Return to Estate Planning Directory Return to Tax Directory Return to Home Page

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

First, some background: During his life a Plan Participant with a previously untaxed retirement plan (or IRA) could withdraw funds at any time from the Plan and pay tax (and perhaps penalty) on the withdrawal. Assuming that the Participant has other assets, his best long-term strategy is to minimize the withdrawals to allow maximum tax deferred growth. To limit the tax deferral, the Minimum Distribution Rules were passed by Congress years ago, requiring distributions to start once the Participant reaches age 70½.

At his death, if the Plan is left to the Spouse, Spouse may roll over the Plan into a new IRA and maintain the tax deferred status.

At his death, if the Plan is left to an individual (other than the Spouse), that individual cannot roll over the Plan but must make an irrevocable election on payment of taxes. The beneficiary may either:

1. make withdrawals at any time over a period ending on December 31, 5 and a fraction years after the death, or
2. annuitize it over his life expectancy.

Until recently, if the Plan was left to a Living Trust, the Trust was ineligible to annuitize the Plan over the beneficiary's life expectancy.

Now, the IRS allows the same tax options if the Plan is left to a Trust if the new requirements are met. Now, we look through the Trust and tax the withdrawals on the same tax basis as if the Plan had been left directly to the individual beneficiary.

The new requirements are that the Trust becomes irrevocable on the death of the Participant and the Plan Administrator is advised (prior to death of the Participant) of the beneficiaries and the basic terms of the Trust (including amendments as they may occur from time to time), or provided with a full copy of the Trust.

This becomes of concern only if the family:

1. has enough in the Plan to make this significant; and
2. desires to delay withdrawals as long as possible to enjoy the tax deferred growth inside the Plan as much as possible.

Tax deferred compounding is the biggest benefit enjoyed by Retirement Plans. The Minimum Distribution Rules try to limit this. There is no question that stretching the Minimum Distribution Rules to the longest term is the best long term economic answer.

However, after Mom and Dad have died, are their beneficiaries more interested in long-term growth or short-term spending?

If the kids are just going to spend the funds, this is not an important issue. On the other hand, if the kids have enough other funds (either their own or other inherited assets) to leave the Plan for the long term, annuitizing it over their life expectancy will generate more after-tax funds than taking it out sooner.

Of course, the problem with the annuitization method is that it is inflexible; once the election is made, the child cannot increase his annual withdrawal due to changed circumstances or emergency, so this method requires careful planning.

A simplistic example illustrates the choice: Assume Mom dies and leaves her $500,000 IRA to Son.

Option 1: Son must withdraw the funds any way he wants during the 5+ years ending on December 31. He may withdraw $100,000 a year or none until the last minute, but at the end of the time period, he must take it all out (and pay tax when he does).

Option 2: Son may annuitize it over his life expectancy. Assume Son has 25 years left. He gets 1/25th in the first year; 1/24th the next year....

(This is the fixed life expectancy; as an alternative he might also elect to recompute annually his life expectancy, but the fixed method is easier for this illustration.)

There is no question (given reasonable growth assumptions) that the annuitization method works better in the long term. But what does Son actually want? Does he want $500,000 up front taxable, or $20,000+ a year for the rest of his life?

Now, the use of the Trust as beneficiary maintains the same options for taxation as if the Plan had been left directly to the individuals. But why do we consider the Trust as a beneficiary instead of the children individually?

Let's look at a Trust and see what can be accomplished. Using myself as an illustration, on my death my wife has full use of everything; at her later death, it goes to my children, who are now young.

Until my young children come "of age," my sister Laura is Trustee for them, investing and spending for their benefit as Laura deems appropriate. Laura is 100% in control.

1. If Laura is sued over a personal car accident and the victim obtains a judgment against Laura, the Trust is not at risk. The Trust is not Laura's; she is merely the manager. The victim cannot seize it any more than I can walk into the grocery store and take food off of the shelf just because I have a car accident judgment against the store manager.

2. If Laura is divorced, her husband cannot get half (or any portion) of the Trust. The Trust is not Laura's; she is merely the manager.

3. If Laura dies and leaves everything she owns to her husband, it has no effect on the Trust, other than the Successor Trustee I selected takes over.

4. If Laura dies there is no tax owed by the Trust.

Amazingly, the same benefits apply even if the Trustee (manager) happens to be my child, and the Trust is established for her sole benefit.

After my wife and I have died, when my kids reach (or have reached) age 30 (my definition of "coming of age"), the Trust divides into equal shares for each child. Rather than terminating the Trust, each child becomes her own Trustee, able to invest or spend on herself, but without ownership of the Trust assets. Therefore the Trust assets, even though my daughter may spend every penny of income and principal in her own discretion, are protected.

1. If my Daughter is sued, the Trust is not at risk.

2. If my Daughter is divorced, her husband cannot get half (or any portion) of the Trust.

3. If my Daughter dies, the Trust goes to my grandchildren, not her husband.

4. If my Daughter dies, there is no tax. (Technically, this is true only for the Generation Skipping Exemption amount; $2,000,000 for a couple.)

Summary: The Trust provides long-term protections for the heirs; the new law equalizes the taxation when a Trust is named beneficiary if the Plan Administrator is advised of the basic terms of the Trust. Therefore, there is no longer any drawback to naming the Trust as beneficiary.

For a married couple, my standard recommendation is that Spouse is the first beneficiary. This allows Spouse the utmost flexibility to do a full rollover. The Trust is named secondary beneficiary.

Return to Estate Planning Directory Return to Tax Directory Return to Home Page