Designating IRA and other Qualified Plan Beneficiaries

Please note that this is a very complex area and what follows is generalizations.  This is an area that should be reviewed on a client-by-client, case-by-case basis with a qualified attorney or CPA.

The surge of Estate Planning “experts,” including websites and seminars over the past 20 years has created a surplus of “information” related to estate planning.  Much of this information, while useful in context, is misunderstood and consequently, misapplied.

My “rule of thumb” for the past few years has been to name adult, responsible beneficiaries as direct beneficiaries on IRA and qualified plan assets, unless there is a compelling reason otherwise.

Along with the growth in family Estate Planning Trusts, has come a misunderstanding by many clients and advisors, of the inter-reaction between Trusts and Qualified Retirement Plans.  We tend to think of Trusts as the best solution for all of our Estate Planning clients’ needs.  In a perfect world, this might be true.  From a planner’s perspective, I would like nothing better than to have the flexibility to funnel all of a client’s assets through their Revocable Living Trust.  It would give us ultimate control.  Unfortunately, it doesn't work that way, and while a frustration for planners, it is what we have to work with.

There is no area more fraught with potential economic disaster that so-called, “qualified retirement plans” and IRA’s.  Unfortunately, because our laws are sometimes at odds with each other, there is potentially major income tax peril in linking qualified plans with a Revocable Trust.  While there will be times when the clients’ objectives will require us to do so, such linking is not without pitfalls, and should be undertaken only very carefully.

My “rule of thumb” for the past few years has been to name adult, responsible beneficiaries as direct beneficiaries on IRA and qualified plan assets, unless there is a compelling reason otherwise.

In spite of this advice, we too often find that a client (or their financial advisor) has designated their Trust as beneficiary.

Qualified Plan and IRA Basics

The “idea” of qualified plans was to encourage people to do their own retirement savings.  The “carrot” was the ability to remove a portion of income from taxation when earned, and while it grew (in some cases, it worked “too well”).  Over my years as an Estate Planning Attorney, I have found it more common than not that a client has IRA and qualified plan assets that they are not drawing from, even when well into retirement.  However, the idea was never intended to be an Estate Planning mechanism for passing wealth down to the next generation.

the idea was never intended to be an Estate Planning mechanism for passing wealth down to the next generation

Because of this, the rules eventually require a “forced” withdrawal.  This normally ocurrs when the account holder (participant) reaches retirement age (“the year in which they reach age 70 1/2”).  A second instance is upon the death of the participant.  If the rules simply required a lump sum distribution at the death of the participant, it would be a simple mathematical equation and it would end there.  In that case there would be no issue with Revocable Trust beneficiary designation.  However, the law identifies some different methods of distribution and several of them are very tax-significant.

While an IRA is technically not a “qualified” retirement plan, it is by far the most common form of retirement savings, and shares essentially the attributes of a “qualified” plan.  Indeed once you are in “retirement mode,” the IRA is perhaps the better and more flexible retirement plan vehicle, particularly in terms of estate planning (and for this reason, we often counsel fully retired persons to roll their qualified plan assets into an IRA).  Most of the rules contained within IRS Regulations are specifically directed at IRA accounts.  IRAs are a more or less statutory retirement plan and as, such, are pretty typically similar, from sponsor to sponsor.  However, it is always advisable to read the plan document (be it an IRA or some other plan type), to ensure that it provides for what we think it does.  While we often apply IRA rules to other qualified plan accounts, it is important to understand that the plan documents may differ significantly.

When there is a Surviving Spouse

The Typical Family.

The most significant beneficiary designation involves the surviving spouse.  In the majority of planning situations, I deal with a married couple who have acquired assets together and raised their mutual children for a period of years.  Their typical wishes are to take care of each other in their retirement years and have any remaining assets go on to their children on a relatively equal basis upon their deaths.  In this case we almost never designate anyone but the spouse as the primary beneficiary of a participant’s retirement plan.  The spouse, in most circumstances, can elect to treat the decedent’s plan as their own.

In spite of this advice, we too often find that a client (or their financial advisor) has designated their Trust as beneficiary.  While this is often a cause for angst, there are IRS rulings (in the case of an IRA) that would allow a surviving spouse who was the sole income beneficiary of the trust to remove the IRA and make the favorable spousal election.  It does, however, increase complexity and reduce flexibility.

“Unique” Circumstances.

There may be circumstances where a direct beneficiary designation to a is not the desired result, such as where there is a second marriage, blended families, non-resident spouse, or perhaps just a concern that the surviving spouse may not appropriately manage the assets.  In this case, we may still want to designate a Trust as beneficiary.  For example, in a second marriage situation, the participant may wish to have the spouse have the annual income from the retirement plan, but ensure that any remaining plan assets go to their own children.  However, to use a common advertising disclaimer; "Do not try this at home."

While Congress has provided that it is permissible to designate a Trust as an IRA beneficiary (and, presumably, by analogy, other “qualified” plans); and the IRS has provided us with guidance on how to safely do so, that guidance is a proverbial minefield of danger.  Any misstep will likely not only result in a deemed lump-sum distribution (and therefore immediate income taxation) of the entire remaining balance, but will also very possibly result in taxation at the highest percentage brackets.

And, even if done properly, the appropriate administration of such accounts in a Trust guarantees long-term ongoing trust administration and lack of ultimate flexibility for the surviving spouse.

There may be circumstances where a direct beneficiary designation to a is not the desired result, such as where there is a second marriage, blended families, non-resident spouse, or perhaps just a concern that the surviving spouse may not appropriately manage the assets

Contingent Beneficiaries and When there is no Surviving Spouse

The concerns are even more compelling when there is no surviving spouse, or when, because of a prior death, the contingent beneficiary designation becomes effective.  Only the spouse is entitled the “treat-the-account-as-is-it-were-my-own” (referred to as a spousal rollover) election.  However, an individual beneficiary may still have some ability to reduce the effects of taxation on the account.

An individually designated beneficiary may elect “beneficiary IRA” treatment (sometimes called a “stretchout” IRA by financial advisors).  The rules here are pretty clear when the beneficiary is an identifiable individual.  The beneficiary may use his or her life expectancy (in accordance with published IRS tables), to calculate an annual required minimum distribution.  Distributions must commence shortly after the death of the participant, regardless of the age of the beneficiary.  But obviously, there is significant value in the continued tax deferral of the balance of the plan assets during the lifetime of the beneficiary.

“pass-through” language must comply with some very technical IRS Regulations requirements that attempt to match trust fiduciary accounting rules with IRA distribution rules.

Unpredictable Beneficiaries

What if our intended beneficiaries are minor children, or children with special needs or other “disabilities?”  These are instances in which we might wish to use a Trust, even in light of all the pitfalls.  These might be one of the “compelling” reasons my “rule of thumb” acknowledges.

The IRS rules, as noted earlier, do allow for a Trust to be the designated beneficiary of an IRA.  But as also noted, not without complexity and inflexibility.  The Trustee may “step into the shoes” of the trust beneficiaries in only a couple of instances.  First, if all of the trust beneficiaries are identifiable persons and the trust provides for immediate distribution of all of their shares to them; or second, if the trust contains specific “pass-through” (sometimes called “see-through”) language.  If there is a class of beneficiaries (like “children” or “grandchildren”), the distribution rules will be keyed to the oldest person in the class (with the effect of forcing the taxable income out in the fastest manner).

In each case, the IRA custodian will likely be somewhat inflexible.  Typically, this means that a trust “beneficiary” IRA is set up and the Trustee is charged with calculating the annual minimum distribution amount, requesting it from the custodian, and distributing it to the beneficiary, in accordance with the trust language.  This will likely continue on a yearly basis for the lifetime of the youngest beneficiary or until assets have been exhausted.  While this gives the “stretchout” benefit, it must be balanced with the economic and emotional costs of maintaining the trust.

And, the “pass-through” language must comply with some very technical IRS Regulations requirements that attempt to match trust fiduciary accounting rules with IRA distribution rules.

What about Charitable Beneficiaries?

The IRS regulations are also clear about who may be a designated beneficiary for purposes of the “stretchout” election.  They must be identifiable individual beneficiaries.  So what if the trust (or the IRA by direct designation) provides for a charitable beneficiary?  The purpose behind the individual requirement appears to be so the life expectancy calculations may be accurately made.  Obviously, an entity cannot have a life expectancy.

But the IRS has acknowledged that charitable beneficiaries are common, and has given us a planning “out.”  As long as the charity’s portion can be determined and is paid out within a year after the death of the participant, the IRS will essentially ignore it.

What this does tell us is how important the details in planning are.  I often find it fits client’s objectives more closely to designate a specific portion of the IRA to charity, or event to split off a separate account and designate it entirely to charity.

As with all Estate Planning, we need to remember that it is a “moving target.”  Regular period review of designations and of your goals are important to making sure this all works.

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Congress Finally Gives us Answers on Estate and Gift Tax

To quote former President Gerald Ford, with respect to the Federal Estate and Gift Tax: "our long, national nightmare is over." Late on January 1, Congress enacted "The American Taxpayer Relief Act of 2012." I won't go into great detail about the act (there is a lot about it we still don't actually know and will have to wait for the analysis of people more capable than I am), but will point out the highlights of the Estate and Gift Tax provisions which are of considerable importance to Estate Planning.

The Act preserves the $5 million per person ($10 million per married couple) "unified" estate and gift tax exemption and indexes it for inflation.

The Act preserves the 2012 levels of a $5 million per person exemption, maintains the "unified"estate and gift structure (meaning the $5 million threshold applied to total transfers, whether by gift during lifetime or inheritance on death), and indexes them for inflation. The Act also makes the concept of "portability," which was added in the 2010 extension for the first time, a permanent part of the tax structure. What "portability" means is that for married couples, the $5 million credit can be allocated or "shared" between them at any time, including after death. This effectively eliminates–in most cases–the need for those "clunky," inconvenient, "AB Trusts" ("his and hers"), and all the allocations and adjustments we were constantly making in those plans. This should have the effect of greatly simplifying the planning process in all but a few instances. The only real, substantive change in the law is a (modest?) increase in the rate (which will only apply after the $5/10 million credit has been used up).

What does "permanent" mean?

Most importantly, the Act makes the current Estate and Gift tax laws permanent. One of my colleagues asked me, what does "permanent" mean? I think that is a fair question. In 2000, the so-called "Bush Tax Cuts" were implemented and because of internal machinations in Congress, were built around a 10-year "sunset." This meant that unless Congress acted during the 10-year period, the laws would automatically expire on December 31, 2010. In a demonstration of the "brinksmanship" for which our modern Congress has become so famous for, in late December of 2010, they "extended" the law for 2 more years.

For the first time in the past 12 years, planners will be able to tell clients what to expect in this area. As we move forward in 2013, I expect that many of our clients will be looking at much simpler estate planning devices.  I think that is a plus

But when they extended the general tax laws, they made unanticipated major changes to the Federal Estate and Gift tax. This was in every way a good change. But it was "temporary," because it was part of an extension, again due to expire recently on December 31, 2012. The new law does not have a "sunset" provision. This means that until Congress acts by legislation to change it, it is permanent. That is as "permanent" as any law gets these days.

My personal view, and what I have been able to glean from reading other sources, suggests that Congress has no appetite to make future major changes to this area, for a number of reasons. So, what we now have is some consistency and something on which we should be able to rely for the foreseeable future.

For the first time in the past 12 years, planners will be able to tell clients what to expect in this area. As we move forward in 2013, I expect that many of our clients will be looking at much simpler estate planning devices. I think that is a plus.

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SHOULD YOU BE DOING LARGE YEAR-END GIFTS IN 2012?

Unfortunately, before we can intelligently answer this question, some history is necessary. With the pending expiration of the so-called "Bush Era Tax Cuts," there is a significant amount of buzz about making large year end gifts to take advantage of the current high gift threshold. Historically, the current Federal Estate and Gift Law scheme dates back to the early 1980's when the "unified estate and gift tax exemption" and the "unlimited marital deduction" were created. A 1986 threshold of $600,000 was set as the amount exempt from federal estate and gift tax transferred by each person. This effectively meant with some careful planning, a married couple could pass $1.2 million to their heirs by lifetime gift or at death before a federal transfer tax was imposed. The amount was capped in 1986 at the $600,000 level. Many of us watched as inflation and growth took our parents' modest estates (often substantially below $600,000) and turned them millions. As we watched, many of us also felt strongly that the $600,000 threshold was no longer a reasonable measure of "modest" wealth and that Congress' failure to address an inflation factor in this threshold was a serious policy flaw.
In 2000, a "conservative" Congress enacted the "Bush Era" tax laws. In the context of the Federal Estate and Gift Tax, those laws made some major changes, but had some perplexing provisions. Inexplicably, they de-unified (if that is a word) the exemptions. They increased the $600,000 Estate Tax Exemption, incrementally over a series of years, to $3.5 million in 2009, and entirely eliminated the Federal Estate Tax (sometimes called the "death tax") in 2010. At the same time they increased the Federal Gift Exemption to $1 million and froze it there. Their plan was that in 2010 and later, there would be no transfer tax on death, the untaxed lifetime gifts would continue to be limited (to $1 million per person). I have never heard a sensible explanation for this "policy." There were some other "nightmarish" provisions in the new law, including a change to "carryover basis" for inherited capital assets.
The problem with their plan was that due to some internal rules, the conservative majority in Congress did not have the numbers to make the changes permanent. So this tax law had a 10-year lifetime, which was due to expire on December 31, 2010. Rather than deal with it, Congress (mostly) "punted" and extended this expiration deadline to December 31, 2012 – right around the proverbial corner!
However, they did some surprising and unexpected things regarding the Estate and Gift tax laws. It gave me some hope that perhaps there would be an end to the seemingly endless uncertainty involve in Estate and Gift Tax planning over the past decade. In late December, 2010, Congress re-instated the Federal Estate Tax (remember, it expired under the short-lived law in 2010), but increased the threshold to $5 million! They also re-unified the credit, increasing the Gift Tax Exemption, also, to $5 million. Then they indexed both of these exemptions for inflation (in 2012, they are slightly over $5 million). But wait – there's more. They also created a new (and long awaited) allocation rule called "portability" (portability means that we no longer had to have separate trusts in most instances for Husband and Wife).
But Alas, all of this is scheduled to end at midnight on December 31. And the aftermath will be all the way back to a $1 million per person unified exemption.
Now, to the question proposed in the title: Should you make large gifts? I like to think of what we have now as a window. At the moment, it is open wide and at its widest opening, there is room to fit $5 million of assets through it ($10 million for married couples). If nothing changes, Congress will close the window most of the way, leaving it open just enough to fit $1 million of assets through it. So, as I view it, there is little to be gained by making gifts of $1 million or less. We will always be able to get that much through the window. Where the gain comes is if we can put more than $1 million through the window, because once it's closed down, we will have forever gotten the excess amount through the window.
When planning year end strategies, we cannot make this analysis in a vacuum. There is always an argument for making gifts of appreciating assets, up to and even above the $1 million discussed above. We move not only the asset itself, but the future growth out of the estate. But we also have to be cognizant of the nature of the asset being moved and whether we can truly afford not to own it anymore. And, perhaps equally importantly, we need to ask whether we want to continue to own it. It has always seemed bad planning policy to me to let tax considerations override the desires of the client.

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Congress Read My Blog!

I am a realist. I assume only a few people read this from time to time. But Congress? I am flattered to no end. Back in February, I excoriated them, stating that their inability to deal with the Estate Tax as it existed was inexcusable and unacceptable:

"This result is symptomatic of the immovable, political partisanship at all costs, out of touch with reality we call "representative" government in Washington, D.C. It is a situation that is untenable for U.S. citizens–clients and planners alike. Most of us are weary of the fighting, infighting and grandstanding behind these "representatives'" abuse of the statement "the American People want . . . . " The reality is they lost touch with what we want years ago. Today, I will settle for a decision. Any decision. We can at least then know what to tell clients and how to plan their estates. Congress? Are you listening? (thought not)."

I suggested that they needed to give us something – anything – to rely on for planning for our clients. My remarks included the sentiment that it wasn't that difficult to pick a number for the exemption equivalent; that I never could make sense of the de-coupling of the gift exclusion from the estate exclusion; and that it only would make common sense to index for inflation.

On Friday, December 17, 2010, after carefully reading my blog (I am certain), Congress has actually made some law that I think is almost too good to be true. There is just too much right with the estate tax provisions of the so-called "Bush Tax Cut" extension! In 1967, for some personal reasons, my mom went all out for Christmas, getting each of her children everything on their "lists" and some additional nice surprises as well. Congress seems to have followed suit this year, with a pretty nice Christmas present for estate planners and their clients.

Here are some highlights. The estate and gift tax "applicable exclusion amount" is now set at $5 million for estates of individuals dying after January 1, 2010, and has been "reunified." It will be indexed for inflation (in increments of $10,000). An additional nice surprise is the concept of "portability" has been added. Married couples may now -- rather than having to proactively plan to use each $5 million for each by creating and funding separate trusts – use each other's unused credit. The mechanics of this are not completely clear, but it looks like a much more "forgiving" solution to this problem.

The "new date of death basis" rules ("stepped up basis") has been restored. The 2010 "carryover basis" rules were a nightmare. Because of years of "stepped up basis" and for other reasons, it was clear to us as practitioners that our clients were going to have poor or non-existent records of their basis in capital assets. And, Congress never made completely clear how the election was going to be made (although they did release and then withdraw a proposed form).

The new law is retroactive to January 1, 2010. Amazingly (yes, I am a cynic), Congress also recognized the practical aspects of their waiting until the proverbial "11^th hour," to address these much needed provisions. For those persons who died between January 1, 2010 and the date of the new law, the executor or administrator may elect to use the new law, or to use the 2010 provisions. And normal filing deadlines for things like tax returns and disclaimers has been extended to 9 months after the December 17, 2010 enactment date.

Thank you Congress, and Merry Christmas to you, too!

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POLITICAL PARALYSIS ON THE FEDERAL ESTATE TAX: SHOULD YOU AMEND YOUR ESTATE PLAN?

On January 1, 2010, the Federal Estate Tax, as we have known it for nearly 30 years, was repealed. But what that means to us as clients and planners is completely unclear. This result is symptomatic of the immovable, poliltical partisanship at all costs, ouit of touch with reality we call "representative" government in Washington, D. C. It is a situation that is untenable for U.S. citizens--clients and planners alike. Most of us are weary of the fighting, infighting and grandstanding behind these "representatives'" abuse of the statement "the American People want . . . " The reality is they lost touch with what we want years ago. Today, I will settle for a decision. Any decision. We can at least then know what to tell clients and how to plan their estates. Congress?? Are you listening?

This result is symptomatic of the immovable, political partisanship at all costs, out of touch with reality we call “representative” government in Washington, D.C. It is a situation that is untenable for U.S. citizens–clients and planners alike. Most of us are weary of the fighting, infighting and grandstanding behind these “representatives'” abuse of the statement “the American People want . . . . “ The reality is they lost touch with what we want years ago. Today, I will settle for a decision. Any decision. We can at least then know what to tell clients and how to plan their estates. Congress? Are you listening? (thought not).

In 1981, Congress enacted the basic structure of the Federal Estate and Gift Tax we have worked with since then. A couple of years later, they “tweaked” the law, adding, among other items, a Generation Skipping Transfer Tax. The Estate Tax was imposed on the value an individual transferred on death. The Gift Tax was imposed on transfers during an individual’s lifetime. The Generation Skipping Tax (GSTT) was imposed--in addition to Estate and Gift Taxes–on transfer to generations further removed than an individual’s own children. This tax scheme contained a couple important exceptions. First, whenever assets are transferred between spouses, there is no tax on that transfer. This has been named the “Marital Deduction.” Mechanically this is a “deduction” on Estate and Gift Tax Returns, but in my view it is inaptly named. It really is a deferral–not a deduction. Because it is a deferral, it can be a trap for the unwary. If relied upon, a married couple might lose an entire exemption.

The second is the charitable deduction. This says that you get a dollar for dollar deduction from Estate and/or Gift Tax on every dollar transferred to charity. This can be a powerful planning tool. But there is a trap waiting for some who have used it in their trusts. I’ll address that below.

Effective in 1986, the maximum value an individual could transfer, during lifetime or at death, was $600,000 (we generally refer to this as an “exemption”). In the late 1990's the amount was incrementally increased from the original $600,000 to $1million. The $1million would have been reached in 2006.

When the “changing of the guard” from a Democrat-controlled Congress and Presidency to all-Republican control was completed in 2000, Congress passed the current law, which accelerated the incremental increases significantly, and eliminated the Estate Tax and the GSTT on January 1, 2010. Inexplicably, the Gift Tax remains in force, with a $1million dollar lifetime exemption. The big problem with this, however, is that the law that became effective in 2000, expires by its own terms on December 31, 2010.

Beginning January 1, 2011, unless Congress acts to change this, the maximum exemption will return to $1 million. In the meantime, we are in a proverbial “no man’s land” regarding planning.

What Should You Do?

If you have not done so already, you need to review your plans with your advisors, in light of this situation. In our practice, we have tried for a number of years, during this period of seemingly phrenetic change, to draft for flexibility. If your documents have not been recently reviewed and do not contain certain language providing for some of this flexibility, you, your spouse, or your children may be in for a rude surprise.

Formula Clauses in Trusts. This is an area which may catch some by surprise. The traditional trust (often referred to as a Credit-Shelter, Bypass, or A-B Trust) technique provides that on death, the maximum amount allowed to pass free of tax (historically, the amount of the exemption) is to be set aside in a trust which allows for limited use and benefit – but not transfer to the spouse and therefore not owned by the spouse. This is done to “bypass” the marital deduction and use all of the exemption (thus, the term “Bypass Trust”). If you are counting on a certain amount or certain specific assets transferring to the spouse, but have only this formula clause in the Trust document, under the 2010 rules, the entir amount of the decedent's trust estate will be held in the Bypass Trust, no matter how large the estate.

If you are counting on a certain amount or certain specific assets transferring to the spouse, but have only this formula clause in the Trust document, under 2010 rules, the entire amount of decedent’s trust estate will be held in the Bypass Trust, no matter how large the estate.

Charitable Formula Provisions. Some Trusts provide that the exempt amount will pass to children or other heirs and balance to a Charity. When there was an established amount and the estate size was modestly over the exemption amount, that probably worked to satisfy a client’s objectives. As the exemption increases or is eliminated, this may not work any more. In 2010, by defiinition, this clause will transfer the decedent's entire trust estate to the Charity and nothing to other heirs.

In 2010, by definition, this clause will transfer the decedent’s entire trust estate to the Charity, and nothing to other heirs!

Other Lurking Issues. Under the current law, the concept of “stepped up” basis is no longer effective. When a capital asset is transferred by gift during lifetime, the transferee “receives” the transferor’s basis (and eventual capital gain on disposition). Under old rules, when a capital asset was transferred “by reason of death,” the transferor’s basis was adusted so the transferee would have a brand new, fair market value, basis on receipt. The new rule, effective January 1, 2010, treats such assets whether inherited by reason of death or received by lifetime gift, the same. The transferor’s basis now “carries over” to the new owner. There is no longer an adjustment to fair market value. This may well have significant consequences and should be considered in planning.

One item of good news here is that the law retained an election by the executor or trustee to step up some of the assets under the old rule. There are rules and time frames, and an administrator will now have to be diligent about it. The amount which may be elected is substantial ($1.3 million).

Conclusion

It is uncertain where we are going with this and whether Congress will act this year–or not at all. It is certain that if you have not done so, you need to review existing plans and adjust where necessary. Earlier, I alluded to drafting for flexibility. There are “disclaimer” techniques and a technique using something called a Power of Appointment which may be very useful in these uncertain times. Your advisor should know about these techniques.

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