the amounts received from the 401(k), exceeds $8,350, then the trust will pay income tax at the 39.6 percent income tax bracket. If Sally is in the 39.6 percent income tax bracket there will be no difference on how much the children will ultimately receive. If Sally is in the 28 percent income tax bracket, then the trust will lose 11.6 percent (i.e. 39.6 minus 28) of the monies.

Conclusion

Estate planning for the use of qualified retirement assets poses many problems and, therefore, requires flexible planning for the surviving spouse. First, the estate planning attorney must identify whether or not the qualified retirement assets will be used to fund the credit shelter trust at the death of the first spouse. Second, the assets must be correctly designated so that the surviving spouse will be able to redirect the qualified retirement assets without losing control and use of the assets. Third, the surviving spouse must consider the income tax impact should a portion of the qualified retirement assets be used to fund the credit shelter trust. Finally, the surviving spouse needs to determine whether or not their interest should be paramount over the interests of the children as the ultimate recipients of the qualified retirement assets.

Benjamin A. Jablow is a board certified tax attorney who is an associated of the Boca Raton law firm of Hunt, Cook, Riggs, Mehr and Miller, P.A. He received his J.D. from Creighton University and his LL.M. in taxation from the University of Florida. His practice areas include tax and estate planning.

1. I.R.C. ' 2010. The term "unified credit" was changed to the "applicable credit amount" in the Taxpayer Relief Act of 1997 (P.L. 105-345). For ease of terminology, the author means the applicable credit amount when he refers to the unified credit. The unified credit for decedent's dying in tax year 1999 will shelter $650,000 of property. The credit is increasing and will shelter $1,000,000 of property for decedent's dying after December 31, 2005.

2. The term "qualified retirement assets" does not include a pension plan or any other plans that will terminate at the death of either the decedent or the decedent's spouse.

3. The term "non-qualified retirement assets" are defined as any asset which are not contained in Code Sections 401 through 408 of the Internal Revenue Code of 1986 (hereinafter all references to the Internal Revenue Code of 1986 shall be to the "Code" or to "I.R.C."). The term includes real estate, stocks and bonds, personal property and any other assets owned by the decedent at the time of his death.

4. The author acknowledges that a disclaimer must be exercised within 9 months of the creation of the property right or within 9 months of the death of the decedent which ever shall occur first. I.R.C. ' 2518. This article will only discuss disclaimers that must be exercised within 9 months of the decedent's death.

5. A properly drafted durable power of attorney will allow the attorney-in-fact to execute disclaimers on behalf of an incompetent individual. Absent a durable power of attorney, a guardian would need to be appointed for the incapacitate individual in order to execute a disclaimer.

6. For purposes of this Article, the designation of a qualified retirement asset to a revocable living trust agreement means the credit shelter trust created under the terms of the trust agreement. Specifically naming the credit sheltered trust (as opposed to the decedent's revocable trust) would eliminate the acceleration of income in respect of a decedent pursuant to I.R.C. ' 691 which could occur if the trust agreement provides for a pecuniary formula. There are no acceleration of income issues if a fractional share formula is used.

7. I.R.C. ' 401(a)(9)(C). Employees who continue to work beyond age 70 = are allowed to delay withdrawing monies under the minimum distribution rules. I.R.C. ' 401(a)(9)(C)(i). Five percent owners must begin withdrawing monies pursuant to the minimum distribution rules regardless of whether they continue to work. I.R.C. ' 401(a)(9)(C)(ii).

8. I.R.C. '401(a)(9)(A) and Prop. Treas. Reg. '1.401(a)(9)-1(c) Question B-1.

9. Id.

10. I.R.C. ' 401(a)(9)(D) and (E).

11. Id. The joint and re-calculating method may only be selected in the event that the account owner's spouse is the designated beneficiary. I.R.C. ' 401(a)(9)(D).

12. I.R.C. ' 401(a)(9)(C). See supra footnote 7 regarding start date for minimum distribution rules for specific employees.

13. Prop. Treas. Reg. ' 1.401(a)(9)-1(d).

14. Id.

15. Prop. Treas. Reg. ' 1.401(a)(9)-1(b) Question and Answer E-1.

16. Prop. Treas. Reg. ' 1.401(a)(9)-2. This is known as the minimum distribution incidental benefit requirement ("MDIB").

17. Prop. Treas. Reg. ' 1.401(a)(9)-1(b) Question and Answer E-5.

18. Prop. Treas. Reg ' 1.401(a)(9)-1(c)(1).

19. Id.

20. Id.

21 I.R.C. ' 401(a)(9)(B).

22. I.R.C. ' 401(a)(9)(B)(ii).

23. I.R.C. ' 401(a)(9)(B).

24. I.R.C. ' 401(a)(9)(B)(ii).

25. I.R.C. ' 401(a)(9)(B)(iv). See also Bergman and Reynolds, 350 T.M., Plan Selection -- Pensions and Profit-Sharing Plans, Worksheet 2.

26. I.R.C. ' 402(c)(9) and Prop. Treas. Reg. ' 1.408-8(A) Question and Answer A-4. See also Acker, 855 T.M., Estate and Trust Administration -- Tax Planning, Article XII Section C.

27. I.R.C. ' 401(a)(9)(B).

28. See supra footnote 26.

29. I.R.C. ' 401(a)(9)(B)(iii).

30. I.R.C. ' 401(a)(9)(B)(i).

31. I.R.C. ' 401(a)(9)(B)(iii).

32. I.R.C. ' 401(a)(9)(B)(i).

33. I.R.C. ' 401(a)(9)(B)(ii).

34. I.R.C. ' 401(a)(9)(B)(i).

35. I.R.C. ' 401(a)(9)(B)(ii) and (iii); Prop. Treas. Reg. ' 1.401(a)(9)-1(c) Question and Answer D-5.

36. This is based upon an increase of $375,000 of Jim's 401(k) which could have been sheltered by the credit shelter trust. This assumes that Jim died in 1999 and that Sally died 10 months later in the year 2000 when the unified credit is $220,550 and will shelter $675,000.

37. The trustee of a revocable living trust can disclaim its interest as the beneficiary of a qualified retirement asset. After the trustee makes the disclaimer, the interest passes either to the contingent beneficiary, if any, or to the account owner's personal representative under the terms of the individual's Will. The surviving spouse could then rollover the qualified retirement asset providing that the surviving spouse is the contingent beneficiary. If the event that the account owner only named the trust, then the terms of the account owner's Will will control. The Internal Revenue Service has issued various private letter rulings dealing with these issues. For a discussion of these issues see Wenig, 848 T.M., Disclaimer, Article II, Section B(4).

38. This is based upon $725,000 of assets (excluding the house) less a unified credit of $650,000 for 1999.

39. This is based upon $1,025,000 of assets (excluding the house) less a unified credit of $650,000 for 1999.

Editor's Note: The author acknowledges that the focus on this article is to analyze ways in which to fully utilize the credit shelter amounts. Further, in larger estates, it may not be beneficial to fully utilize the credit shelter amount, the analysis requires that you "run the numbers" to determine whether the "forgone" estate tax benefit (by not fully funding the credit shelter trust) is greater than tax benefit of deferral by rolling-over part or all of the deferred compensation if the designated beneficiary is the surviving spouse.

41. If the trust is deemed a grantor trust pursuant to I.R.C. ' 671-678, then the grantor will pay income tax on the income until the power is either released or terminated.

42. I.R.C. ' 1(e).

43. I.R.C. ' 651(a).

44. I.R.C. ' 661(a).

45. Id.

46. The author acknowledges that the taxpayer can have a tax basis in the qualified retirement asset. For purposes of this article, all qualified retirement assets are subject to income tax and the taxpayer does not have a basis in the account.