One of the most troublesome, anxiety-producing and perhaps least profitable areas of the modern estate-planning practice is planning properly for the ultimate distribution of clients’ retirement accounts on death. Yet, our clients often have significant retirement account assets in proportion to their overall wealth, making this area of estate planning one of the most important to address and to get right. A combination of factors leads to the annoyance and anxiety associated with planning for retirement accounts, including, most notably, confusing Treasury regulations, oddly reasoned private letter rulings, lack of uniformity among retirement account custodians and incredulous clients. Over time, I’ve developed some practical solutions to this vexing problem.
For purposes of this article, reference to “retirement accounts” includes any plan, individual retirement account or Roth IRA subject to the required minimum distribution (RMD) rules. If a non-spouse individual is designated as the beneficiary of a retirement account on the participant’s death, the individual can generally stretch out the RMDs over her life expectancy, meaning the younger the individual beneficiary, the lower the annual RMDs and the longer that income tax is deferred with respect to distributions from traditional inherited retirement accounts. Additionally, a longer stretch out results in assets growing free of income tax consequences inside both traditional and Roth inherited retirement accounts. Most agree that designating individuals as beneficiaries of retirement accounts and obtaining these benefits are relatively simple.
The issues I address result primarily from a common recommendation to clients of above-average wealth to consider creating irrevocable spendthrift trusts for each of their beneficiaries on death to provide creditor and divorce protection of assets intended for those beneficiaries. Because the protection afforded by such spendthrift trusts is desirable and available in some states even if the intended beneficiary serves as a trustee, many of our clients choose to create such trusts in their estate plan. This advice is more significant with respect to inherited retirement accounts following the U.S. Supreme Court’s determination in 2014 that such inherited accounts aren’t protected from bankruptcy creditors under federal law.1 Drafting spendthrift trusts and ensuring they’re funded properly on a client’s death is relatively straightforward with respect to assets not held in retirement accounts. Doing so with retirement account assets is a completely different story.
See-Through Trusts
Although the rules are somewhat complicated, most estate planners are familiar with how to create a see-through trust, which is a trust that, when designated as a beneficiary of a retirement account on a participant’s death, is treated as if the trust beneficiaries were designated directly as beneficiaries of the retirement account.2 Essentially, to qualify as a see-through trust, a trust must: (1) be valid under state law; (2) be irrevocable; (3) have identifiable beneficiaries; and (4) as of Oct. 31 of the year following the year of the participant’s death, provide the trust agreement and list of beneficiaries (as of Sept. 30 of such year) to the retirement account administrator.3
Ensuring a trust is see-through is only the starting point. Realizing the true advantage of a see-through trust designated as the beneficiary of a retirement account also requires that the identifiable beneficiaries of the trust are all individuals. This is because estates, charitable beneficiaries and non-see-through trusts don’t qualify for a stretch out of RMDs. Further, because the oldest individual who counts as a beneficiary sets the RMDs, it’s generally advisable to ensure that only one individual beneficiary, the intended primary beneficiary of the trust, is counted for this purpose.
There are two types of trusts that currently ensure that result. The first, commonly known as a “conduit trust,” is a safe harbor explained—in a confusing manner —and approved in the regulations.4 A conduit trust must provide that all distributions from a retirement account received by the trust are immediately distributed to a specific beneficiary of the trust. The RMDs from an inherited retirement account owned by a conduit trust are based on the life expectancy of the beneficiary who must receive these distributions.
The second type is commonly known as an “accumulation trust,” and it’s been explained in detail and approved only in PLRs.5 Such a trust permits retirement account distributions to the trust to be accumulated rather than immediately distributed. RMDs from an inherited retirement account owned by an accumulation trust can also be based on the primary beneficiary’s life expectancy so long as no other beneficiary of the trust is: (1) an individual older than the primary beneficiary, or (2) a non-individual.
Separate Accounts Rules
If your client only intends to provide for one child or other non-spouse beneficiary, then you’re in luck, as most of the issues addressed in the remainder of the article are irrelevant. Your client may simply designate his revocable trust that creates a conduit or accumulation subtrust as primary or contingent beneficiary of a retirement account directly on the beneficiary designation form. Because there’s only one countable beneficiary of the trust, it will receive the desired stretch out based on her life expectancy. If you happen to have any clients that have two or more children or non-spouse beneficiaries, read on.
If conquering conduit and accumulation trusts was the finish line of estate planning for retirement accounts when a client has more than one child, it wouldn’t be so bad. Unfortunately, we also must deal with an illogical rule regarding the preparation of retirement account beneficiary designations to establish separate accounts for separate trusts created under a single revocable trust to take full advantage of stretch outs. Further, because retirement account beneficiary designation forms aren’t completely within a client’s or estate planner’s control, the confusion is compounded by the involvement of another party, the retirement account custodian, who must ultimately accept the beneficiary designation.
Unless separate accounts under a retirement account are established after a participant’s death, the beneficiaries are aggregated for determining RMDs, meaning the RMD for each beneficiary is based on the oldest beneficiary’s life expectancy. To establish separate accounts for this purpose, the retirement account must be divided into separate shares on the beneficiary designation form. Designating a revocable trust that divides into separate subtrusts pursuant to its terms doesn’t work (anymore).
One of the funniest and most honest lines I’ve read in an estate-planning book or journal appears in Natalie Choate’s invaluable treatise on this topic.6 She writes, “In one of the best-reasoned PLRs ever, the IRS stated that the RMD trust rules require treating the trust beneficiaries as if they had been named directly as the participant’s beneficiaries, so the children’s interests qualified as separate accounts even though the named beneficiary was a single trust. Unfortunately, the IRS promptly abandoned this rule.” PLR 200234074 (Aug. 23, 2002), to which Natalie referred, set forth a ruling that if still intact could have prevented many headaches. Essentially, it permitted a client to designate his revocable trust as the beneficiary on the beneficiary designation for his retirement account. Because the trust by its terms is then divided into separate subtrusts, each separate subtrust received separate account treatment for all purposes including most significantly the determination of the life expectancy of each beneficiary for determining RMDs of the inherited retirement account.
The IRS quickly flip-flopped and released final regulations that contradict this practical PLR. Treasury Regulations Section 1.401(a)(9)-4, A-5(c) states, “….the separate account rules under A-2 of Section 1.401(a)(9)-8 are not available to beneficiaries of a trust with respect to the trust’s interest in the employee’s benefit.” The IRS has interpreted this to mean that the oldest beneficiary of a client’s revocable trust, including all countable beneficiaries of see-through subtrusts, in the aggregate, determines the RMD for each beneficiary in a situation in which only the client’s revocable trust is designated directly as beneficiary on the retirement account beneficiary designation.7 Language necessary to divide a client’s retirement account into separate shares and transferring them to separate subtrusts created under a client’s revocable trust, which is required under this rule to obtain separate account treatment for each subtrust, generally takes more space than is available on a standard beneficiary designation form. Thus, estate planners often draft custom beneficiary designation attachments to accomplish this. While many custodians are familiar with the reasons why these custom attachments are proposed, they don’t always accept them. This is frustrating to all involved, especially clients, their estate planners and financial advisors, who may not agree with their custodian, all of whom may have spent hours in the planning process determining the proper way to distribute retirement accounts and facilitating that plan only to reach a roadblock in implementing it.
Practical Solutions
Designate individuals directly as beneficiaries. As a first step, consider whether designating an irrevocable spendthrift trust as beneficiary of a retirement account is necessary. In some states, such as Missouri, inherited retirement accounts are protected from bankruptcy by state statute. Even in states where inherited retirement accounts held outside of trusts aren’t protected, there are more times than estate planners generally admit that a client would choose to designate individuals, rather than trusts, as beneficiaries of his retirement accounts, once the costs and benefits of holding them in trust are explained to him.
Yes, if someone offered to give me money, including retirement account assets, I want it in trust—with me serving as the sole trustee—simply for the creditor protection a trust provides. But, I’m a trust lawyer. The complexity and costs of administering a trust properly, which are over and above the costs of dealing with the complexities and frustrations at the planning stage discussed above, don’t affect me the way they affect pretty much everyone other than a trust lawyer or expert. So, even though an irrevocable spendthrift trust can ultimately prove helpful even to a beneficiary who’s unlikely at the time of her benefactor’s estate planning to need creditor or divorce protection or a professional fiduciary overseeing her assets, it isn’t always worth the cost. When a client fully understands these considerations, he may often choose to designate individual beneficiaries of retirement accounts rather than trusts, even when his remaining assets will be held in trust for his beneficiaries. If an individual beneficiary is a minor, this could still make sense if her share will be owned in a custodial account rather than a conservatorship.
Designate charities directly as beneficiaries. If your client intends to provide for a charity, he should designate it as beneficiary of his traditional retirement accounts because a charity doesn’t care to defer the payout of the inherited retirement account as it will not pay income tax on it. If it makes sense in the overall estate plan for the entire retirement account to be distributed to charity at the time of the participant’s death despite the unpredictable nature of the value of such account at death, the charity can be named as the sole beneficiary.
Name the client’s revocable trust as beneficiary. Most of us would agree the point at which this planning becomes overly burdensome is when dealing with the requirement to divide the retirement account into shares on the beneficiary designation form to achieve maximum advantage of the stretch out, which often requires a custom attachment to the form. If the client could designate his revocable trust as beneficiary, it would be simple and readily accepted by the applicable custodian. Despite the current rules that apply, there are some cases in which it still makes the most sense to do just that.
Consider a client with two children who are two years apart in age. Designating the client’s revocable trust as beneficiary of his retirement account means the older of the two children will set the RMDs for both children. True, the client won’t maximize income tax deferral for the younger of the two children, but it’s hardly a huge issue. Unless you know the client has a custodian that routinely accepts customized attachments, be practical and, after explaining the issues, offer the client the option to designate his revocable trust as beneficiary.
What the three suggestions above have in common is that the beneficiaries can be designated on a standard beneficiary form. That said, some readers may retort, what if a named beneficiary predeceases the client, resulting in a minor beneficiary inheriting? Or, what if the client with two children designates his revocable trust and one child predeceases leaving much younger grandchildren to inherit? This would certainly make a difference, and a custom beneficiary designation attachment could account for future events in the most tax-efficient manner. Even so, we must realize that an estate plan is only at its best on the day it’s agreed to and signed. Encourage clients to review their estate plans at least every five years and at any time a current or successor fiduciary or beneficiary becomes disabled or dies. A good planning and business practice for advisors is to calendar that time period, and ask clients whether there’s been any change that might affect their estate plans.
Client can release the custodian from determining the shares and beneficiaries. Despite the above, there’s no question that using a custom attachment to a beneficiary designation to designate separate trusts as beneficiaries of a retirement plan or simply to account for future events is sometimes the most prudent plan regardless of the complexity and costs involved. Unfortunately, I believe custodians have initially rejected a high percentage of the custom beneficiary designation attachments for retirement accounts that I’ve prepared as part of trust funding advice to clients. A portion of those clients have brought the rejection to my attention. At times, the communication of the rejection doesn’t explain it. When the rejection is explained, it may be as general as “attachments aren’t accepted” to as specific as “attachments that use the term ‘per stirpes’ aren’t accepted.” Either way, this situation almost always results in confusion and frustration at a minimum and potentially even a loss of trust among the parties involved—at least the custodian, the client and me.
The combination of this recurring pattern and my thinking about this from the custodian’s viewpoint gave me a new perspective. As a result, initially for my personal estate planning and then for my clients, I’ve offered the custodian a complete release and indemnity in determining the fractional shares created by the custom attachment and the identity of the beneficiary trusts and their beneficiaries. Instead of the custodian determining these, the release clearly states that the successor trustee of the client’s trust makes that determination. While releasing, and especially indemnifying, any other person or custodian is an important decision, for my situation, this resulted in the best of both worlds. I’d carefully drafted the beneficiary designation attachment to carry out my intended estate plan and the income tax consequences associated with it, and I’d also carefully selected my successor trustee. I’m confident, like many clients completing their estate plan, that the successor trustee will know my beneficiaries and the intended estate plan and will seek legal advice or other assistance if needed. I want my retirement account custodian to rely on my successor trustee in determining my intent. That’s already a part of such trustee’s duties anyway. This approach has been successful many times, and this year I’ve had two client custodians offer this solution unsolicited by me. See “Sample Release and Indemnity Language,” this page.
Simplifying the Process
Estate planning for retirement benefits under current law is overly complex. Agreement among clients, estate planners, financial advisors and custodians on beneficiary designations, especially with custom attachments, is often difficult to achieve. If everyone is practical, solutions are possible. As I write this article, many commentators believe the rules regarding calculation of RMDs and beneficiary stretch out of inherited retirement accounts will change some time this year. While simplicity may be at least a secondary goal of this legislation, recent history has indicated that change doesn’t always simplify. On the other hand, practicality tends to do so.
Endnotes
1. Clark v. Rameker, 573 U.S. ___ (2014).
2. For example, see Keith A. Herman, “How to Draft Trusts to Own Retirement Benefits,” ACTEC Law Journal (Winter 2004), at pp. 101-161 and Steve E. Trytten, “The Zen of Drafting See-Through Trusts,” Trusts & Estates (June 2014).
3. Treasury Regulations Section 1.401(a)(9)-4, A-5.
4. Treas. Regs. Section 1.401(a)(9)-5, A-7(c)(3), Ex. 2.
5. Private Letter Ruling 200537044 (Sept. 16, 2005) is one example.
6. Natalie B. Choate, Life and Death Planning for Retirement Benefits (Ataxplan Publications, Boston 2019).
7. Contrary to the clear language of Treas. Regs. Section 1.401(a)(9)-4, A-5(c), separate accounts treatment is available for all purposes other than determining the measuring life for required minimum distributions when a single revocable trust is designated as beneficiary of a retirement account. For example, see PLR 201503024 (Jan. 16, 2015).