This article appeared in the July 1999 issue of the Section Review.
© 1999 Massachusetts Bar Association
Karen J. Folbis an associate at the Newton firm of Vacovec, Mayotte & Singer. GENERAL TAX RULES Qualified retirement plan benefits are generally includedin a deceased participant's estate under Internal Revenue Code §2039(a), which provides that a decedent's gross estate includes the valueof an annuity or other payment receivable by any beneficiary by reason ofsurviving the decedent. If the decedent's taxable estate is less than, orequal to, the unified credit amount, including the retirement plan balances,there will be no federal estate taxes, regardless of who is the designatedbeneficiary of the plan balances, assuming the decedent has all of his unified credit available for use at death. If the decedent's taxable estate is greater than the unified credit amount, including the retirement plan balances,or if the decedent has used some or all of his unified credit so that some amount of federal estate tax is due, the issue of who to designate as beneficiary of the plan balances becomes increasingly important.
Unfortunately, a plan participant cannot transferownership of plan balances out of his own name in an effort to reduce estatetaxes, unless he makes withdrawals from the plans. Such withdrawals, however,may have adverse tax consequences of their own, such as the elimination of theincome tax deferral and a 10 percent early withdrawal penalty (if theparticipant is under age 591/2 at the time of withdrawal). IRC§§ 72(t).
In addition to the estate tax due on retirement planbalances at death, the beneficiary of retirement plan assets is usually subjectto income tax on the distribution of such assets, since this propertyconstitutes income in respect of a decedent. IRD is defined as income generated(or earned) by the decedent before his death that is not realized (or received)until after his death. IRC § 691. The beneficiary of IRD property issubject to income taxes on such property, just as the decedent would have beenif he was still alive. IRC § 691. All qualified retirement plan and IRAbenefits constitute IRD since the decedent had a right to receive such benefitsat the time of death. Therefore, when retirement plan funds are withdrawn, thebeneficiary is subject to income tax on the distribution, just as the decedentwould have been.
The timing of distributions from retirement plans,therefore, determines when the recipient of the funds must pay such income tax.In general, if distributions have begun before the date of death, the remainingretirement plan funds must be distributed at least as rapidly as if theparticipant has survived. IRC § 401(a)(9)(B)(i). If, on the other hand,the participant died before minimum distributions had begun, the plan balancesmust be distributed within five years of the date of death. IRC §401(a)(9)(B)(ii). However, if the participant dies before his requiredbeginning date (generally, April 1 of the year following the calendar year inwhich he reaches age 701/2) and he designates another individual as abeneficiary of the plan(s), the balances may be distributed over the lifetimeof the designated beneficiary, as long as such distributions begin no laterthan one year after the participant's death. IRC §401(a)(9)(B)(iii).
SURVIVING SPOUSE AS BENEFICIARY If the surviving spouse is the designated beneficiary of aparticipant's retirement plan balances, a decedent may be entitled to amarital deduction on this property, thus excluding the retirement funds fromestate tax liability.
Additionally, the surviving spouse may rollover theinherited retirement funds into his own IRA and postpone making requiredwithdrawals, which would generate income tax, until his own requireddistribution date. IRC §§ 402(c)(9) and 401(a)(31). Then, at thesurviving spouse's required beginning date for minimum distributions, hemay begin withdrawing funds over the joint life expectancy of himself orherself and a younger beneficiary. IRC §§ 402(c)(9) and 401(a)(31).This option is beneficial if the surviving spouse is younger than the decedentas it will result in a longer deferral of distributions.
Alternatively, the surviving spouse may leave the funds inthe decedent's plan until the decedent would have reached age 701/2and then make the required withdrawals. IRC § 401(a)(9)(B)(iv). Thisoption is beneficial if the surviving spouse is older than the decedent. Thisoption is available to a trust for the benefit of the surviving spouse, such asa QTIP trust, as well.
It is important to note that although the surviving spousewill owe income tax on the distribution under IRC § 691(a) when hewithdraws the benefits, the amount of tax owed will only go to reduce thesurviving spouse's future taxable estate.
TRUSTS AS BENEFICIARY In order for any trust to be named the designatedbeneficiary of retirement plan benefits, the "trust rules" of IRC§ 401(a)(9) must be complied with. First, the trust must be valid understate law. Also, all beneficiaries of the trust must be individuals. Next, thebeneficiaries must be identifiable from the trust instrument. Finally, a copyof the trust instrument must be provided to the plan administrator.
In general, if a trust is named beneficiary of retirementplan benefits, the benefits must be distributed to the trust within five yearsof the participant's date of death. IRC § 401(a)(9)(B)(ii). Incertain instances, however, the oldest individual beneficiary of the trust maybe treated as the designated beneficiary. Prop. Reg. 1.401(a)(9)-1, Q&AE-5(a)(1). Therefore, this beneficiary's life expectancy may be used asthe measuring period for determining minimum distributions to be paid to thetrust. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1). A trust will qualify forthis exception to the five-year rule if it meets the "trust rules"of IRC § 401(a)(9), referred to above.
When IRD is paid to a trust, the income is taxed at thecompressed trust income tax brackets. Thus, plan benefits paid to a trust willmost likely result in the funds being taxed more heavily than if the benefitswere paid to individuals and taxed at the individual rates.
Finally, any trust which is designated beneficiary thatprovides that the retirement funds pass as part of a pecuniary gift, which istypically found in pourover trusts with a pecuniary marital deduction formula,may result in the immediate realization of taxable income to the trust. PLR9507008. Instead, the trust should use a fractional funding formula to avoidtriggering this income tax. IRC § 2056(b)(10); Regs. 1.691(a)-4(b)(2); PLR9537005.
QTIP TRUST AS BENEFICIARY There are several non-tax reasons to leave your retirementplan benefits to a QTIP Trust as opposed to outright to the surviving spouse.For instance, the plan participant may fear that, after the participant'sdeath, the surviving spouse will remarry and divert the assets away from theparticipant's children from the first marriage. Alternatively, thesurviving spouse may be unsophisticated in investing, or may be a spendthriftor may be incompetent. Since these are valid concerns, the participant must besure that the QTIP trust qualifies for the marital deduction, that it complieswith the "trust rules" so that the surviving spouse may beconsidered the "designated beneficiary" for purposes of the minimumdistribution rules and that the trustee avoids triggering an income tax whenfunding the QTIP trust.
In order for retirement plans payable to a QTIP trust toqualify for the marital deduction, the trustee must be required to withdraw allincome earned each year on the IRA property (or the minimum requireddistribution if greater) and to pay such amount to the surviving spouse on anannual basis. PLR's 9038015 and 9043054. Also, no person may have thepower to appoint any of the principal to someone other than the survivingspouse during his lifetime. Id. The IRS has ruled that the beneficiarydesignation form itself should also contain similar marital deduction trustprovisions. Rev. Rul. 89-89. In other words, the beneficiary designation formshould state how benefits are to be withdrawn, in addition to naming thetrustee of the QTIP trust as the beneficiary. Specifically, the trustee shouldbe required to withdraw from the IRA each year, and place in the QTIP trust,all of the income earned by the IRA that year. Finally, it is important toremember that the executor needs to elect QTIP treatment for the benefitsthemselves as well as for the trust. PLR 9442032.
Making retirement plan benefits payable to a marital trustwill generally result in much less income tax deferral during the survivingspouse's life than if the benefits were payable to the surviving spousedirectly. This is because if the surviving spouse is individually designated beneficiary,he may roll the funds over into his own IRA, thus deferring distributions untilhe reaches the required beginning date for minimum distributions. IRC§§ 402(c)(9) and 401(a)(31). When a marital trust for the benefit ofthe surviving spouse is designated beneficiary, on the other hand, the minimumdistribution rules most likely require annual distributions to the trustbeginning the year after the decedent's death, which do not qualify forspousal rollover treatment. In this case, only the surviving spouse's ownlife expectancy can be used to measure the payout.
CREDIT SHELTER TRUST AS BENEFICIARY Naming a credit shelter trust as the designatedbeneficiary of retirement plan benefits will result in some estate tax savingson the surviving spouse's death due to the use of the unified credit byboth spouses' estates, while still making some of the retirement planbenefits available for the surviving spouse during his lifetime.
One disadvantage of using a credit shelter as thedesignated beneficiary of retirement plan assets is that as the assets arewithdrawn to fund the credit shelter trust, income taxes are due and are paidfrom those very assets, thus the estate is not receiving the full benefit ofthe unified credit.
OTHER INDIVIDUAL BENEFICIARIES If only one person is named the designated beneficiary,then, under the exception to the five-year rule, the beneficiary can withdrawthe benefits "in accordance with regulations" over a period of timethat does not exceed his life expectancy. IRC § 401(a)(9)(B)(iii).
If there are several people who are jointly named thedesignated beneficiaries (e.g., "to my children who survive me"),then according to the proposed regulations, the benefits must be withdrawn overa period of time using the life expectancy of the oldest beneficiary. Prop.Reg. 1.401(a)(9)-1, Q&A E-5(a)(1). In order for this exception to thefive-year rule to apply, all of the designated beneficiaries must beindividuals. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1).
Note that if the retirement plan is divided into separateaccounts, each beneficiary may use his own life expectancy for his share of thebenefits. Prop. Reg. 1.401(a)(9)-1, Q&A E-5(a)(1).
ESTATE AS BENEFICIARY Since an estate cannot be a designated beneficiary, theparticipant who names the estate as beneficiary is limited to using his ownlife expectancy to calculate required minimum distributions. IRC §401(a)(9)(A)(ii). The time period over which these distributions must be madedepends on whether the participant reached his required beginning date as ofthe date of death. If the participant has reached his required beginning dateand has named his estate as beneficiary of the plan benefits, the funds must bedistributed to the estate at least as rapidly as they would have been distributedto the participant had he survived. IRC § 401(a)(9)(B)(i). If theparticipant was recalculating his life expectancy to calculate the requiredminimum distributions, the entire amount of the proceeds must be distributed tothe estate by Dec. 31 of the year following the date of death. Prop. Reg.1.401(a)(9)-1, Q&A E-8(a). This is because the participant's lifeexpectancy is reduced to zero in the year in which he dies. Prop. Reg.1.401(a)(9)-1, Q&A E-8(a). If the participant was not recalculating hislife expectancy for purposes of the minimum distributions, the estate maycontinue to use the participant's life expectancy to calculate therequired minimum distributions.
If the participant has not reached his required beginningdate as of the date of death, and the estate is the beneficiary of theretirement funds, the participant is deemed to have no designated beneficiary,and the five-year rule applies for purposes of minimum distributions. IRC§ 401(a)(9)(B)(ii). That is, distribution of the entire amount of thebenefits must occur by Dec. 31 of the fifth calendar year following theparticipant's date of death. IRC § 401(a)(9)(B)(ii).
CHARITY AS BENEFICIARY If a charitable organization is directly named thebeneficiary of all or some of a participant's retirement plan balances atthe participant's death, the amount given to the organization willgenerally be includible in the participant's estate for estate taxpurposes. Rev. Rul. 67-242, 1967-2 CB 227; PLR 7827008. However, the estate maybe entitled to a charitable deduction on the estate tax return for amountspassing to an organization described in IRC § 501(c)(3). IRC § 2055.The gift to charity will still be subject to the excise tax on excessaccumulations, which would have to be paid by the estate or the charity, sincethis tax is considered a debt of the estate. However, the charitableorganization will not recognize income when it receives distributions from aretirement plan. If a plan participant designates a charitable organization asremainder beneficiary, payments are made to the participant over his own lifeexpectancy alone and no other individual's life expectancy may be used.
Alternatively, a charitable remainder trust may be thedesignated beneficiary of some or all of the retirement funds. In such a case,non-charitable beneficiaries would be entitled to an income stream during theirlifetime and the remainder would pass to the charity. At theparticipant's death, the plan funds would be includible in his estate,but the present value of the charitable remainder interest would qualify for acharitable deduction on the participant's estate tax return. IRC§§ 2055(a) and 2055(e)(2)(A). Although the gift of income to thenon-charitable beneficiaries would be taxable in the participant'sestate, if the surviving spouse is the sole income beneficiary, the gift mayqualify for the marital deduction, resulting in zero federal estate tax. IRC§ 2056(b)(8). Payments made to the non-charitable beneficiaries have thesame character as they would have in the hands of the participant, that is suchdistributions are subject to income tax to the recipient as IRD. IRC §691(a)(1)(B). Although distributions from the retirement plans constitute IRD,a CRT is not subject to income tax on the IRD, unless the CRT has unrelatedbusiness taxable income. PLR 9237020.
CONCLUSION In most instances, naming the participant's spouseas beneficiary results in the maximum amount of flexibility and tax savings.However, there are a variety of situations where naming the surviving spouse asbeneficiary is undesirable. In such a case, a QTIP trust may be named asbeneficiary. The use of the marital deduction, whether in connection with agift to the surviving spouse directly or the QTIP trust, for retirement planbenefits both minimizes estate taxes and postpones income taxes.
No matter who is actually named the designatedbeneficiary, careful attention should be paid to the tax consequences of such adesignation since there are strict requirements that must be followed whendesignating the beneficiary of any retirement plan. Finally, due to thecomplexity of the law governing qualified retirement plans, estate planningpractitioners should carefully review the law and plan documents beforedrafting any estate plan for a plan participant.