Friday, March 29, 2013

Using Trusts to Protect Inherited IRAs

Many people have large IRAs and retirement plan accounts and need special estate planning for these assets. A 2009 study by the Investment Company Institute found that retirement plans account for 34% of all household financial assets, up from 14% in 1978; IRAs alone account for more than 10% of all household financial assets; and 47 million U.S. households have IRAs.

Compare these numbers to the approximately 4,000 estate tax returns that will be required to be filed annually under the new “permanent” estate tax exemption of $5 million adjusted for inflation, and it is easy to see that planning for retirement accounts presents a more significant opportunity for the estate planning advisory team than does estate tax planning.

People want to protect their IRA and retirement plan assets for their families, but most do not understand what can happen to those accounts after they die. And, unfortunately, much of the information that plan owners and beneficiaries receive from family members, other lay sources, and, surprisingly, even some advisors is outdated or incorrect.

Without proper planning, trillions of dollars in IRAs and qualified plans that are passed down to beneficiaries upon death could be exposed to the beneficiaries’ creditors and other beneficiary-associated risks. By using specially designed IRA trusts, the plan owner’s beneficiaries can be protected from creditors, predators, and the temptation inherent in “found” money and thus ensure that the beneficiary achieves the maximum tax deferral that you intend.

In this issue of The Wealth Counselor, we will explain some of the rules about retirement plans that every member of the advisory team must know and how a properly prepared retirement plan trust (which we will here refer to as an “IRA trust”) can protect the plan assets after the owner’s death.

Problems with Inherited IRAs and Retirement Assets

Impact of Income Taxes
Unless the your  retirement plan assets are in a Roth IRA or other Roth vehicle, income taxes must be paid whenever assets are withdrawn from these accounts. The top federal income tax rate is now 39.5% and state income taxes, where applicable, are in addition. (The 3.8% Medicare surcharge does not apply to retirement account withdrawals but the withdrawals from non-Roth accounts do get counted in determining if and by how much the taxpayer has exceeded the applicable threshold amount for the surtax.)

Impact of Income Tax Deferral
Different Levels of Protection for IRAs and Inherited IRAs
Qualified retirement plans, including SEP and Simple IRA plans, are protected under ERISA, but traditional, Roth, and inherited IRAs are protected under state laws, which vary greatly. For example, during the original IRA owner’s lifetime, protection can range from unlimited protection to a specified dollar amount or, as in California, to an amount reasonably necessary for the owner and any dependents. Protection for inherited IRAs may be different than that provided to the owner. This varies from state to state and is determined by the beneficiary’s state of residence when the protection question arises. Therefore, only the surest result is obtained through good, proactive planning.

Planning Tip: It is critical to understand how the laws in your state apply to an original owner and to someone who has inherited an IRA. You cannot assume that the beneficiary residing in another, often currently unknown state will have the same asset protection as the owner or a beneficiary residing in your state.

“Found” Money Is Extremely Slippery
Studies show how fast the average beneficiary goes through life insurance proceeds. Spending “found” money simply does not carry the significance of spending one’s own hard earned money. An IRA or other retirement account passing to an individual beneficiary is also “found” money and just as slippery.

IRAs and other retirement plans offer the substantial tax benefit of income tax deferral. Stretching out the inherited retirement plan’s distributions over a beneficiary’s actuarial life expectancy yields a much greater return than if the beneficiary cashes out the plan and pays taxes immediately on the full distribution plus on any future earnings on those assets.

Planning Tip: It can be very helpful to have a chart or calculator that illustrates the benefits of income tax deferral based on actual account balance, actuarial life expectancy, and beneficiaries’ ages.

Divorce and Unintended Beneficiaries
Although an inherited IRA is not a marital asset, it is “on the table” in a divorce because it can be transferred as part of a divorce settlement. Also, the beneficiary of an inherited IRA will make his/her own beneficiary designation in case of death before the account is depleted. Most people do not want a child’s ex-spouse to get their IRA, or a child’s new spouse to inherit, because both carry the risk that the grandchildren will be disinherited.

Loss of SSI/Medicaid
Any inheritance, including assets in an inherited IRA, are considered “resources” for determining SSI/Medicaid eligibility. At least temporary loss of SSI/Medicaid or other government benefits by a disabled beneficiary is hard to avoid if there is more than $2,000 in the inherited IRA.

Planning Tip: Assets held in a properly drafted IRA trust can provide much better protection and ensure maximum stretch out.

Basic Retirement Plan Concepts
A major advantage of qualified retirement plans and IRAs is that the income tax on plan earnings is deferred until withdrawal. With the exception of a Roth IRA or plan account, the account owner (referred to herein as “the owner”) must commence Required Minimum Distributions (RMDs) by his or her Required Beginning Date (RBD). The owner is never required by tax law to make withdrawals from any Roth account but the Roth account beneficiary is.

Required Beginning Date (RBD)
Generally the RBD is April 1 in the year following the calendar year in which the owner reaches age 70 ½ or, for a qualified plan, the calendar year in which the owner retires from employment. There is a qualified plan exception for less than 5% owners. In each year beginning with the year of the RBD, the owner must withdraw at least the Required Minimum Distribution (RMD).

Calculating Required Minimum Distributions (RMDs)
RMDs are calculated by dividing the prior year’s 12/31 account balance by the applicable life expectancy factor as provided by the IRS.

Life Expectancy Factors
There are different life expectancy factors for different account holders. That from the Uniform Table is used for an owner’s lifetime distributions. (This table recalculates life expectancy every year so that even someone age 110 has a life expectancy and will not be required to empty the account.) However, if the owner’s spouse is the owner’s sole beneficiary and is more than ten years younger than the owner, the Joint & Last Survivor Table is used instead of the Uniform Life Table during the owner’s life. The Single Life Table is used by all qualified beneficiaries after the owner’s death.

Planning Tip: When working with a qualified plan, be sure to read the plan agreement and become aware of optional plan provisions. If the custodian is not willing to do what you want, consider changing to a new custodian if possible, or rolling the account assets into an IRA.

Spousal Rollovers
Only a surviving spouse can rollover an IRA (or qualified plan) into his/her own IRA. Once rolled over, the IRA is treated as if all contributions to it had been made by the surviving spouse. In other words, the surviving spouse uses the Uniform Table to determine RMDs, which must begin by the surviving spouse’s RBD.

Planning Tip: A surviving spouse can defer a rollover indefinitely. If the surviving spouse is younger than 59 ½, rolling over before attaining age 59 ½ risks incurring the 10% early withdrawal penalty. In such cases, consider establishing an inherited IRA and rolling over when the surviving spouse attains age 59 ½. If the surviving spouse is the sole beneficiary, his or her RBD from the inherited IRA is the same as was his or her deceased spouse’s RBD.

Qualified Plan Rollovers by Non-Spouse Beneficiaries
A non-spouse beneficiary is now allowed to do a trustee-to-trustee rollover of a qualified plan to his or her own Inherited IRA.

NOTE: All inherited IRA accounts must be titled in the original owner’s name for the benefit of the beneficiary (e.g., Mary Smith, Deceased, IRA f/b/o Jim Smith). Anything else is considered a 100% taxable distribution.

Designated Beneficiary
If there is a designated beneficiary of the inherited IRA or plan account, the designated beneficiary’s life expectancy is used to determine RMDs in years following the year of the owner’s death. This allows the inherited account to be distributed over the beneficiary’s actual life expectancy, resulting in maximum stretch out and tax deferral.

* If there is not a designated beneficiary and the owner died before his or her Required Beginning Date, the account must be completely distributed by the December 31 following the fifth anniversary of the owner’s death (the “five-year rule”).
* If there is not a designated beneficiary and the owner died on or after his or her RBD, the RMD is determined using the Single Life Table as if the owner were still living (the “ghost life expectancy rule”).

A designated beneficiary (as defined by Treas. Reg Section 1.401(a)(9)-4):
* Must be named a designated beneficiary under the terms of the plan or by an affirmative election by the employee;
* Need not be specified by name but must be identifiable on the date of death;
* May be a class of beneficiaries capable of expansion or contraction (e.g., my children or grandchildren);
* Must be an individual alive on the date of the owner’s death;
* May be a trust if all of its beneficiaries who have to be considered are individuals alive on the date of the owner’s death, the oldest of whom may be determined (a “qualifying” trust).

A designated beneficiary is NOT:
* an estate;
* a charity;
* a non-qualifying trust;
* any non-individual other than a qualifying trust; or
* an individual born after the date of the owner’s death.

The IRA Trust
The advantages of using trusts in general include spendthrift protection, creditor and predator protection, beneficiary divorce protection, special needs planning, consistent investment management, estate planning, and exercising control over the trust assets after the death of the trust maker.

Disadvantages of trusts include greater complexity; legal, accounting and trustee fees; and for trusts that are not required to distribute all their taxable income, greatly compressed income tax brackets (the 39.5% top income tax bracket for individuals begins at $400,000, for such trusts it begins at $11,950).

To be a qualified trust, and thus qualify as a designated beneficiary of an IRA or retirement plan account, an IRA trust must:
1. Be valid under state law;
2. Be irrevocable not later than the death of the owner; and
3. Have beneficiaries all of whom are individuals who are identifiable from the trust instrument when considered on September 1 of the year following the owner’s death.

In addition, the documentation requirement for a trust beneficiary must be satisfied.

Planning Tip: A single revocable living trust would meet requirement #2 because it becomes irrevocable upon the trust maker’s death. However, unless it contains a “conduit” provision, discussed below, a single RLT is unlikely to satisfy requirement #3. A joint revocable living trust would not satisfy requirement #2 because it continues to be revocable until the death of the second spouse. For these and many other reasons, a specialized IRA trust is a preferable IRA beneficiary.

Planning Tip: The documentation requirement is fairly easy to satisfy, but it is vital not to miss the documentation deadline. The trust document must be provided to the account custodian by October 1 of the year following the owner’s death.

Types of IRA Trusts
Conduit Trust
The IRS regulations for IRA trusts provide an example that is commonly referred to as a “conduit” trust. This is a trust in which all distributions from the IRA are required to be immediately distributed to the trust’s beneficiary(ies). With a conduit trust, identification of countable beneficiaries and qualifying the trust as a designated beneficiary is easier because “downstream” and contingent beneficiaries are not considered. On the other hand, because all distributions, including RMDs, must be immediately distributed to the beneficiary(ies), those distributions are not asset protected as they would be if they could stay in the trust.

Accumulation Trust
An accumulation trust is one in which distributions from the inherited IRA may be kept within the trust rather than being distributed to the beneficiary(ies). That way, the trust assets have more protection against creditors and predators. This also more easily allows the beneficiary(ies) SSI/Medicaid eligibility to be preserved. On the other hand, an accumulation trust is a separate taxpayer and is subject to the compressed income tax brackets for undistributed income. Plus, the risk of the trust not being a designated beneficiary (and thus able to take advantage of the stretch) is greater because all beneficiaries have to be considered except those who are “mere potential successor” beneficiaries.

Example: The owner’s child is the primary beneficiary and a charity is the contingent beneficiary. With a conduit trust, the charity would not be counted and the child’s life expectancy would be used to determine the trust’s RMDs, which would produce maximum stretch out and tax deferral opportunity. With an accumulation trust, the charity would be counted and the trust would not be a “designated beneficiary.” That would cause the trust’s RMDs to be determined using the five-year rule or the owner's ghost life expectancy, depending on whether the owner’s death occurred before or on/after his or her RBD.

In PLR 100537044, the IRS permitted a one-time “toggle” from conduit to accumulation trust. Having such a provision could be important if there is a change in circumstances of a beneficiary (disability, drug problems, etc.) between the time the owner set up the trust and September 1 of the year following the owner’s death. In the “toggle,” any general power of appointment given to a beneficiary must be converted to a limited power of appointment, which can create a Generation-Skipping Transfer Tax issue.

Planning Tip: Consider giving the Trust Protector the “toggle” power in any IRA trust to provide flexibility to deal with possible future events.

Separate IRA Trust vs. Trust in a Revocable Living Trust or Will
A separate IRA Trust is more likely to qualify as a designated beneficiary than is either a non-conduit RLT or trust established under a will.

Commonly encountered issues with using RLTs and trusts in wills as IRA/retirement plan beneficiaries include the possible adverse effects of formula funding clauses; pecuniary clauses and recognition of income; powers of appointment (can expand the class of potential beneficiaries); adoption effect clauses; provisions for payment of debts, taxes and expenses; apportionment language/firewall provisions; older or unidentifiable contingent beneficiary(ies), and non-individual remote contingent beneficiaries.

Drafting Issues and Beneficiary Designations
Revocable vs. Irrevocable
A revocable IRA trust allows for changes to be made easily, but it may open the IRA to the account owner’s creditors at death. See, Commerce Bank v. Bolander, 2007 WL 1041760, Kan. App. 2007. Making the IRA trust irrevocable will protect against the Commerce Bank case problem. Making the IRA trust irrevocable does not have to be a final decision by the IRA owner. While an irrevocable trust may not be changed by its maker, a competent IRA owner can always create a new IRA trust and make a new beneficiary designation pointing to the new IRA trust.

Beneficiary Designations—Separate Shares
If an IRA is payable to an IRA trust rather than the separate beneficiaries’ shares of the trust, the trust’s RMD will be determined by the life expectancy of the oldest trust beneficiary (problematic if one beneficiary is age 60 and another beneficiary is age 2). By contrast, if multiple sub-trusts of an IRA trust are allocated shares of an IRA in the beneficiary designation form, the IRA share of each sub-trust will be paid over the life expectancy of the oldest beneficiary of that sub-trust.

Disclaimer Planning
IRA trusts can contain credit shelter and QTIP trusts for the benefit of the surviving spouse. Proper structuring of the beneficiary designation allows for disclaimer planning for the spouse and other beneficiaries. Note that no further stretch is allowed after the death of the spouse with regard to IRAs not rolled over to the surviving spouse’s own IRA by instead going to a credit shelter or QTIP trust established by the IRA owner.

Planning Tip: The general treatment for disclaimer planning is 1) spouse; 2) if spouse disclaims, IRA trust (for funding of credit shelter/QTIP); 3) if spouse is deceased, to the separate IRA sub-trusts for descendants, per stirpes. Also, children can be given the power to disclaim so that IRA distributions can be stretched out over the owner’s grandchildren’s lifetimes.

Custom-drafted beneficiary designations are required to allow proper disclaimer planning and separate share treatment. (See planning tip above.) However, some IRA custodians will not accept custom beneficiary designations and insist on using their own forms, especially for “smaller” accounts (those under $500,000). In such cases, giving the custodian a choice between losing the account to a more reasonable custodian and accepting the proposed custom beneficiary designation may produce the desired result.

Naming a separate IRA trust as designated IRA or retirement plan beneficiary is preferable to naming beneficiaries outright. It ensures that your goals are carried out, including that your beneficiaries will use the IRA stretch out potential. It provides asset protection against predators, the beneficiaries’ creditors and loss upon divorce. It can provide bloodline protection, preventing unintentional beneficiaries and disinheriting of descendants. It provides for beneficiaries who have or later develop special needs without jeopardizing their valuable government benefits. And it can even keep the IRA assets under your current advisor’s management.

Each situation is different. For IRA trust planning, individual, case-by-case analysis with input from all advisors is essential.

With so much outdated and incorrect information about IRAs and IRA planning being tossed around, current and knowledgeable advisors will stand out and prove invaluable to both you and the other members of the advisory team.

What the New Tax Law Means to You

On January 2, 2013, the President signed into law the American Taxpayer Relief Act of 2012 (the 2012 Tax Act) to deal with the so-called “fiscal cliff.” The 2012 Tax Act included revisions to estate, gift and generation-skipping transfer (“GST”) tax laws and income tax laws that will affect estate planning for the foreseeable future. In this edition of The Wealth Counselor, we will take a first look at those changes and what they will mean to you.

Changes to the Federal Estate Tax Law

* The federal gift, estate and GST tax provisions that had been put in place as temporary measures in December 2010 were made permanent as of December 31, 2012. This is great news because, for more than ten years, we have had uncertainty due to the fact that the estate, gift, and GST exemptions and rates, and basic income tax provisions and rates, all had expiration dates. And while “permanent” in Washington only means this is the law until Congress decides to change it, at least we now have some certainty with which to plan.

* The federal estate and gift tax exemption will remain at $5 million per person, adjusted annually for inflation after January 1, 2011. In 2012, the exemption (with the adjustment) was $5,120,000. The amount for 2013 is $5,250,000. This means that the opportunity to transfer large amounts during lifetime or at death remains.

Planning Tip: If you did not take advantage of the $5+ million gift tax exemption in 2011 or 2012, you can do so now—and there are significant advantages to doing so sooner rather than later, as discussed below.

Planning Tip: For those who used their full $5.12 million exemption in 2012, there is an additional $130,000 exemption they can be used in 2013. And, with the exemption amount now tied to inflation, they can expect to be able to transfer even more each year.

* The Generation-Skipping Transfer (GST) tax exemption also remains at the same level as the gift and estate tax exemption ($5 million, adjusted for inflation). The GST tax, which is in addition to the federal estate tax, is imposed on amounts that are transferred (by gift or at your death) and “skip” a generation—for example, a gift to a living child’s descendant.

Planning Tip: Having this permanent GST exemption will allow you to take advantage of planning that will greatly benefit future generations. For example, a dynasty trust that is properly set up can now last forever, and the trust assets should never be subject to federal estate, gift or GST tax.

Planning Tip: The downside of not having trust assets subject to estate tax is that they do not get a basis adjustment to fair market value at death. However, with proper planning, it is possible to elect estate inclusion at the death of a beneficiary to take advantage of the basis adjustment when the beneficiary does not have an otherwise taxable estate.

* Married couples can take advantage of these higher exemptions and, with proper planning, transfer up to $10+ million through lifetime gifting and at death.

* The tax rate on estates larger than the exempt amounts was increased from 35% in 2012 to 40% in 2013 and beyond.

* The “portability” provision, which allows an executor to transfer the unused exemption of the first spouse to die to the surviving spouse, was also made permanent. While this may at first glance appear to be an easy way to use both spouses’ estate tax exemptions, problems remain. For example, if the surviving spouse remarries and dies before spouse #2, all of spouse #1’s exemption is lost. Also, there is significant cost to using the “portability” provision because it requires filing an estate tax return, and there is no “portability” of any unused GST tax exemption.

Planning Tip: Trust planning remains the best option. It makes excellent use of both spouses’ estate and GST tax exemptions. Trust planning can also provide for a surviving spouse and let the first spouse to die keep control over how his/her share of assets will be managed and distributed. This is important if there are children, and it is critical if there are children from a previous marriage.

* Separate from the new tax law, the amount for annual tax-free gifts has increased from $13,000 in 2012 to $14,000 in 2013 as a result of an inflation adjustment. This means you can now give up to $14,000 to as many individuals as they wish each year, and not pay a gift tax. For married people, the spouse can join and, together, both spouses can give up to $28,000 per person per year.

Planning Tip: Annual tax-free gifts are in addition to the $5+ million gift and estate tax exemption. This is another opportunity for you s to transfer significant amounts out of your estate.

Changes to the Federal Income Tax Law
In addition to these changes to the federal gift, estate and GST tax laws, there are several changes to the federal income tax laws, including several income tax increases that can be mitigated by proper planning:

* The 2% Social Security tax holiday that was instituted as a stimulus measure was not extended, so everyone will see a decrease in net pay.

* Ordinary income tax rates increase from 35% to 39.6% for singles earning more than $400,000 a year ($450,000 a year for married couples). All other ordinary income tax rates effective in 2012 were made permanent.

* There is a new Medicare 0.9% surtax on ordinary income and a new 3.8% surtax on investment income. Both are applicable to income over $200,000 for singles ($250,000 for married couples) and were part of the 2010 health care bill.

* The top capital gains and dividend rate increased to 20% for those earning more than $400,000 a year ($450,000 for married couples).

* The AMT exemption is now permanent. For 2013, it increased to $50,600 for single and to $78,750 for married taxpayers, with the exemption and phase out amounts indexed for inflation.

* Several business provisions were extended, including the R&D tax credit, work opportunity tax credit, accelerated depreciation, and Section 179 levels.

* The direct IRA to charity transfer for those over 70.5 years of age was reinstituted retroactive to 2012. A special catch-up rule allowed transfers in January 2013 to be counted as 2012 distributions.

The Need for Proper Planning Remains
For most Americans, this tax legislation has removed the emphasis on estate tax planning and put the emphasis back on the real reasons they should do estate planning: taking care of themselves and their families. Proper estate planning is essential to:

* Avoid state inheritance/death taxes that have lower exemptions than federal taxes;

* Avoid probate, which can be quite expensive and time consuming in some states;

* Ensure assets are distributed the way you want;

* Protect an inheritance from irresponsible spending, from a child’s creditors and from being part of a child’s divorce proceedings;

* Provide for a loved one with special needs without losing valuable government benefits;

* See that control of the your assets remains in the hands of the person you trust most;

* Provide responsibly for minor children or grandchildren;

* Help protect assets from creditors and frivolous lawsuits (especially important for professionals);

* Protect the you, your family and your assets in the event of your incapacity;

* Establish business succession planning at retirement, incapacity and/or death; or

* Help create meaningful charitable gifts.

For Those with Larger Estates
Ample opportunities remain to transfer large amounts tax-free to future generations. But with the increase in estate and income tax rates, it is critical that professional planning begins as soon as possible.

Planning Tip: You do not have to make transfers in cash or liquid assets or completely give away assets. One can transfer illiquid assets like a business, or a home or other real estate, to a trust. If you transfer a home, the owners can continue to live there and take the tax deductions. If a business is transferred, it can be done in such a way that owners can keep control and receive income. By planning now, future appreciation of these assets will not be subject to estate tax, and current depressed values can result in very favorable valuations.

Planning Tip: You can leverage your exemption and make it worth much more by using asset value discounts associated with lack of control and lack of liquidity and by using the tax-free growth inside a life insurance policy. Life insurance policy proceeds, when structured properly, can be completely free of probate, and income, gift and estate taxes, and can be protected from beneficiaries’ creditors and predators—even divorce proceedings. Life insurance is also more important than ever because of its income tax benefits, given higher income tax rates.

What to Expect in the Future
With Congress looking for more ways to increase revenue, many reliable estate planning strategies may soon be restricted or eliminated. Already being discussed are minimum terms for grantor retained annuity trusts (GRATs), elimination of valuation discounts for family limited partnerships, limits on installment sales to grantor trusts and other changes to grantor trusts. Other revenue raisers may be proposed that have not yet been widely discussed. Thus, it is beneficial to implement these strategies as soon as possible to increase the likelihood that they will be grandfathered should Congress decide to change the law.

For those who have been sitting on the sidelines, waiting to see what Congress would do, the wait is over. Now that we have some certainty with “permanent” laws, there is no excuse to postpone planning any longer. In fact, delaying planning could cause you to lose out on strategies that could have significant benefit to your family. Take action today.


1.   The federal estate tax laws are now permanent. This means Congress can
      never change them.                                                              T         F

2.   The estate, gift, and generation skipping transfer (GST) tax exemptions are
      now set at $5 million and are adjusted for inflation. This means
they are $5,250,000 in 2013.                                                        T         F

3.   If you have already used your $5.12 million exemption in 2012, you will not
      be allowed any additional exemption in 2013 or subsequent years.      T        F

4.   Married couples can use both their exemptions and, in 2013, transfer up to
      $10,500,000 tax-free.                                                              T         F

5.  If you use your gift/estate tax exemption, you cannot make annual tax-free
      gifts.                                                                                          T         F

6.   The top estate tax rate is now 40%.                                               T         F

7.   The capital gains and dividend tax rate is now 20% for everyone.          T         F

8.   The payroll tax holiday ended, so everyone will see an increase in net pay.     T         F

9.   There is no longer any need for those with estates smaller than $5 million
      to do estate planning.                                                                                 T         F

10. There are proven estate planning techniques available now that may soon be
      eliminated as Congress looks for more ways to raise revenues.         T         F

True: 2, 4, 6, 10
False: 1, 3, 5, 7, 8, 9