Your Living Revocable trust holding your retirement assets. How can it be?

Section 401 of the Internal Revenue Code (including, but not limited to, profit sharing plans, money sharing plans, thrift plans, 401(k) plans, employee stock ownership plans (ESOPs), simplified employee pension plans (SEPs), SIMPLE plans and other defined contribution plans), an individual retirement arrangement under Section 408 (“IRA”) or Section 408A (“Roth IRA”) or a tax–sheltered annuity under Section 403 (“TSA”). The term “qualified retirement benefits” means the amounts held in or distributed pursuant to a plan qualified under Section 401, an IRA, a TSA or any other benefit subject to the distribution rules of Section 401(a)(9).

Income tax

Unlike most assets in the estate, qualified retirement benefits inherited by a beneficiary carry with them potential income tax consequences to the beneficiary who receives them.

Unlike other assets included in the gross estate of a decedent, the qualified retirement benefits get no step–up in basis at the decedent’s passing. 

Designated Beneficiary

A grantor’s estate achieves greater income tax advantages if the grantor names a “Designated Beneficiary” (DB) as his or her beneficiary or beneficiaries at death. If the Participant designates a DB as beneficiary, and if permitted by the rules of the plan, the IRA provider or plan administrator can make required minimum distributions (other than amounts rolled over by the surviving spouse) to the beneficiary, based on beneficiary’s single life expectancy. Under this rule, in calculating his or her required minimum distributions (MRD) each year, the beneficiary determines his or her divisor from the Single Life Table (Treas. Reg. § 1.401(a)(9)–9, Q&A 1.) using the DB’s attained age in the calendar year following the year of the Participant’s death. Each year, the beneficiary reduces the divisor for the previous year by 1.0 to determine the MRD for that year. Treas. Reg. § 1.401(a)(9)–5, Q&A5(c)(1) and (3). Thus, even if the beneficiary takes only the MRD each year, the plan will terminate by the end of the beneficiary’s life expectancy. The advantage of this distribution scheme is that the Internal Revenue Service will tax the beneficiary only as he or she receives the distributions from the plan and, thus, the beneficiary will pay less taxes on those distributions received over his or her life expectancy. This results in tax–free growth in amounts remaining in the qualified retirement plan during the beneficiary’s lifetime.

If the beneficiary is not a DB, it must take the benefits more quickly from the plan. If the grantor dies before his required beginning date (generally April 1 of the year following the year in which the owner reaches age 70½. Treas. Reg. § 1.401(a)(9)–2 Q&A 2 (IRA); I.R.C. § 401(a)(9)(C)(i) (other plans)) and if permitted by the plan, the plan must make full distribution (other than amounts rolled over by the surviving spouse) of the account balance by December 31 of the year that includes the fifth anniversary of the Participant’s death. I.R.C. § 401(a)(9)(B)(ii); Treas. Reg. § 1.401(a)(9)–3 Q&A 4. Most planners call this rule the “Five–Year Rule.” If the grantor dies on or after the RBD, the plan must make distributions from the qualified retirement plan (other than amounts those rolled over by the surviving spouse) over the Participant’s remaining life expectancy (the Participant’s so–called “ghost life expectancy“).

If the grantor dies on or after the RBD, the plan must make distributions from the qualified retirement plan (other than amounts those rolled over by the surviving spouse) over the Participant’s remaining life expectancy (the Participant’s so–called “ghost life expectancy“).

A trust can qualify as a DB, but only if it meets certain specific requirements. Treas. Reg. § 1.401(a)(9)–4 Q&A 5(a) and (b).

1. The trust qualifies as a valid trust under state law (or would otherwise qualify if only it had principal). Treas. Reg. § 1.401(a)(9)–4 Q&A 5(b)(1).
2. The trust is irrevocable or becomes irrevocable upon the Participant’s death. Treas. Reg. § 1.401(a)(9)–4 Q&A 5(b)(2).
3. All of the trust beneficiaries are “identifiable” from the terms of the trust. Treas. Reg. § 1.401(a)(9)–4 Q&A 5(b)(3). “Identifiable” means that the “beneficiary need not be specified by name . . . so long as the individual who is to be the beneficiary is identifiable. . . . The members of a class capable of expansion or contraction will be treated as identifiable if it is possible to identify the class member with the shortest life expectancy.” Treas. Reg. § 1.401(a)(9)–4 Q&A 5(b)(3), citing § 1.401(a)(9)–4 Q&A 1.
4. The grantor or Trustee provides a copy of the trust instrument to the plan administrator along with an agreement to provide any amendments to the trust within a reasonable time, or the Participant or Trustee may provide list of all of the beneficiaries and agree to make a copy of the trust document available upon request. Treas. Reg. § 1.401(a)(9)–5 Q&A 5(b)(4).

Meeting these four requirements does not guarantee that the trust will qualify for DB treatment.

A “fifth requirement” is that the trust has only identifiable individuals named as beneficiaries of the trust. Section 1.401(a)(9)–5 Q&A 7(a) of the Treasury Regulations states that, as a general rule, the plan will use the life of the oldest beneficiary as the measuring life for MRD purposes if the trust names more than one individual beneficiary.

Nuances

However, there is a concerns that a clause requiring or permitting the payment of the decedent–grantor’s debts, expenses, and taxes from qualified retirement plan assets may cause a living trust to lose its status as a see–through trust for IRA distribution purposes, thus resulting in the trust’s failure as a DB. Why this concern? Because the Internal Revenue Service has suggested that even indirectly allowing benefits to pass to the Participant’s estate (as through a trust provision which allows or directs the use of trust property to pay the Participant’s debts or probate expenses) may result in the Service treating the grantor’s estate as a beneficiary — thus resulting in loss of DB status for the trust. 

This loss of DB status for the trust could have disastrous income tax consequences for the trust and its beneficiaries and require the trust to pay taxes under either the “Five–year Rule” or the “ghost life expectancy” rule.

However, many times IRS has found that RLT still qualifies as a see-through, because

1. The trust prohibits use of qualified retirement benefits for paying trust taxes and expenses. 
2. State law protects qualified retirement benefits from creditors’ claims.
3. The executor did not use qualified retirement benefits for this purpose after the beneficiary “Determination Date” (September 30 of the year following the year of the Participant’s death). 
4. No other assets were available for satisfaction of the expenses.

Apportioning death taxes from qualified retirement plans assets not paid to the trust. It is worth noting that the terms of the trust will not control as to assets that pass outside of it, so it is debatable whether the language that prohibits apportionment of death taxes to retirement accounts passing outside the trust has any significant legal effect. But the trust and Last Will often name the same person as Trustee and personal representative, the language reinforces the notion that the Trustee uses other assets to satisfy the death tax liability. With this language included, the trustee is effectively on notice that other assets (potentially trust assets) must be used to satisfy the death tax liability that arises as a result of those retirement accounts.

This article is provided to you for educational purposes only. Please discuss your situation with your estate planning attorney and the consequences of naming your LRT as the beneficiary of the retirement plans because everyone’s situation is different and results may vary.