For more information regarding the content of this edition of Estate Planning & Tax Watch, please contact Bill Rasmussen.
October 31st is a federal income tax deadline that is rarely discussed outside the offices of estate planning and other tax professionals, but failure to plan for and comply with this deadline can be very costly. The benefits of complying with this deadline require not only competent lifetime planning, but also competent estate administration after the taxpayer's death.
So what is this deadline, and what does it affect?
The Deadline. October 31st is a deadline for delivering a copy of a taxpayer's Will or trust agreement to an IRA custodian or qualified retirement plan administrator after the taxpayer has died.[i] This deadline does not apply in every case where a deceased taxpayer had an IRA or was a participant in a qualified retirement plan – it only applies when the taxpayer put a particular type of planning in place prior to death. The deadline is triggered when the deceased taxpayer has named a trust as a beneficiary of his or her qualified retirement plan or IRA. Because in many cases an IRA or qualified retirement plan is payable to a trust created at death for one or more family members (such as spouses, children and grandchildren), this deadline may apply in a majority of estate plans.
A Key Income Tax Benefit. Income tax deferral is a key tax benefit at stake with this deadline. IRAs and qualified retirement plans[ii] are subject to minimum required distribution rules that mandate how quickly assets held in these plans must be distributed and subjected to income tax. Special rules apply when these types of retirement plans are payable to trusts. Under these rules, competent and careful planning is required to stretch out the minimum required distributions and to maximize income tax deferral of the qualified plan or IRA.
For example, when a taxpayer's IRA is payable to a trust for a child established under the taxpayer's Will, proper lifetime planning and proper estate administration can provide maximum income tax deferral, so that
- IRA distributions to the child's trust may be spread over the child's life expectancy, and
- the investments in the undistributed portion of the IRA belonging to the trust may continue to grow on a tax-deferred basis.
On the other hand, poor planning or incompetent administration could result in accelerated income tax, with the entire IRA subjected to income tax within five years of the taxpayer's date of death.[iii]
A Hypothetical Situation. These rules, and how they overlap with some of the tax and non-tax considerations involved in a typical estate plan, are perhaps best illustrated by an example. Consider the following hypothetical (and very typical) situation:
John and Jane are a married couple in their sixties (retired) with an adult son and daughter. Their son is a physician, happily married, and has two young children. Their daughter is in a troubled marriage with a child, and divorce is a possibility. All family members reside in Texas.
Both John and Jane worked for many years at large public companies and built up much of their wealth in employer-sponsored qualified retirement plans. They currently hold their retirement plan assets in rollover IRAs.
John and Jane want a fairly standard estate plan: Upon the death of the first to die of John and Jane, they want everything to pass to the surviving spouse. When the surviving spouse dies, they want everything to pass to their children. In this case, a large part of the “everything” passing to children will consist of investments held in one or more rollover IRAs.
Because their son is a physician and could be sued for medical malpractice, John and Jane want his inheritance to receive maximum protection from lawsuits. Because their daughter could be facing a divorce, John and Jane want her inheritance to be protected from division in a divorce. They also want to be sure that their daughter's inheritance will never pass from her to her husband. John and Jane want any inheritance remaining after their son and daughter have died to pass to their grandchildren.
The Documents that Matter. As we consider John's and Jane's options, it is important to point out that the Wills signed by John and Jane will not determine who receives the IRAs when the surviving spouse dies. It is the beneficiary designation on file with the IRA custodian that governs who receives an IRA after the IRA owner dies. Of course, an IRA beneficiary designation may name the trustee of a testamentary trust (a trust created under a Will)[iv] as beneficiary of the IRA, but the two documents – the Will and beneficiary designation – must be coordinated to make the desired estate plan work.
“Keeping it Simple.” If John and Jane wanted to keep things as uncomplicated as possible, they could simply name their son and daughter as the individual beneficiaries who are to receive the IRAs after the death of the surviving spouse. This would eliminate the need for special planning designed to stretch out minimum required distributions payable to a trust. However, this arrangement would completely fail to address their larger planning goals that have nothing to do with income tax deferral.
For example, let's assume that
- John and Jane name each other as primary beneficiaries, and their son and daughter as equal secondary beneficiaries, of their IRAs,
- John predeceases Jane, so his IRA passes to Jane,
- Jane rolls over John's IRA into her own IRA, creating one consolidated IRA, and
- upon Jane's death, the single IRA is divided equally into an inherited IRA for the son and an inherited IRA for the daughter.
If the son and daughter each receive an inherited IRA in this manner, then John's and Jane's planning goals fail in the following ways:
- The son's inherited IRA may be vulnerable to the claims of creditors. A recent decision by the U.S. Bankruptcy Court for the Southern District of Texas[v] found that an inherited IRA passing to a non-spouse was not exempt from the claims of creditors under the Texas law that protects an individual's non-inherited IRAs.
- The daughter's inherited IRA is not fully protected in the event of divorce. Even though the inherited IRA should be the daughter's separate property (because it is inherited), under Texas marital property rules, undistributed income accumulating in the IRA during her marriage may be characterized as community property subject to division upon divorce.
- There is nothing to prevent the daughter's inherited IRA from passing to her husband upon her death.
- There is no guarantee that the remaining portions of the inherited IRAs will pass to grandchildren upon the deaths of either the son or daughter.
Planning that Works. In this case, “keeping it simple” by directly naming the children as beneficiaries of the IRAs could lay the groundwork for several unpleasant outcomes. These outcomes can be avoided, however, if John and Jane implement the right kind of planning. In order to achieve their planning goals, John and Jane may:
- Name the trustee of a testamentary trust for the son as a beneficiary of the surviving spouse's IRA. A properly structured trust created under the Will of the surviving spouse may offer substantial creditor protection for trust assets, including an inherited IRA. This should offer a level of protection for the son's inheritance that would be absent if the IRA passed to him outright.
- Name the trustee of a testamentary trust for the daughter as a beneficiary of the surviving spouse's IRA. The daughter's beneficial interest in the testamentary trust established for her under the surviving spouse's Will should be her separate property that is protected from division upon divorce. Assets held by an appropriately structured trust, including the inherited IRA, should not be characterized as either separate property or community property, because trust assets are not owned by the daughter – they are owned by the trust.[vi]
- Structure the daughter's trust to exclude her husband as a beneficiary. The daughter's trust may be structured to prevent her husband (whom she may divorce) from receiving any trust property upon the daughter's death.
- Structure the son's and daughter's trusts to benefit grandchildren. The trusts for the son and daughter may be structured so the property in the son's trust automatically passes to the son's children when the son dies, and the property in the daughter's trust automatically passes to the daughter's child when the daughter dies.[vii] This is a typical arrangement for trusts for family members, and building a succession of beneficiaries into an estate plan isn't exactly rocket science for a competent estate planner. The key here is making certain that a significant amount of the family's wealth (the IRA) actually ends up in the trusts, in order to keep this resource in the right hands. This type of planning can easily fall through the cracks, however, because doing it right requires carefully prepared beneficiary designations that are coordinated with the Will that sets up the trusts.
The Importance of Doing it Right. The planning options outlined above are just a few of the building blocks that can form part of an individual's estate plan. If these building blocks are not structured and implemented correctly, then critical tax and non-tax benefits may be lost. The non-tax features of an estate plan are often varied and may be uniquely tailored to an individual's financial and family situation. As different pieces of the puzzle are arranged and rearranged to achieve an individual's planning goals, it is critical that trusts for family members and related planning are properly structured to preserve opportunities to maximize income tax deferral.
It would be all too easy for John and Jane to put an estate plan in place that seemingly delivers all of the non-tax planning goals described above, but which fails to implement the tax planning needed to stretch out IRA distributions over the lifetime of the son or daughter (thereby losing out on tax-deferred growth of the IRA).
Getting the plan right is only the first part of the equation for John and Jane. Assuming John and Jane put a well-designed plan in place, after the surviving spouse dies, the October 31st tax deadline will need to be met and other estate administration steps will need to be taken to ensure that the son, daughter, and grandchildren receive the benefits of the planning.
Like so many aspects of an estate plan, making sure that it is carried out correctly involves careful choices. In the case of the October 31st deadline and the other steps needed to implement the plan after the surviving spouse's death, the choice of responsible and capable individuals[viii] to serve as executor and trustee is just as important as having properly drafted tax provisions in the Will.
Note: For individuals who died in 2007, the deadline for delivering a copy of the decedent's Will or trust agreement to a plan administrator (if applicable) is October 31, 2008.
Think About Your Planning Goals. The hypothetical situation involving Jane and John is intended to highlight everyday estate planning issues that demand competent income tax planning. Income tax deferral is one of many critical factors that should be considered in a well-designed estate plan. If your 401(k), IRA or other retirement plan is a significant part of your estate, and if you want these assets to pass to family members with the extra protections a well-designed estate plan can offer, then you should be confident that your plan has the right kind of tax and non-tax planning needed to achieve your goals.
[i] Treas. Reg. Section 1.401(a)(9)-4. The deadline is October 31 of the year following the year of death. An alternative method of meeting the requirements under this deadline involves sending the plan administrator a list of every beneficiary of the trust created under the Will or trust agreement (as opposed to a copy of the Will or trust agreement).
[ii] The minimum distribution rules apply to qualified pension, profit sharing and stock bonus plans described in Section 401(a) of the Internal Revenue Code (the “Code”), annuity plans described in Code Section 403(a), annuity and custodial accounts described in Code Section 403(b), IRAs and IRA rollovers, and eligible deferred compensation plans of state and local governments described in Code Section 457.
[iii] The differing income tax treatment turns on whether the IRA or qualified plan has a “designated beneficiary” (a technical tax term defined in Treasury Regulations). In general, a “designated beneficiary” must be an individual human being, so if a taxpayer names his or her “estate” as the beneficiary of an IRA, the IRA will need to be fully distributed and subjected to tax (i) within five years of the taxpayer's date of death, or (ii) over the remaining projected life expectancy of the deceased taxpayer (using life expectancy tables published by the IRS). Whether the distributions must be made within five years or over the deceased taxpayer's remaining projected life expectancy will depend on whether the taxpayer dies before or after his or her “required beginning date” (the date when a taxpayer is required to start withdrawing minimum distributions from an IRA or qualified plan). This unfavorable treatment may be avoided, however, under special rules that apply when a qualified plan or IRA is payable to a properly structured trust. Under these rules, the IRS may “look through” the trust and treat an individual trust beneficiary as the “designated beneficiary” of the IRA or qualified plan, allowing minimum required distributions to be stretched out over the lifetime of the individual trust beneficiary.
[iv] A testamentary trust is an irrevocable trust created under a deceased person's Will. The property held in the trust is managed, invested, and distributed by a trustee for the benefit of a beneficiary, who could be a spouse, child or grandchild. The same type of irrevocable trust may be set up under a Revocable Trust (commonly referred to as a “Living Trust”), an estate planning vehicle that may be used as an alternative to a Will. Like a Will, a Revocable Trust may serve as the governing estate planning document that directs who should receive an individual's property at death. For ease of illustration, the discussion in this article refers only to planning with Wills; however, the discussion also applies to planning with Revocable Trusts, which are frequently used in estate plans for both married and unmarried individuals.
[v] In re Jarboe, 365 B.R. 717 (Bkrtcy. S.D. Tex. 2007).
[vi] Technically, legal title to trust assets is held by the trustee, but for ease of discussion this article refers to assets being owned or held by the “trust.”
[vii] The property passing to grandchildren could be held in a separate lifetime trust for each grandchild, offering the same protections as the trusts for the son and daughter.
[viii] In some situations a corporate fiduciary (a bank or trust company) may be an appropriate alternative to naming an individual as executor or trustee.
This information is intended for educational purposes only and does not constitute specific legal advice or create an attorney-client relationship with Porter & Hedges, L.L.P. Do not use this information as a substitute for specific legal advice. Attorney advertising.