select
This is a tooltip for the edit command button
NAELA News Journal - NAELA News Online

Paying Retirement Benefits to Trusts

By Mark D. Munson, CELA
Published June 2018
Conventional wisdom strongly suggests that paying retirement benefits, such as 401(k)s, 403(b)s, traditional individual retirement accounts (IRAs), and Roth IRAs, to a trust is a bad idea because it accelerates the payout period from a retirement benefit to an entity with compressed income tax brackets, both of which produce equally bad results for income tax purposes. Consequently, owners of retirement benefits are routinely advised to designate spouses, children, relatives, and other individuals as beneficiaries of retirement benefits. The advice is simple, straightforward, and inexpensive to the client. Unfortunately, the result of this simple and straightforward advice may turn out to be very expensive and often ignores the non-tax considerations of estate planning that are usually very important to the client, most notably of which in many cases is asset and creditor protection for the client’s intended beneficiaries.

Many estate planning clients, even those of modest wealth, are intrigued at the possibility of leaving inheritances to children, grandchildren, and other loved ones in ways that provide asset protection from events such as divorce, lawsuits, personal guarantees of business or self- employment debt, uninsured health care costs, and exorbitant long-term care costs. Some clients identify the reasons of immaturity, lack of fiscal responsibility, need for incentives, or disability as reasons to direct inheritances to trusts rather than to loved ones outright. Other clients identify the desire to save wealth transfer taxes, such as gift tax, estate tax, and generation-skipping transfer tax, as a reason to direct an inheritance to a trust rather than to a beneficiary outright. More often than not, the decision not to leave an inheritance to a beneficiary outright is a combination of many different factors and considerations. Trusts established within a decedent’s estate plan work very well to accomplish these non-tax objectives due to the existence of statutory trust provisions, such as spendthrift laws (for most creditors), and case law, especially when discretionary distribution standards along with the imposition of fiduciary duties and responsibilities are properly factored and considered.

As more and more clients have the majority of their wealth within retirement benefits, they are looking for ways that allow their beneficiaries (i.e., their loved ones) to have their cake (the income tax benefits realized when an individual rather than a trust is designated as beneficiary of the retirement benefit) and eat it too (the non-income tax benefits realized when a trust rather than an individual is named as beneficiary of a retirement benefit). The only way to accomplish this result is to have a “see-through trust” designated as the beneficiary of the retirement benefit.

Income Tax and Individuals as Beneficiaries of Retirement Benefits
From an income tax perspective, designating an individual as a beneficiary of a retirement benefit yields the best results and income tax efficiencies. The reason for this can be traced to federal income tax law. Federal income tax law allows an individual to inherit retirement benefits over her life expectancy, which is based on the individual’s age at the time of the owner’s death and an actuarial table published by the Internal Revenue Service (IRS). The Single Life Expectancy table published by the IRS generally allows an individual to inherit retirement benefits until some point in time when the individual is in his or her 80s. For example, an individual who is 15 years old when the retirement benefit owner dies, has a life expectancy of 67.9 years according to the IRS Single Life Expectancy table, while an individual who is 60 years old has a life expectancy of only 25.2 years.

A required minimum amount must be distributed annually from the inherited retirement benefit to the individual until he or she reaches the final year of his or her actuarial life expectancy. This concept is commonly referred to as “stretch” (i.e., allowing an individual to “stretch” out distributions from the inherited retirement benefit over his or her life expectancy). Naturally, the younger an individual is, the longer his or her life expectancy will be, which means that the all-important distribution period (or, stretch period) from the inherited retirement benefit can be longer as well. For reasons explained below, a longer distribution period from an inherited retirement benefit can be quite advantageous for income tax purposes when compared to a shorter distribution period.

When an individual is named as beneficiary of a retirement benefit, the individual’s life expectancy and the distribution period from the retirement benefit are directly correlated. In fact, they are the same. The concept of “stretch” is voluntary and an individual who is designated as a beneficiary of a retirement benefit does not have to take annual required minimum distributions over his or her lifetime. In fact, an individual who has been designated as beneficiary of a retirement benefit can simply request a lump-sum payout from the retirement benefit custodian, trustee, or issuer upon the death of the owner.

Income Tax and Trusts as Beneficiaries Of Retirement Benefits
Estates and (non-see-through) trusts, along with other non-individual beneficiaries, such as charities, must inherit retirement benefits within five years if the owner dies before his or her required beginning date (RBD), which is April 1 of the year after the individual turns age 70.5, or over the owner’s life expectancy if the owner dies after his RBD (i.e., after April 1 of the year after the individual turns age 70.5). This usually results in a short distribution period from the inherited retirement benefit. A shorter distribution period for an inherited retirement benefit results in accelerated income taxation when compared to a longer distribution period. As a general rule, a retirement benefit that must be distributed to a non-individual beneficiary (such as a non-see-through trust, an estate, or a charity) results in accelerated income taxation when compared to a retirement benefit that must be distributed to an individual beneficiary or a see- through trust. This is precisely why it is usually better to designate an individual as the beneficiary of a retirement benefit than a non-individual.

The income tax value of obtaining the longest distribution period possible from an inherited retirement benefit should not be overlooked. There are a couple of reasons for this. First, the required minimum amount that must be distributed to a beneficiary from an inherited retirement benefit on an annual basis, which is subject to immediate income taxation (unless the distribution is from a Roth IRA), is calculated based on the rules explained above. If the five- year payout rule is not applicable to determine the distribution period, the life expectancy payout rule is applied to determine the distribution period (again, it is either the owner’s life expectancy that is used or an individual beneficiary’s life expectancy that is used).

The applicable distribution period and the amount of the annual required minimum distribution have an inverse relationship with one another. The longer the applicable distribution period, the smaller the amount of the required minimum distribution and the amount subject to immediate income taxation. The shorter the applicable distribution period, the larger the amount of the required minimum distribution and the amount subject to immediate income taxation.

Second, any amount not required to be distributed to the beneficiary can remain inside of the inherited retirement benefit. This allows for continued tax-deferred growth of the assets within the retirement benefit (or continued tax-free growth in the case of a Roth IRA). If the applicable distribution period is long, which means that the amount of initial required minimum distributions will be small, it is quite likely that the appreciation of assets within the inherited retirement benefit will be greater than the minimum required distribution, especially during the early years of the applicable distribution period. This results in a dual income tax benefit to the beneficiary; 1) a small minimum required distribution that is subject to immediate income taxation (which is good for the beneficiary’s overall immediate income tax burden); and 2) a certain amount of the annual appreciation remains within the inherited retirement benefit, which is tax-deferred until it is part of a distribution at some point in the future.

As explained above, a trust is a non-individual beneficiary. If a trust is named as beneficiary of a retirement benefit, it will probably have a shorter distribution period than if the retirement benefit owner had just designated the trust beneficiary as the outright beneficiary of the retirement benefit. When the shortened distribution period is combined with the trust’s compressed income tax brackets (for 2018, a trust is taxed at the top income tax rate of 37% after only $12,500 of taxable income; while an individual must have $500,000 of taxable income in order to be taxed at that rate; while a married couple’s income must have $600,000 of taxable income in order be taxed at that rate), designating a trust can have disastrous income tax consequences.

See-Through Trusts as Beneficiaries of Retirement Benefits
The “see-through trust” is an exception to the traditional rule that a trust is a non- individual beneficiary. If a trust meets the “see-through trust” requirements, the trust will be disregarded if it is designated as the beneficiary of a retirement benefit. If the trust is disregarded as the beneficiary of the retirement benefit, the beneficiaries of the trust are considered the beneficiaries of the retirement benefit. In such a case, we are able to “see-through” the trust and identify the trust’s beneficiaries in order to determine the applicable distribution period in accordance with the rules discussed above. If all of the “counted” beneficiaries of the trust are individuals (which, of course, the drafting attorney should make sure of), the life expectancy rules discussed above will determine the applicable distribution period of the inherited retirement benefit. If life expectancies of individuals are allowed to be used to determine the applicable distribution period from the inherited retirement benefit to a trust, the advantageous income tax consequences discussed above can be realized by the trust, which ultimately benefits the “see-through trust’s” beneficiaries.

In order to qualify as a “see-through trust,” the trust must satisfy certain criteria mandated by the IRS via treasury regulation. See Treasury Regulation § 1.401(a)(9)-4, A-5(b). See also page 38 of IRS Publication 590. These requirements are:

1. The trust must be valid under state law;
2. The trust must be irrevocable (or will, by its terms, become irrevocable upon the death of the employee);
3. Trust beneficiaries as to retirement benefits payable to the trust are identifiable within the trust document; and
4. The retirement benefit custodian, issuer, administrator, or trustee must be provided with a copy of the trust document by October 31 of the year after the year of the retirement benefits owner’s death and there is an agreement to supplement that information in the event it is ever changed.
5. All of the “counted” beneficiaries of the trust are individuals.

Again, if all of the requirements identified above are satisfied, the trust will be considered a “see-through trust” and then it will be possible to realize a longer applicable distribution period because all of the beneficiaries of the “see-through trust” will be individuals. From a drafting standpoint, all of the IRS requirements should be addressed within the “see-through trust.” In addition, the attorney will need to determine what type of “see-through trust” to draft. There are two types of see-through trusts: the “conduit trust” and the “qualified accumulation trust.”

Conduit (See-Through) Trusts
The “conduit trust” is the simpler of the two. At a minimum, the conduit trust must direct the trustee to immediately distribute the annual minimum required distribution received from the inherited retirement benefit to a trust beneficiary, who must be an individual. The conduit trust can contain language to authorize the trustee to take distributions from the inherited retirement benefit that are in excess of the annual required minimum distribution so that the entire inherited retirement benefit can be made available to provide financial assistance to the beneficiary. In the event the conduit trust is drafted to allow the trustee to take distributions in excess of the required minimum distribution, any amount distributed from the inherited retirement benefit to the conduit trust must then be distributed from the conduit trust to the trust beneficiary. In short, nothing can be left (or, accumulated) inside of a conduit trust.

As is the case with most trusts, the conduit trust has two classes of beneficiaries; the current (or conduit) beneficiary and the remainder beneficiary. The conduit beneficiary is the trust beneficiary entitled to receive any distribution that the trustee receives from the inherited retirement benefit (less costs of trust administration). It goes without saying that the remainder beneficiary of the conduit trust is any beneficiary who will inherit upon the death of the conduit beneficiary.

Only one individual should be identified as the conduit beneficiary of a conduit trust. If an owner of retirement benefits would like to leave her retirement benefits to multiple
individuals, but would like for each individual’s life expectancy to be used in order to determine an applicable distribution period for each individual, then separate conduit trusts should be established for each individual beneficiary. The life expectancy of the conduit beneficiary will determine the applicable distribution period of the retirement benefit that is payable to that particular conduit trust.

In the event retirement benefit names multiple individuals as conduit beneficiaries, then the age of the oldest conduit beneficiary will be used to determine the applicable distribution period.

The remainder beneficiary of a conduit trust can be anyone or anything. In this sense, the remainder beneficiary is not “counted” for purpose of determining the applicable distribution period. In addition to simplicity, this is one of the advantages of a conduit trust. If the conduit beneficiary of a conduit trust dies during the applicable distribution period (i.e., before the inherited retirement benefit is completed distributed and paid out to the trustee of the conduit trust), the remainder beneficiary can be a charity, a third-party special needs trust, or an asset protection trust for the benefit of one or more remote descendants or other individuals. The remainder beneficiary of a conduit trust is not considered (or, “counted”) when determining the applicable distribution period of an inherited retirement benefit that is payable to a conduit trust; only the conduit beneficiary is considered (or, “counted”). The same cannot be said of a “qualified accumulation trust.”

Qualified Accumulation (See-Through) Trusts
The name “qualified accumulation trust” refers to a trust that: 1) is an accumulation trust (which is a trust where the trustee has the power and authority to receive property and hold it for distribution at a later date rather than receive property and immediately have to distribute it to a trust beneficiary or beneficiaries); and 2) satisfies all of the rules discussed below.

As the name suggests, a qualified accumulation trust allows the trustee to accumulate annual minimum required distributions inside of the trust after they are received from the inherited retirement benefit (and, of course, this is the primary difference when compared to the conduit trust). Typically, the trustee is given discretion to make and not make distributions to or for the benefit of the current beneficiary or beneficiaries of the qualified accumulation trust. A qualified accumulation trust must have at least one current beneficiary, but it may have more than one. The current beneficiary or beneficiaries of a qualified accumulation trust must be an individual(s). For a qualified accumulation trust to be drafted so that it can be understood and administered with the greatest amount of ease possible, the remainder beneficiary (or beneficiaries) should be an individual(s). In addition, the remainder beneficiary or beneficiaries should be entitled to inherit all of the trust’s assets, including the right to receive assets within the inherited retirement benefit not yet distributed, both immediately and outright upon some future event that is expressly stated in the qualified accumulation trust document. The identity of the remainder beneficiary (or beneficiaries) is determined upon the death of the retirement benefits owner and must be set in place by September 30 of the year after the year that the retirement benefits owner died (in other words, not removed as a beneficiary via qualified disclaimer or some other method). The date of September 30 of the year after the year of the retirement benefit owner’s death is often referred to as the “Beneficiary Finalization Date.” All “counted” beneficiaries of a qualified accumulation trust must be individuals by the Beneficiary Finalization Date. The concept of “counted” beneficiaries of a qualified accumulation trust is discussed below.

The applicable distribution period of a qualified accumulation trust is based on the life expectancy of the oldest individual who is living at the time of the retirement benefit owner’s death, has not been removed as a beneficiary prior to the Beneficiary Finalization Date, and is either: 1) entitled to receive a distribution from the accumulation trust during the trust’s administration (i.e., a current beneficiary); or 2) entitled to receive a distribution from the qualified accumulation trust immediately and outright upon its termination (i.e., a remainder beneficiary). It does not matter whether the oldest individual is a current beneficiary or a remainder beneficiary.

Examples
These complex rules are more easily explained with an example. Owner dies and designates Trust X as beneficiary of her retirement benefits. Trust X meets all of the “see-through trust” requirements. Trust X directs the trustee to distribute trust income and principal to Child 1 only when determined necessary by the trustee during Child 1’s lifetime, otherwise everything is to be accumulated and held in trust. Upon Child 1’s death, Trust X directs that the trust assets are to be distributed immediately and outright in equal shares to Child 1’s two children, GC1 and GC2. Trust X further provides that if both GC1 and GC2 predecease Child 1, the trust assets are to be distributed immediately and outright to Owner’s sister, Sis, who is older than Child 1.  Finally, Trust X provides that if GC1, GC2, and Sis all predecease Child 1, the trust assets are to be distributed immediately and outright to a charity, Charity.

If Child 1, GC1, GC2, Sis, and Charity all survive Owner and are living on the date of Owner’s death, Trust X will be deemed a qualified accumulation trust and the applicable distribution period of Owner’s retirement benefit will be based on the life expectancy of Child 1 because he is the oldest beneficiary between the current beneficiary and the “counted” remainder beneficiaries. Current beneficiaries of an accumulation trust are always “counted” for purposes of determining the oldest beneficiary in order to determine the applicable distribution period (which explains why only individuals should be named as a current beneficiary of a qualified accumulation trust).

Not all remainder beneficiaries of a qualified accumulation trust are “counted” in order to determine the applicable distribution period. The current beneficiary is Child 1 and the “counted” remainder beneficiaries in this first example are GC1 and GC2. Upon the death of Child 1, Trust X provides that both GC1 and GC2 inherit immediately and outright. Even though both GC1 and GC2 could predecease Child 1 sometime after Owner’s death, all that matters is that they are alive at the time of the Owner’s death. In this particular example, it is not necessary to use (or “count”) all of the remainder beneficiaries named in the qualified accumulation trust document in order to determine the applicable distribution period of the inherited retirement benefits that are payable to the qualified accumulation trust. Each and every current and remainder beneficiary of an accumulation trust must be “counted” for purposes of determining the applicable distribution period of a qualified accumulation trust until you identify the remainder beneficiaries who: 1) are alive at the time of the owner’s death; 2) who have not been removed prior to the Beneficiary Finalization Date; and 3) will for sure receive all trust assets immediately and outright upon the occurrence of some future event identified in the qualified accumulation trust document.

In this case, both GC1 and GC2 were alive on the day Owner died, they were not removed as beneficiaries of the qualified accumulation trust before the Beneficiary Finalization Date, and they both would inherit immediately and outright if Child 1 died the day after Owner died.  Again, it does not matter that they both could die before Child 1 as long as they were living at the time of Owner’s death and not removed as beneficiaries of the qualified accumulation trust prior to the Beneficiary Finalization Date. As a result, Sis and Charity are able to be disregarded as beneficiaries of Trust X.

It is exceedingly important to note that GC1 and GC2 could be removed as beneficiaries under the qualified accumulation trust document if they are living on the date of Owner’s death but die before a required survival period as provided in the trust document or by state law. In this case, they are (in effect) not living at the time of Owner’s death and, as a result. would also be removed before the Beneficiary Finalization Date. If both GC1 and GC2 die before the Beneficiary Finalization Date but after the expiration of a survival period, then they would be deemed to be living on the date that Owner died (because both of them were actually living on that date) and they would not be removed prior to the Beneficiary Finalization Date.

If Trust X said to Child 1 for life, then to GC1 until age 50, and then immediately and outright to GC1 upon reaching age 50 or to Sis immediately and outright if GC1 dies before reaching age 50, then to Charity if Sis is not then living, and all survive Owner, the analysis is a bit more complicated. If at the time of Owner’s death, GC1 is under age 50, the applicable distribution period will be based on Sis’s life expectancy. Child 1 is “counted” as a trust beneficiary because Child 1 is a current beneficiary. GC1 is “counted” as a trust beneficiary because GC1 is a remainder beneficiary, but we cannot stop with GC1 because we do not know for sure that GC1 will ever inherit immediately and outright because GC1 could die before reaching age 50. This means that we must “count” the next remainder beneficiary, who is Sis. We know for sure that Sis will inherit immediately and outright if both Child 1 and GC1 die immediately after Owner. Thus, we can stop with Sis and do not need to count Charity as a trust beneficiary. Of the “counted” trust beneficiaries (Child 1, GC1, and Sis), Sis is the oldest. As a result, the applicable distribution period of Owner’s inherited retirement benefits will be based on Sis’s life expectancy.

If GC1 was older than 50 at the time of Owner’s death in the modified fact pattern immediately above, it is possible to say for sure that GC1 would inherit outright and immediately upon the death of Child 1 if Child 1 died the day after Owner died. In this case, it would not be necessary to “count” Sis as a trust beneficiary. Consequently, the applicable distribution period would be based on Child 1’s life expectancy since he is the oldest trust beneficiary.  We would be able to ignore both Sis and Charity as trust beneficiaries.

Back to the original example. If Child 1, Sis, and Charity survive Owner and GC1 and GC2 both predecease Owner, Trust X will be deemed an accumulation trust and the applicable distribution period of Owner’s retirement benefit will be based on Sis’s life expectancy because she is oldest beneficiary between the current beneficiary and “counted” remainder beneficiaries. In this case, Child 1 is the current beneficiary and Sis is the remainder beneficiary who is alive at the time of Owner’s death and who will for sure receive trust assets immediately and outright upon the death of Child 1. Again, it does not matter that Sis may die before Child 1 at some point in time after Owner’s death. Charity will be disregarded as a beneficiary of Trust X.

If Child 1 and Charity survive Owner and GC1, GC2, and Sis all predecease Owner, Trust X will not be deemed a qualified accumulation trust because Charity is not an individual. In fact, Trust X will not qualify as a “see-through trust.” Consequently, the applicable distribution period of Owner’s inherited retirement benefit will be paid to Trust X based on Owner’s life expectancy (if Owner died after his RBD) or over five years (if Owner died before his RBD).

Summary
Although highly technical and complex, there are significant and powerful tax and non- tax reasons for clients to consider including provisions for see-through trusts within their estate plans and then designate those trusts as beneficiaries of their retirement benefits. When the elder law and estate planning attorney is able to incorporate see-through trusts”into a client’s estate plan, the attorney is allowing her client to have his cake and eat it too.
About the Author
Mark D. Munson, CELA, is a member of the NAELA Board of Directors. The author wishes to profusely thank and acknowledge the gracious and invaluable insight and peer review provided by Atty. Michelle L. Ward of Keebler & Associates of Green Bay, Wisconsin.