Trusts as Beneficiaries of Retirement Plans

By Attorneys Terry L. Campbell & Jennifer M. Jedrzejewski
Published in the Wisconsin Law Journal on September 13, 2006

The retirement plan beneficiary designation is an important part of estate planning. Retirement plan death benefits (particularly from IRA accounts) generally may be distributed over the life expectancy of the “designated beneficiary.” Distributions over the life expectancy of a designated beneficiary provide substantially longer income tax deferral, which often translates into more money for the beneficiary. The general rule had been that the retirement plan owner actually must have designated an individual to be his or her beneficiary in order for the person to qualify as a designated beneficiary.

A common goal in estate planning is to reduce or eliminate estate taxes. Often, a trust is prepared which will effectively utilize the marital deduction and the applicable credit. The assets are either titled to or pour into a trust at death so that the trustee can then divide the assets and distribute them according to the provisions of the trust. The assets placed into the credit trust, up to the applicable credit amount, will bypass both estates for estate tax purposes.

However, this strategy does not work well with retirement benefits, as there can be substantial complications and disadvantages involved in making retirement benefits payable to this credit trust. For example, distributions to the typical credit trust from the client’s retirement plans may be included in the trust’s gross income as “income in respect of a decedent.”

If you fund the credit trust with retirement assets, the goal of reducing estate taxes will be achieved. However, this distribution creates a substantial income tax liability, as the credit trust may not qualify as a “designated beneficiary.”

IRS regulation section 1.401(a)(9)-4, A-5 now allows a client to name a trust as beneficiary and still have a “designated beneficiary” for purposes of the minimum distribution rules. These rules permit you to look through a trust instrument and treat the trust beneficiaries as if they had been named directly as the beneficiaries, if the following four requirements are met:

• The trust must be valid under state law;
• The trust is irrevocable or will, by its terms, become irrevocable upon the death of the participant;
• The beneficiaries of the trust must be identifiable from the trust instrument; and
• Certain documentation must be provided to the plan administrator.
  If the retirement plan owner dies leaving retirement benefits to a trust and the above four rules are satisfied, then for purposes of section 401(a)(9), the beneficiaries of the trust (and not the trust itself) “will be treated as having been designated as beneficiaries of the employee under the plan ….”In addition to the above rules, a fifth rule must be satisfied to ensure that the life expectancy method will be available. The beneficiaries themselves must qualify as “designated beneficiaries.” Therefore, the fifth rule is:
• All beneficiaries of the trust must be individuals.

There are numerous scenarios to illustrate how these new trust rules can be utilized with the traditional estate planning goals. The following are two examples:

Example 1. Husband and wife are both elderly and in poor health. Husband has a terminal condition and owns a sizeable IRA account. They have one child and one grandchild. Husband sets up a trust which qualifies as a designated beneficiary, and the grandchild is the beneficiary of this trust. Husband designates this trust as beneficiary of $675,000 of IRA funds. A special beneficiary form is drafted that provides distributions from the IRA account are paid to this trust equal to the minimum required annual distributions based upon the grandchild’s life expectancy. Income tax is due each year as each annual distribution is made. The trust can provide that these distributions are paid out for the grandchild beneficiary. At husband’s death, this $675,000 can be sheltered by the applicable credit and will be out of both husband and wife’s taxable estates.

Example 2. Aunt Peg was never married and has no children of her own. She wants to leave her IRA to her three young nephews as a way to provide them a nest egg, but she is concerned that if she names them directly as beneficiaries, they will simply cash out the account immediately upon her death. Aunt Peg sets up a trust, which qualifies as a designated beneficiary, and names the three nephews as the beneficiaries of this trust. Aunt Peg then designates this trust as the beneficiary of her IRA. This will ensure that her nephews take advantage of the “life expectancy method,” whether they want to or not, and will provide professional management of the undistributed portion of the IRA. The trustee is instructed to withdraw the minimum required distribution (based on the life expectancy of the oldest nephew) each year from the IRA and distribute it equally to the surviving nephews.

The latest regulations provide a way to designate a trust as the beneficiary of a retirement plan while reaping not only the estate tax benefits from this designation, but also maintaining the income tax benefits of the minimum distribution rules. Unfortunately, however, the above five rules are not as simple to satisfy as they may appear. Furthermore, even if a trust qualifies under these rules, it does not mean that the trust is the best choice as beneficiary of retirement benefits.

The primary purpose of this article is to provide awareness. It offers a very basic, skeletal explanation of extremely complicated rules. Practitioners must exercise extreme caution and should carefully review the regulations and examples as well as the client’s specific circumstances before utilizing this estate planning technique.