Archive | December 2011

Niche Trusts

Revocable Living, Irrevocable Life Insurance, Charitable Lead, and Grantor Retained Annuity – these are trust descriptors that are familiar to estate planning professionals. However, there are many less well-known types of trusts that clients may ask about or benefit from having. Some of those other types of trusts will fill an estate planning need like no other arrangement can. Some arrangements called “trusts” do not fit the traditional trust definition. Still other things called “trusts” are outright shams.

As professionals, we need to know about the lesser-known trusts, when to use them, when to avoid them, and when to warn our clients to get out of them.

In this issue of The Wealth Counselor, we review some trust basics and then provide an introduction to a number of these lesser-known trusts and things called “trusts.”

What Is a Trust?
Almost always, when someone says “trust,” they mean what is called an “express trust” – a tri-party relationship intentionally established by a grantor (who is the owner of property), a trustee (who receives and agrees to hold and manage the property), and a beneficiary or beneficiaries (for whose benefit and enjoyment the property is to be held). In this discussion, “trust” means “express trust” unless the contrary is stated.

A trust is a fiduciary relationship between the trustee and the beneficiary and between the trustee and the grantor. It involves two distinct elements of ownership of an asset: 1) legal (transferred by the grantor to the trustee) and 2) beneficial (vested in the beneficiaries to the extent specified in the trust agreement).

Although a trust is a relationship, for IRS purposes, it is treated as an entity. Under the Treasury Regulations, the key distinguishing factor of a trust is that it exists to protect and conserve property for the benefit of beneficiaries “who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.”

Planning Tip: An entity that is not classified as a trust under Treas. Reg. 301.7701-4 is a business entity.

Private Trusts
Most trusts are private trusts. In addition to those commonly encountered, there are many that have very special purposes. Some of them are:

Health and Education Exclusions Trust (HEET): The HEET is a multi-generational or “dynasty” trust. Through a HEET, a wealthy grantor can confer even more benefit on grandchildren and generations beyond than the amount that is exempt from the Generation Skipping Transfer (GST) Tax. The HEET does this by limiting distributions for the benefit of “skip persons” to direct payments of their medical and higher education tuition expenses. A skip person is someone two or more generations younger than the grantor. A HEET also prohibits direct payments to skip persons or for purposes that are not exempted from gift, estate, and GST tax. The HEET must have a least one beneficiary with a substantial present economic interest who is a non-skip-person. Typically, the non-skip beneficiary chosen is a charity so that the HEET can continue in existence for as long as the charity exists.

Planning Tip: A HEET is frequently created by a taxpayer who has already used their GST exemption, has charitable goals and wishes to create an education and health care safety net for future generations.

Delaware Incomplete-gift Non-Grantor (DING) Trust: A DING is a non-grantor self-settled irrevocable trust that gives the grantor creditor protection and avoids state income tax on undistributed ordinary income and capital gains. Delaware was the first state to allow self-settled asset protection trusts. Now, however, DINGs are not limited to Delaware. States where domestic asset protection trusts can be established now include Alaska, Nevada, New Hampshire, Rhode Island, South Dakota, Tennessee, Utah and Wyoming.

Assets placed in a DING get a step up in basis on the grantor’s death and are included in the grantor’s estate for estate tax purposes. A DING must require the consent of an adverse party for any trust distribution (typically a committee composed of two beneficiaries of the trust other than the grantor).

Rabbi Trust: The first Rabbi Trust was set up for a rabbi; hence, the name. They are used with various nonqualified deferred compensation arrangements for highly compensated executives who wish to defer the receipt of some of their compensation in order to minimize current income taxes. The Rabbi Trust can be revocable or irrevocable and funded or unfunded. A funded Rabbi Trust provides the executive more security; however it must be carefully structured to prevent the employee from being taxed now. The trustee must be an independent third party and the assets must be held separate from the employer’s other funds.

Planning Tip: Assets held in a Rabbi Trust are subject to the claims of the employer’s general creditors, so it is important to use this technique only with a financially solid company. The fact that the executive will be an unsecured creditor of the company should the company become insolvent is not especially reassuring, but is necessary in order to prevent the executive from being taxed currently on the deferred compensation.

Oral Trust: Although trusts are usually written documents, that is not always required. The Uniform Trust Code (UTC) does acknowledge that under certain circumstances a trust may be created orally. However, oral trusts of real property are not permitted in some states. The biggest problems with an oral trust, of course, are interpretation and enforcement. Disputes about the terms or even the very existence of an oral trust are common.

Alimony and Maintenance Trust: These are also called “Section 682” trusts. They are an exception to the general grantor trust rules in that the income paid from these trusts to an ex-spouse under a dissolution or separation decree/agreement will be taxed to the payee (the ex-spouse) and not to the grantor. Typically the trust’s income is paid to the former spouse for a specified term or amount or until the spouse dies. After the former spouse’s interest has ended, the trust can continue for the benefit of the grantor’s designated successor beneficiaries, typically the children.

Planning Tip: An alimony trust may be useful if a business owner cannot or does not want to sell an interest in the family business to make payments to his former spouse or if the business lacks the liquidity to redeem the stock of the former spouse. It can protect the payee in the event the payor should die or become financially insolvent before all payments have been made. Also, the trustee can be a neutral third-party who can act as an intermediary between the former spouses. One downside is that the trust can become under- or over-funded, so care should be taken when drafting the document and funding the trust.

Commercial Trusts
Also known as a business trust, the commercial trust is an unincorporated business organization. It is created by a written agreement under which assets are managed by a trustee for the benefit and profit of its beneficial owners. It is typically funded in a bargained-for exchange and shares of beneficial ownership are issued to the participants. The trustee can make risky investments for entrepreneurial gain and share that risk of loss with the beneficial owners. This arrangement is different from the traditional grantor/trustee/beneficiary relationship and the trustee does not have the same kinds of fiduciary duties and protections as in a conventional trust arrangement. It is not clear that these trusts would have as much asset protection as a conventional corporation or an LLC, or how they would be recognized in bankruptcy. Specific commercial/business trusts include:

Investment Trust: This trust is used by multiple individuals to pool funds for common investments. One common type of Investment Trust is the Real Estate Investment Trust (REIT). The trust may provide that beneficial interests in the trust may be bought and sold.

Environmental Remediation Trust: These are established to collect and disburse funds for environmental remediation of an existing waste site when the ultimate cost of remediation is uncertain. They are used in sales of contaminated real property.

Statutory Land Trust: These private non-charitable trusts are used to hold title to real property while keeping the identity of the beneficiary confidential, and are used to maintain privacy in the transfer of real estate (acquisition or sale). They can avoid probate, but do not provide asset protection.

Liquidating Trust: These relate primarily to income tax and bankruptcy. In bankruptcy, they are used to liquidate assets under Chapter 11. Outside bankruptcy, they are used to facilitate a sale.

Voting Trust: These allow voting rights in a business entity to be transferred to a trustee, usually for a specified period of time or for a specific event. They are useful in resolving conflicts of interest, in securing continuity, for corporate reorganization, and in divorce when it is necessary to divide an LLC or corporation owned by a divorcing couple.

Specific Purpose Trusts
There are some trusts created for specific purposes rather than for the benefit of individual beneficiaries. Non-charitable purposes include pets, artwork, aircraft; charitable purposes include private foundations organized as trusts and charitable land banks. Specific examples include:

Funeral and Cemetery Trust: A funeral trust is an arrangement between the grantor and funeral home or cemetery involving prepayment of funeral expenses. An endowment cemetery trust is a pooled income fund held in the name of the cemetery for ongoing maintenance of cemetery grounds. A service and merchandise cemetery trust, similar to a funeral trust, is for merchandise like a gravesite marker or mausoleum and for burial service.

Pet Trust: Many pet owners want to provide for the continuing care of their pets after their own deaths. As a result, many states have adopted some form of pet trust legislation. It is important to specifically identify the animal the trust is to benefit, especially if the pet is valuable or a large sum of money is involved. Special considerations include: how long the trust will need to last, what kind of care is needed and who will provide it, whether to name a separate trustee to manage funds in addition to a caretaker, successor fiduciaries and caretakers, a sanctuary or shelter of last resort if the pet outlives the caretakers or those named cannot serve, liability insurance for potential damage caused by the pet, a trust protector, and reimbursement of taxes if the payee is subject to additional income taxes. Also consider how much money will be required to fund the trust and what will happen to any funds that remain after the pet has died.

Gun Trust: Federal, state and local firearms laws strictly regulate possession and transfer of certain weapons and bar certain persons from owning or having access to firearms. When an estate has firearms, the executor must be careful to avoid violating these laws. Transferring a weapon to an heir to fulfill a bequest could subject the executor and/or the heir to criminal penalties. Just having a weapon appraised could result in its seizure.

A trust designed specifically for the ownership, transfer and possession of a firearm (known as a gun trust or firearm trust) can avoid some of the rules that regulate such transfers. The trust, which must be carefully drafted to account for the different types of firearms held and comply with firearms laws, establishes a trustee as the owner of the firearms. The trust can name several trustees, each of whom may lawfully possess the weapon without triggering transfer requirements. Once a weapon becomes a trust asset, any beneficiary (including a minor child) may use it.

Marketing Tip: There are four million members of the National Rifle Association (NRA) and an estimated 240 million firearms in this country. That means millions of American own guns. Many families also have guns as heirlooms. Providing guns trusts (and pet trusts, for that matter) is an excellent way to reach out to potential clients for estate planning.

Other Trusts
Blind Trust: These are used by higher net worth clients who are involved in public companies or politics and who need to strictly limit their knowledge of how their assets are being managed in order to avoid any conflict of interest or even the appearance of one. Investments are transferred to an independent trustee who is permitted to sell or dispose of any assets transferred to the trust, and then reinvest in assets that are unknown to the grantor.

Coogan Trust: This is a statutory trust account required in some states to protect a part of the earnings of child actors. It is named after the child actor, Jackie Coogan, who learned on becoming an adult that his parents had saved very little of his earnings.

Totten Trust: This is a pay-on-death account that, until the death of the depositor, is treated as an informal revocable living trust. While living, the depositor may be the grantor, trustee and beneficiary. Upon the depositor’s death, the proceeds in the account will be paid to the beneficiary previously designated on a signature card by the depositor (who can change the designation any time before his/her death).

Sham Trusts
These are so-called trusts marketed by hucksters that violate public policy and are not recognized by state or federal income tax authorities or the courts. The document may claim to create a trust and promise tax benefits, but makes no actual change in ownership or control of the grantor’s property or beneficial interests. They may be complex, involving multiple foreign and domestic trusts, and entities holding interests in other trusts. Funds may flow from one trust to another by various agreements, fees and distributions; often there are no named beneficiaries. They may claim that paying taxes is entirely voluntary. Names include Constitutional Trusts, Pure Trusts, Pure Equity Trusts, Contract Trusts, and Freedom Trusts.

Planning Tip: If your client has one of these sham trusts, the risk of an IRS audit with accompanying penalties – civil and criminal – is high. They thus provide the advisor an opportunity to un-do a great harm, providing the client is willing.

Constructive Trusts
A constructive trust is not a trust, but it resembles one. It is an equitable remedy imposed by a court to transfer the benefit of property to the rightful party when someone else has unjustly received it. A court may impose a constructive trust to remedy fraud, misrepresentation, bad faith, overreaching, undue influence, duress and mistake. Courts may also use the constructive trust doctrine creatively when a wrong has been committed but no legal remedy is available.

There are many kinds of trusts and trust-like arrangements that estate planners may not routinely use in their practices. It’s good to be aware of them, and to understand when one might be useful for a client and when one might be dangerous, or possibly even criminal. Each represents an opportunity for the professional to enhance their role as trusted advisor.


Trustee Selection for Irrevocable Trusts

Most professionals who work with trusts have plenty of “nightmare stories” about trustees chosen by clients for their irrevocable trusts. No doubt this is because trustees are often chosen without careful consideration of the qualifications required.

In this issue of The Wealth Counselor, we will examine who can, who should, and who should not serve as trustee; non-tax and tax factors that should be considered when selecting a trustee; who can, and should, be given the right to remove and replace a trustee; and using a team approach to segregate duties among lay and professional trustees.

Irrevocable trusts are created in two ways:

  1. A revocable trust becomes irrevocable after the grantor has died.
  2. An irrevocable trust is established while the grantor is living to save estate taxes (by removing assets from the grantor’s estate) and/or for asset protection or Medicaid (Medi-Cal in California) planning.

While a grantor may technically be allowed to serve as the trustee of an irrevocable trust he creates, it is not a good idea at best. That is because if the grantor has any discretion with trust asset distributions, it could lead to inclusion of the trust assets in his estate for tax, Medicaid and other purposes, which could frustrate the trust’s objectives.

Often there is someone the grantor knows who the grantor suggests to be the trustee. Typical choices are the grantor’s spouse, sibling, child, or friend. Any of these may be an acceptable choice from a legal perspective, but may be a poor choice for other reasons. For example, some families would be torn apart if one sibling had to ask another for a distribution.

Left to their own devices, clients trustee appointments will frequently be made (out of ignorance) with little consideration of the qualifications the trustee should have. Likewise, those who agree to be trustees typically have no idea what they are getting into. Non-professional trustees often are overworked, underpaid, unappreciated, find they are dealing with unhappy and unappreciative beneficiaries, and may even wind up being sued by the beneficiaries.

With this in mind, let’s look at some factors (non-tax and tax) that should be considered when selecting a trustee.

Non-Tax Considerations for Selecting a Trustee
Here are some of the characteristics that the client should consider in choosing an individual trustee:

Judgment: Clients typically want their trustee to make the same decisions they would. Someone who shares the grantor’s values, virtues, spending habits and faith is more likely to do this. Also, consider whether the trustee candidate will be aware of his own capabilities and weaknesses. If the trustee candidate does not have accounting or investment experience, would she have the judgment to admit this and engage an appropriate qualified professional?

Availability/Location: Does this trustee candidate have the time required to be a trustee? Will he be available when needed or will work and/or family demands leave too little time for trust responsibilities? Where does the candidate live? If the trustee lives in a place different than the trust situs, different laws may apply. Is living near the beneficiary important?

Longevity: How long will the trustee be needed? Many grantors are most comfortable with friends who share their values and have gained wisdom from life experiences, but someone near the grantor’s age may not live long enough to fulfill the job. A trust established for the grantor’s child will likely need a trustee for many years to come. Thus, for trusts that may last a long time, a corporate trustee is often the preferred choice.

Impartiality: The trustee must be capable of being impartial among the beneficiaries. This is especially difficult to do if the trustee is one of several beneficiaries. Corporate trustees, because they can be impartial, are often chosen to prevent a sibling or relative from being placed in an uncomfortable (and often unfair) position.

Interpersonal Skills: The trustee needs to be able to communicate well and effectively to the beneficiaries and to professionals who may be involved with the trust. Some people may be good record keepers or investors, but lousy at diplomacy or feel intimidated or even be offended if a beneficiary gets an attorney. A good trustee will need to be able to work calmly and well with all involved.

Attention to Detail: Does the trustee understand the serious duties that come with the job and is she willing to be accountable for her actions? Fiduciaries are often thought by the beneficiaries to be guilty until proven innocent. While it may not happen, the trustee should assume he will be sued at some point and keep meticulous records as a ready defense. A trustee who expects to be sued will be much better prepared than one who doesn’t think it will happen and, as a result, does not take the record keeping requirement seriously.

Investment Experience: While it is helpful to have investment experience, the trustee can certainly get by without it, as long as he/she recognizes this is an area for which to secure professional help. Also, if the trustee lives in a place different than the trust situs, different investment laws may apply, making it especially prudent or even essential to seek professional assistance.

Planning Tip: CPAs can make good trustees, but often are unwilling or unable (because of insurance considerations) to serve. Sometimes, the best choice would be a corporate trustee. Seldom will the unguided grantor even think of using a team, which can include both various professionals and friends and family members.

Fees: The non-professional trustee rarely discusses fees with the beneficiaries. Often, family members and friends will not charge a fee for their services out of a sense of family duty or respect for the grantor. But trustees should be paid and, more often than not, an unpaid trustee will eventually come to that conclusion or fail to diligently carry out his duties. From the outset, a trustee should keep close track of time and expenses so that a reasonable fee can be substantiated. Generally, a reasonable fee is what a corporate trustee would charge, so thinking that a non-corporate trustee will do the same necessary work for less is false economy.

Planning Tip: Become knowledgeable about the fees charged by corporate trustees in your area as a guideline. Talk about trustee fees when establishing the trust to avoid problems and misunderstandings later.

Insurance: Anyone serving as a trustee needs to have plenty of insurance (errors and omissions or liability). Some of the laws that govern trustees are absolute standards, so a trustee needs to have adequate insurance for protection in the event of a mistake or an innocent error. The amount of insurance needed can depend on the degree to which a trustee is indemnified. However, legal defense costs in trustee litigation can be very large and are typically borne by the insurer.

Indemnification: This often comes up when family members or friends are serving as trustee. Grantors want to indemnify family members and their friends; they do not want them to be sued. It is possible to reduce or eliminate the prudent investor rule for such trustees. However, indemnification is a two-edged sword because it may result in the non-professional trustee not taking the job seriously.

Planning Tip: A good alternative is to have a family member or friend serve with a corporate fiduciary that is assigned the administrative and investment responsibility. The family member or friend trustee could make or veto discretionary distributions, but having no oversight, administration, or investment obligations would be less likely to be sued if something goes wrong.

Planning Tip: Indemnification might be appropriate in a situation with obvious bad family dynamics, where the siblings are already fighting each other yet the grantor insists on naming one sibling as trustee. In such a situation, your recommendation to name a corporate fiduciary instead should be well documented.

Planning Tip: Waiving the prudent investor rule can also be helpful in other situations, depending on the use of the trust. For example, with the sale of an appreciated asset(s) to a grantor trust, the trustee is usually buying hard-to-value assets (real estate, wholesale business interest) from the client in order to shift future appreciation to the trust and away from the grantor. Rather than starting initially with a corporate fiduciary who is not familiar with the asset or situation, it may be more effective (saving both time and money) to have the initial trustee be someone close to the family who better understands the issues, and then change later to a corporate fiduciary. Waiving the prudent investor rule and providing indemnification for the initial trustee in this situation could make sense.

Planning Tip: Being able to waive all or part of the prudent investor rule when using an irrevocable life insurance trust (ILIT) gives greater latitude and peace of mind to make some of the transactions meet the unique needs of the client. Beware, however, of the risk that the trustee, shielded from liability, may fail to do the appropriate work to make sure that the insurance held in the ILIT is appropriate as markets change.

Note: Florida is considering a statute that would relieve trustees of the duty to review the propriety of investments in life insurance policies, which would, in effect, waive the prudent investor rule for life insurance policies owned by ILITs. This would help to solve the problem of corporate trustees not wanting to serve as the trustee of ILITs due to the obligation to review policies that have not performed very well.

Tax Considerations
Estate Tax
If a purpose of the trust is to remove assets from the grantor’s estate, the grantor cannot have any role in determining who gets distributions or when they occur. However, the grantor can have the power to remove and replace the trustee or to control the investments of the trust. Neither of those will cause estate tax inclusion providing the grantor cannot appoint a trustee who is related or subordinate to the grantor (as would be a brother, employee or someone else who will capitulate to the grantor’s wishes). Interestingly, there is no problem appointing, at the inception of the trust, an initial or successor trustee who is related or subordinate to the grantor.

Planning Tip: It is unclear if a grantor can have the right only to remove a trustee and allow the next named successor trustee to take over. While also unclear, it seems that a grantor can reserve the right to remove and replace someone who is not a fiduciary (for example, a trust protector).

Income Tax
A non-adverse trustee having certain powers may trigger grantor trust rules and cause the grantor to be taxed on the trust’s income. In some instances the client may not want the tax to come back to the grantor and instead want a trust that is a separate tax-paying entity for which the income that is distributed to the beneficiaries is be taxed to the beneficiaries.

Planning Tip: Because the trustee’s identity may affect state income tax as well, you may be able to shift the trust situs to a state with a lower income tax rate. Depending on the trust assets, this could be important as some investments (such as oil and gas) may be taxed significantly higher in some states than in others.

Beneficiary Removal and Replacement of Trustee
This is an area that is customizable for each trust and can help maintain some downstream flexibility. Some grantors may not want the beneficiaries to be able to remove the trustee, especially if the grantor is aware of family quarreling. But if the corporate or individual trustee knows it cannot be replaced there is little need for responsiveness or careful attention to investments. Because there does need to be a way to have the trustee removed if things should deteriorate, the document can include that the trustee can only be removed for cause as determined by the court. On the other end, spendthrifts may want to “trustee shop” until they find one that will do whatever they want, so there will need to be some restraints on when a trustee can be replaced.

Team Approach
There are times when a team can do a better job than a single trustee. Having more than one trustee, even with different duties and responsibilities, can work well for many situations. The trust can benefit from assigning the trustees specific duties based on their strengths and experience. Of course, the fewer people who are involved, the less complicated the administration. Also, disagreements will have to be worked out. If there are two trustees or any even number, deadlocks are possible. With an odd number, a simple majority would be needed. If an agreement cannot be reached, the court can be allowed to intervene as a last resort.

Also, as mentioned earlier, family member trustees can work with professionals as paid advisors instead of as trustees. This would allow the advisors to provide valuable input and insight into both the grantor’s desires and the personalities of the beneficiaries, without being so exposed to possible lawsuits.

Planning Tip: Ethical issues can arise if the attorney represents more than one trustee, so she should be sure to have a waiver of conflict or other plan in place.

Planning Tip: Naming someone as trustee is a nomination. The person named is under no obligation to accept the responsibility when the time comes, and it is not unusual for someone to refuse to serve or to step aside once he understands the duties and responsibilities involved. For this reason, it is important for the trust maker to name several successor trustees and to clearly communicate with each before finalizing the choices. Most drafting attorneys will also recommend naming a corporate trustee as trustee of last resort, especially if no procedure for appointing successors is provided to the beneficiaries, short of going to court.

The Trustee’s Duties and Responsibilities

– administer the trust
– be loyal
– be impartial
– be prudent
– control and protect trust property
– collect trust property
– inform and report to beneficiaries
– diversify investments
– keep records and no commingling
– enforce and defend claims

A competent trustee is as important to the success of a trust as its being well-drafted. Naming a favorite family member as trustee may not be the smartest (or kindest) thing the grantor can do. As experienced professionals who have seen the consequences of unwise choices for trustee, we are in a unique position to counsel our clients with their and their beneficiaries’ best interests in mind.

Retirement Planning: Coordinating with the Client’s Overall Planning Objectives

Volume 6, Issue 12
From Nick Shimoda, JD, LL.M

Nick Y. Shimoda, P.C.

newsletter_image 305 Regency Court
P.o. Box 1765 Dothan, AL 36302-1765

The Firm focuses on Simple & Complex Estate Planning, Special Needs Planning, Elder & Medicaid Law, Probate Law, Guardianships, Conservatorships, LLCs, S-Corps., FLPs, 501(c)(3) Corps., Mergers & Acquisitions, Trademarks, and Tax & Litigation matters regarding the same.

Coordinating retirement plans with wealth transfer planning can be challenging. This is primarily because retirement accounts are driven by income tax laws designed to encourage Americans to accumulate wealth for retirement, not for transferring wealth upon death.

In this edition of The Wealth Counselor, we will examine some of the critical rules in using IRAs and qualified retirement plans for wealth transfer planning, common misperceptions in this area, and why naming a trust as beneficiary may be the only way to accomplish some of the client’s planning objectives. Completely covering these subjects requires volumes, so we will cover only the basics.

This topic is especially important now as the baby boomer generation begins retiring. At the end of 2010, IRAs and qualified retirement plans held nearly $17.5 trillion, accounting for 37% of all household financial assets. And because of how lifetime minimum required distributions are calculated, IRAs and qualified retirement plans may be the largest assets held at death.

The Fundamentals
Distribution Calendar Year
A distribution calendar year is a year in which the participant is required to take a distribution from the plan. The first distribution calendar year is the calendar year in which the participant reaches age 70 1/2 (for some employees under some qualified retirement plans, this may be the year in which the participant retires)

Required Beginning Date (RBD)
A special rule applies to the first distribution calendar year. The required distribution for that year may be taken as late as April of the following year, which is called the required beginning date (RBD). Because all other required distributions must be made within their assigned year, the distribution for the second distribution calendar year must be made before December 31 of the year in which the RBD falls.

Minimum Required Distribution (MRD)
In each distribution calendar year, the participant is required to take at least a prescribed distribution, called the minimum required distribution (MRD). The MRD for each distribution calendar year is determined by dividing the prior year-end account balance by a life expectancy factor for the participant that is supplied by the IRS. If the participant’s sole beneficiary is his or her spouse who is more than 10 years younger than the participant, the MRD is calculated using the Joint and Last Survivor Table. Otherwise, the Uniform Lifetime Table, which assumes a joint life expectancy with someone presumed to be ten years younger, is used. Under the Uniform Lifetime Table, a participant who only takes the MRD each year cannot outlive his or her retirement benefits.

Planning Tip: Taking only the MRD also means that the account will probably grow for years past the RBD. For example, if an IRA is growing at a rate of 5.5%, at age 100, the participant will still have about 60% of the original account balance is still in the account. Planning for the beneficiaries, therefore, is very important.

Minimum Required Distribution for the Year of Death
If the participant has not yet taken the entire MRD for the year in which he/she dies, the beneficiary must withdraw the remaining amount of the participant’s MRD by before the end of that year. If there are multiple beneficiaries, the MRD rules are satisfied as long as the beneficiaries, in the aggregate, take the balance of the year-of-death MRD and it does not have to be pro rata.

Minimum Required Distributions after Death
After the participant’s death, MRDs apply to the beneficiary and normally begin the year after the year of the participant’s death. The after-death MRD rules are more complicated than the lifetime MRD rules, and are based on three factors:

(1) Whether death occurs before or after the participant’s RBD for that IRA or qualified retirement plan;
(2) Who, or what, is the beneficiary; and
(3) For qualified retirement plans, what the plan allows.

Note: The rules are different if the spouse is the sole beneficiary; that will be covered later.

Planning Tip: If your client is a participant in a qualified retirement plan, make sure you review and understand what the plan will allow as a part of any planning, because, in many cases, plan rules trump the general rules.

Who is the Participant’s Beneficiary? Is There a “Designated Beneficiary” (DB)?
Beneficiary means those who are entitled to the plan benefits upon the participant’s death. Retirement benefits generally pass as non-probate property, by contract, to the beneficiary named in the participant’s beneficiary designation form or, if there are none, as specified in the plan. The provisions in the participant’s will or revocable living trust are irrelevant as to who receives the benefits, unless the plan or the participant’s beneficiary designation provides otherwise.

“Designated beneficiary” does not mean the beneficiary designated by the participant. It is a legal term and understanding its meaning is crucial to planning and for compliance with post-death MRDs.

There is a Designated Beneficiary for an account if, on September 30 of the year following the year of the participant’s death, there is no beneficiary that has to be considered in making the analysis that is not a human being or a qualified “look-through” trust and the plan administrator or custodian can know, with certainty, the oldest person who has to be considered in making the analysis.

Planning Tip: During this period of at least nine months, clean-up strategies can be used.  These include removing non-qualified beneficiaries and division into separate shares (discussed below).

Planning Tip: Most IRAs and qualified retirement plans have printed beneficiary designation forms they expect the participant to use. Most, but not all, will accept attachments. Some will accept a separate instrument. Due to the limited space on most forms, it will probably be necessary to add an attachment. When drafting beneficiary designations, make sure the plan permits what you are trying to accomplish.

Keys to Achieving “Designated Beneficiary” Status: Only an individual or a qualified “look through” trust can be a Designated Beneficiary. Estates, partnerships, corporations, LLCs, other trusts, and charities do not qualify. If there are multiple beneficiaries, all must be individuals and the oldest must be identifiable.

Determining the MRD for the Beneficiary after the Participant Dies
When determining the MRD for years after the participant’s death, the critical questions are: (1) Is there a Designated Beneficiary; (2) Did the participant die before or after the Required Beginning Date? and (3) What does the plan provide?

If there is a Designated Beneficiary, regardless of when the participant dies, each beneficiary may use the Designated Beneficiary’s age factor as shown in the Single Life Table to determine his or her MRD unless the plan requires more rapid distribution. Using the Designated Beneficiary’s age is commonly known as a “stretch-out,” and, in most cases, maximum stretch-out results in significantly more wealth passing to the beneficiary.

Using the Life Expectancy Rule, the beneficiary calculates the MRD for the first year by dividing the account balance by the Designated Beneficiary’s life expectancy. Each subsequent year, calculate the MRD by dividing the remaining account balance by the prior year’s divisor minus “1.” Thus, using this method, a beneficiary will withdraw all of the retirement benefits by the life expectancy of the Designated Beneficiary, even if taking only the MRD each year.

Death before Required Beginning Date
If the participant died before his or her RBD and there is no Designated Beneficiary, distributions must comply with the Five-Year Rule unless the plan requires more rapid distribution.  Under the Five-Year Rule, the entire plan balance must be distributed by December 31 of the year containing the fifth anniversary of the participant’s death. Annual distributions are not required. If there is a Designated Beneficiary, use of the Five-Year Rule is optional unless the plan provides otherwise.

Planning Tip: The Five-Year Rule only applies if the participant dies before his or her RBD.

Death after Required Beginning Date
If the participant died after his or her RBD, unless the plan requires more rapid distributions, the beneficiary’s MRD is determined using the Single Life Table factor for the longer of the life expectancy of a person the same age as the participant and the life expectancy of the Designated Beneficiary, if any.

Planning Tip: Because a Roth plan has no RBD, the Five-Year Rule applies to Roth plans with no Designated Beneficiary, even if the participant has reached his or her RBD for other IRAs or qualified retirement plans. Also, distributions from a Roth plan cannot satisfy MRD requirements for non-Roth plans.

Multiple Beneficiaries
If there are multiple beneficiaries, there is no Designated Beneficiary unless all of the beneficiaries are individuals. If all of the beneficiaries are individuals, the Designated Beneficiary is the oldest beneficiary and it is his or her life expectancy that sets all MRDs. There are, however, two “escape hatches:”

(1)  The ability to remove a beneficiary through disclaimer or distribution of that beneficiary’s share. This must be done by September 30 of the year following the year of death.

Example: If the beneficiary designation is to a trust that distributes a specified sum to a charity and splits the balance between Child 1 and Child 2, you can make the distribution to charity prior to the critical date. That would leave you with the two individuals, Child 1 and Child 2, and the older of the two would be the Designated Beneficiary.

Example:  If the beneficiary designation is to a trust that distributes one-third to the participant’s mother and one third each to Child 1 and Child 2, if the beneficiary’s mother disclaims her interest prior to the critical date, the beneficiaries would be Child 1 and Child 2 and the older of the two would be the Designated Beneficiary.

(2)  The separate accounts rule: If the participant’s benefits under a plan are divided into separate accounts with different beneficiaries, the post-death MRD rules apply separately to each account. This allows multiple beneficiaries to each use their own life expectancy in determining post-death MRDs. (The separate account rule is not applicable to multiple beneficiaries who take their interests through a trust that is named as a beneficiary of the plan.)

Planning Tip: In order to satisfy compliance for the separate accounts rule, there must be pro rata sharing in gains and losses, which is normally done by fractional or percentage division. A pecuniary gift would not meet the definition unless (under local law or beneficiary designation) the gift shares in post-death gains and losses pro rata with the other beneficiaries’ shares. However, you can eliminate the recipient of a pecuniary gift from being included in the Designated Beneficiary determination by distributing that gift before September 30 of the year following the year in which the participant died.

Planning Tip: Separate accounts must be established by December 31 of the year following the year of the participant’s death to use separate life expectancies. If established later, the separate accounts are still effective for all other purposes.

Critical Dates

September 30 of the year following the year of death
* Beneficiaries must be identified
* Non-designated beneficiaries eliminated by disclaimer or satisfaction of bequest

October 31 of the year following the year of death
* Trust documentation must be filed with the plan administrator if a trust is named a designated beneficiary

December 31 of the year following the year of death
* First distribution to beneficiary must be made
* Separate accounts must be created to be able to use individual life expectancies

Surviving Spouse as Sole Beneficiary
Special rules apply if the surviving spouse is the sole beneficiary. For example, if the surviving spouse is more than ten years younger than the participant and the sole beneficiary, the participant’s MRDs are determined by using the Joint and Survivor Table.

If the surviving spouse is the only beneficiary, he or she can roll over the inherited benefits into his or her own retirement plan or elect to treat an inherited IRA as his or her own IRA. There is no deadline by which the spouse must make the rollover decision, but until the rollover is made, MRDs would have to be under the inherited IRA rules based on the spouse’s age unless the plan requires more rapid distributions.

Planning Tip: A spouse who is under 70 1/2 can postpone distributions until reaching his or her own required beginning date, and can take MRDs using the recalculation method from the Uniform Lifetime Table. In addition, after rollover the spouse can name his or her own beneficiaries who can then use their own life expectancies after the surviving spouse dies, resulting in the maximum stretch-out.

Planning Tip:  If the surviving spouse is under 59 1/2, special care must be taken in deciding whether and when to do a rollover. This is because distributions taken from the account after rollover and before the survivor reaches age 59 1/2 are subject to the 10% early withdrawal penalty.

If the participant dies before his or her RBD and the spouse does not do a rollover (i.e., treats the plan as an inherited plan), annual distributions to the surviving spouse can be postponed until the end of the latter of the year following the year in which the participant died or the year in which the participant would have reached age 70 1/2. If, after rollover, the surviving spouse dies before his or her RBD, the MRDs for her beneficiaries will not be based on the participant’s remaining life expectancy.  For them, MRDs will be based on either the five-year rule or, if the spouse has a Designated Beneficiary, the life expectancy of that Designated Beneficiary.

While the surviving spouse remains the beneficiary and has reached his or her RBD, following the surviving spouse’s death, distributions may be stretched over the surviving spouse’s hypothetical remaining life expectancy under the fixed-term method (life expectancy rule).

Trust as Beneficiary
There are two common myths about estate planning for qualified retirement plans and IRAs:
(1)  You cannot name a trust as beneficiary and get a stretch-out; and
(2)  Naming an individual as beneficiary will result in a stretch-out.

The problem with naming an individual as beneficiary is that he or she is likely to cash out the IRA or plan account, thus negating the participant’s careful planning for long-term tax-deferred growth. Example: A 25-year-old inherits a $100,000 IRA. Will he choose a $60,000 automobile (the amount after cashing in the IRA and paying the income tax) or $400,000 in after-tax income over his or her life expectancy (based on 5% growth and combined state and federal income tax of 35%)? If the client’s goal is to preserve tax-deferred growth, it is advisable to have a trustee involved who will ensure that happens.

Normally a trust is a non-individual and cannot qualify for Designated Beneficiary status, but it is possible to name a trust as beneficiary and still have a Designated Beneficiary for purposes of determining MRDs. Special rules allow a “see-through trust” that lets you look through the trust and treat the trust beneficiaries as the participant’s beneficiaries, just as if they had been named directly as beneficiaries by the participant.

Planning Tip: If a trust is made the beneficiary, neither the spousal rollover nor the special accounts treatment is available. However, if the trust states that property can be distributed out to the spouse, then the IRA could be distributed to the spouse and the spouse could roll over the IRA.

Requirements for a See-Through Trust
To qualify as a see-through trust, the trust must meet certain criteria:
(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 participant. (While it is not necessary to include this wording in a revocable living trust or testamentary trust under a will, WealthDocxTM does so out of caution and for the benefit of the plan provider. Also, a trustee’s power to amend the administrative provisions of the trust should not be considered a power to revoke. See PLRs 200537004 and 200522012.)
(3)  Certain documentation must be provided to the plan administrator by October 31 of the year after the year of the participant’s death.
(4)  Trust beneficiaries who are to be included in the Designated Beneficiary determination must be identifiable from the trust instrument and all must be individuals.

A Designated Beneficiary need not be specified by name as long as the individual who is to be the Designated Beneficiary is identifiable under the plan. Thus, the members of a class of beneficiaries capable of expansion or contraction will be treated as being identifiable if it is possible to identify the class member with the shortest life expectancy. For example, “my descendants” is a class that can be identifiable even if they are not individually named.

Which trust beneficiaries are to be included in the Designated Beneficiary determination? The general rule is that contingent and successor beneficiaries count, unless the beneficiary is a “mere potential successor to the interest of one of the beneficiaries upon that beneficiary’s death.” What is a “mere potential successor” beneficiary is demonstrated by an examination of “conduit” and “accumulation” trusts.

Conduit Trusts: These specifically require that any distributions that come from the IRA and go into the trust must be immediately distributed to the identifiable current beneficiaries. The IRS regulations say that, with a conduit trust, the Designated Beneficiary analysis has only to look at the current beneficiaries because all others are mere potential successors. Thus, with a conduit trust remainder beneficiaries could be charities and older beneficiaries.

Planning Tip:  With conduit trusts distributions cannot accumulate in the trust, so there is no asset protection for those distributions. Also, if there is a special needs beneficiary, required distributions could result in the loss of government benefits.

Accumulation Trusts: The advantage of these trusts is that distributions can accumulate and do not have to be immediately distributed to the beneficiaries, so they provide asset protection for plan distributions. However, these trusts are more difficult to draft so that there will be a Designated Beneficiary.  All potential remainder beneficiaries must be identifiable and they must all be individuals. This is not possible, for example, when the remote contingent beneficiaries are someone’s heirs at law.

Stand-Alone Retirement Trust (SRT)
Using an SRT to receive retirement plan benefits is often the best solution. As you have seen, qualified retirement plans and IRAs are special assets with unique tax rules that provide well for accumulating wealth for retirement but do not work so well when trying to pass this wealth on to the next generation. It is always best to transfer property to the next generation in trust rather than outright. When the facts are such that an accumulation trust is best, it is difficult to draft it in a revocable living trust.

An SRT is an inter vivos trust created by the participant as grantor; it can be revocable or irrevocable. It is nominally funded during the grantor’s life and will receive retirement plan benefits upon the death of the participant by means of properly drafted beneficiary designations.

Planning Tip: Using an SRT can ensure stretch-out (if that is the client’s objective) while also allowing the financial professional to maintain the assets under management.

Understanding retirement planning helps the planning team help clients pass more wealth to their loved ones, integrate a client’s IRA with their overall wealth plan, maximize continued tax-deferred growth, protect and grow IRA savings for their families, and take advantage of the rules applying to separate accounts governing IRAs and qualified plans so that each beneficiary can control his or her own inheritance.

Like other aspects of planning, it is helpful to review client retirement planning objectives and beneficiary designations frequently to ensure they coordinate with the client’s planning.


We can help you protect your assets and legacy using Last Will and Testaments, Trusts, Durable Powers of Attorney, Health Care Powers of Attorney, HIPAA Authorization Forms, Advanced Directives for Health Care, Tax Planning, and Special Needs Trusts.