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Estate Planning & Required Minimum Distributions

INTRODUCTION

Effective estate planning for retirement benefits requires understanding rules created by the income tax laws mandating minimum distributions from the client’s retirement accounts. These income tax laws are found primarily in Internal Revenue Code 401(a) and Treasury Regulation 1.401(a)(9)-0 through 1.401(a)(9)-9. Proper planning also requires an understanding of the non-probate transfer rules under California law found in Probate Code 5010 through 5032. Finally, it necessitates an appreciation for the variety of estate planning instruments that can be used to carry out the client’s intent without running afoul of the minimum distribution and non-probate transfer rules. This article is broken down into seven sections, which are:

  • Part I – Definitions (which sets out the nomenclature used in this article).
  • Part II – General Minimum Distribution Rules (which contain the required minimum distribution rules for individual beneficiaries other than spouses).
  • Part III – Minimum Distribution Rules for Trusts (which contains the special rules applicable to Trusts that have been named as beneficiaries).
  • Part IV – Minimum Distribution Rules for Spouses (which explains the different distribution rules and options available to spouses).
  • Part V – Estate Planning Instruments (which lists the various tools with which the planner should become familiar).
  • Part VI – Helpful Hints (which discusses planning tips and traps).
  • Part VII – Relevant Treasury Regulations (which contains a copy of the pertinent Treasury Regulations).

PART I. DEFINITIONS FOR THIS ARTICLE

For the purpose of this article only, the following terms have the following meanings:

“IRC” means Internal Revenue Code.

“Retirement Account” means individual retirement accounts as defined in Internal Revenue Code 408; qualified pension, profit sharing, and stock bonus plans under IRC 401(a), and annuity contracts under IRC 403(b): Treasury Regulation 1.401(a)(9)-1,A-1; 1.403(b)-3,A-1; 1.408-8,A-1.

“Plan Administrator” means the person designated as the plan administrator in the plan document, and if there is no designation, then the employer, and if there is no employer (i.e., an IRA), it is the person responsible for the control, disposition or management of the Retirement Accounts, which in the case of an IRA would ordinarily be the financial institution acting as custodian of the IRA. Treasury Regulation 1.414(b)-1(b).

“Employee” means the participant in the plan or IRA.

“Employee’s Spouse” means the spouse of the Employee.

“Beneficiary” means an individual or non-individual, such as a charity of Trust, that is listed as beneficiary under the Retirement Account.

“Designated Beneficiary” or “DB” means a Beneficiary under the Retirement Account who is an individual.

“Required Minimum Distributions” or “RMD” are the annual distributions required to be made under the tax laws from the Retirement Account to the Beneficiary.

“Required Beginning Date” or “RBD” is the date by which minimum distributions from the Retirement Accounts must commence or are deemed to have commenced. The Employee’s RBD is generally April 1 of the calendar year following the later of the year in which the Employee attains age 70 ½ or the year in which the Employee retires. Treasury Regulation 1.401(a)(9)-2, A-2.

PART II. GENERAL MINIMUM DISTRIBUTION RULES

The assets within Retirement Accounts remain exempt from taxation during the period held within the Retirement Account. IRC 408(e); IRC 501(a). The assets become subject to income tax on distribution from the Retirement Account to the beneficiary. IRC 408(d); 402(a). The Secretary of the Treasury is given the power to prescribe specific rules for minimum distributions. IRC 401(a)(9)(A)(ii) and 408(a)(6). The Treasury Regulations covering required minimum distributions are found in Treasury Regulation 1.401(a)(9)-0 through 1.401(a)(9)-9, attached. For each of the distribution rules set forth below. The minimum distributions set forth below are the general rules, which apply in the absence of negating language in the plan document. In the case of distributions coming from Retirement Accounts, which are not IRAs, the plan document needs to be examined carefully to determine the distribution options for a beneficiary who is not the deceased Employee’s spouse. The planner should also consult IRS Notice 2007-7 to determine if the non-spouse beneficiary may roll the qualified plan asset directly into an inherited IRA. Generally, even if the plan document does not permit roll-overs to an IRA on the Employee’s death, the Employee’s Spouse may nevertheless roll the assets in a new IRA in the Employee’s Spouse’s name. Internal Revenue Code 402(c)(9).

Rule #1 – Distributions Based on Life Expectancies. The distributions that are required to be made annually to the Employee (i.e., the required minimum distributions or RMD) are determined based on the life expectancy of the Employee and/or the life expectancy of the Employee and the Employee’s Designated Beneficiary according to the specific rules prescribed under the Treasury Regulations. IRC 401(a)(9)(A)(ii).

Rule #2 – Single Life Table. Except in cases where the DB is the Employee’s Spouse, the life expectancy is determined using the Single Life Table (Treasury Reg 1.401(a)(9)-9, A-1 in conjunction with the Fixed Term Method.

Rule #3 – Only Individuals Qualify as Designated Beneficiaries. Only individuals qualify as Designated Beneficiaries. Treasury Regulation 1.401(a)(9)-4, A-1, A-3. Estates and charitable organizations do not qualify as Designated Beneficiaries. Trusts do not qualify as Designated Beneficiaries. However, in certain instances, the existence of the Trust may be disregarded and the beneficiaries of the Trust may be treated as Designated Beneficiaries. Treasury Regulation 1.401(a)(9)-4, A-5. See Rule 15 below.

Rule #4 – Death Before RBD with Designated Beneficiary. If the Employee dies before the RBD and if the Employee has a Designated Beneficiary, then RMDS to the Designated Beneficiary will be based on the greater of (i) 5 years or (ii) the DB’s life expectancy. Treasury Regulation 1.401(a)(9)-3, A-1.

Rule #5 – When Distributions Must Commence. Except in the case of a spouse named as Designated Beneficiary, the Designated Beneficiary must commence distributions by the end of the calendar year following the calendar year of the Employee’s death. Treasury Regulation 1.401(a)(9)-3, A-3.

Rule #6 – Death Before RBD Without a Designated Beneficiary. If the Employee dies before the RBD and if the Employee does not have a Designated Beneficiary (either because the Employee had not named beneficiary or the named beneficiary did not meet the requirements of a Designated Beneficiary), then the entire Retirement Account must be distributed to the beneficiary within 5 years. Treasury Regulation 1.401(a)(9)-3, A-4 (a)(2).; IRC 401(a)(9)(B)(ii).

Rule #7 – Death After the RBD With Designated Beneficiary. If the Employee dies after the RBD and if the Employee has a DB, then RMDS are based on the greater of (i) Employee’s life expectancy and (ii) the DB’s life expectancy. Treasury Regulation 1.401(a)(9)-5,A-5(a)(1).

Rule #8 – Death After RBD Without Designated Beneficiary. If the Employee dies after the RBD and if the Employee has no DB, then the RMD is based on the Employee’s life expectancy. Treasury Regulation 1.401(a)(9)-5, A-5(a)(2)

Rule #9 – Use Shortest Life Expectancy if Multiple DBs. If the Employee has multiple DBs, then only the shortest life expectancy is used in calculating the RMD (i.e., use the life expectancy of the oldest DB). Treasury Regulation 1.401(a)(9)-5,A-7(a). But see Rules 11 and 12 below for exceptions.

Rule #10 – DB Status of Individuals is Negated if Entities are Named as Co-Beneficiaries. If the Employee has specifically named both individuals and entities as beneficiaries, like trusts, estates and charities, then the Employee is deemed to have no DB. Treasury Regulation 1.401(a)(9)-4, A-3. Effectively, the naming of a non-individual as a beneficiary jointly with an individual beneficiary defeats the Designated Beneficiary status of the individuals, who would otherwise qualify as a DB in the absence of the naming of the non-individual beneficiary. But, see Rule #11 below for exceptions.

Rule #11 – Cash Out Before September 30 of Following Year. Only beneficiaries who remain part of the Retirement Account as of September 30 of the year following the year of the Employee’s death are taken into account in determining the DBs. Treasury Regulation 1.401(a)(9)-4, A-4. Thus, in the event that beneficiaries named by the Employee include both individuals and non-individuals, like charities, the charity will be disregarded as a beneficiary if the charity cashed out before September 30 of the following year, leaving only DBs as named beneficiaries. In such case, the RMDs will be based on the life expectancy of the oldest individual beneficiary. Example: Employees names his son as beneficiary as to 50% of the Retirement Account and a charity as beneficiary as to the other 50%. Employee dies on January 31, 2009. If the charity is cashed out by September 29, 2010, then the son is considered the only beneficiary and the son make take distributions based on the son’s life expectancy.

Rule #12 – Separate Share Rule Can Save DB Status If Act Promptly. If the Retirement Account is divided into separate accounts for each individual beneficiary by no later than December 31 of the year following the year of the Employee’s death, then the RMDs are determined separately for each new account using only the life expectancy of the beneficiary of the new account. Treasury Regulation 1.401(a)(9)-8, A-2 (a)(2).

Rule #13 – Separate Share Rule Does Not Apply to Single Trust with Multiple Beneficiaries. The Separate Share Rule (Rule #12 above) is not available to multiple beneficiaries of the same Trust. Treasury Regulation 1.401(a)(9)-4, A-5(c).

PART III. MINIMUM DISTRIBUTION RULES FOR TRUSTS

Rule #14 – Trust Beneficiaries May be Treated as DBs if Certain Requirements are Met. In the case of Trusts, the beneficiaries of the Trust are considered the DBs of the Retirement Account if certain basic requirements (“Basic Requirements”) are met.

Rule #15 – Look Through Requirements for Trusts. The beneficiaries of the Trust will be treated as DBs if each of the following five Basic Requirements are met:

  • Requirement #1. The Trust must be valid under state law.
  • Requirement #2. The Trust must be irrevocable upon the Employee’s death.
  • Requirement #3. The Trust beneficiaries must be identifiable, which allows for determination of the beneficiary with the shortest life expectancy.
  • Requirement #4. The beneficiaries’ names and birthdates and a copy of the Trust agreement must be sent to the plan administrator by October 31 of the year after the year in which the Employee died;
  • Requirement #5. By September 30 of the year following the year of the Employee’s death, all Trust beneficiaries must be individuals. This is the most difficult to satisfy, since Trust beneficiaries include not just the current beneficiary, but also the contingent remainder beneficiaries. Treasury Regulation 1.401(a)(9)-4.

Rule #16 – Accumulation Trusts Consider Life Expectancies of All Potential Trust Beneficiaries. When a Trust is named as beneficiary of a Retirement Account, RMDs to the Trust are determined using the life expectancy of the oldest Trust beneficiary. This generally includes the remainder beneficiaries and contingent remainder beneficiaries, as well as the current beneficiaries. Treasury Regulation 1.401(a)(9)-5, A-7(b), A-7(b), A-7(c), Example 1. IRS Letter Rulings 200610026, 200438044, 200228025.

Rule #17 – Exception:DBS of Conduit Trusts are Current Beneficiaries Only. If the Trust instruments requires that all RMDS received by the Trustee must in turn be distributed to the beneficiaries within the same year of receipt (i.e., passed through), then the Trust qualifies as a “Conduit Trust” and only the current beneficiaries are deemed Designated Beneficiaries. 1.401(a)(9)-5, A-7(c)(3), Example 2. All Trusts other than Conduit Trusts are considered Accumulation Trusts, meaning Trusts that are not required to annually distribute all required minimum distributions received by the Trust. Rule #16 above refers to Accumulation Trusts.

Rule #18 – Beware of Trust Provisions Granting Powers of Appointment. Beware of Powers of Appointment. If an Accumulation Trust contains a testamentary power of appointment, then all permissible appointees are counted. Thus, if the power of appointment permits the distribution to charities, then charities would be considered as a beneficiary and since charities do not qualify as a DB, the Accumulation Trust would be deemed to have no DB. If the power of appointment permits distributions to spouses of lineal descendants (without any qualification), then the age of the spouse cannot be determined (since the descendant could marry a 25-year old or a 95-year old).

Rule #19 – Beware of Trust provisions Directing Payment of Expenses and Taxes. Beware of expense and taxation clauses. If the Trust provides that certain expenses, debts or taxes are to be paid from the Trust on the Employee’s death, then the Employee’s estate may be considered as a named beneficiary, and since it is not an individual, then it does not qualify as a DB, causing the Trust to have no DB.

Rule #20 – Be Aware of the Distinction Between Taxable Income and Accounting Income. Taxable income and accounting income (i.e., income for trust distribution purposes) are generally different. The distinction becomes important when distributions to the beneficiary are tied to the net income. Probate Code 16361.

Rule #21 – Order of Characterization of Distributions. The amount of a distribution, from a Retirement Account to a Trustee of a Trust, which is determined for Trust accounting purposes to be net income, is as follows:

  • First, based on the characterization by the plan administrator. If the plan administrator characterizes the payment as interest or dividend, then it is treated as a distribution of income.
  • Second, if the plan administrator does not characterize it, then, to the extent that all payments received during the taxable year in the aggregate are less than 4% of the value of the Retirement Account, such payments are treated as income. Any cumulative amounts during the same taxable year in excess of 4% are treated as principal. Probate Code 16361.

PART IV. REQUIRED MINIMUM DISTRIBUTION RULES FOR SPOUSES

Rule #22 – Spouse May Roll Over Retirement Account and Start Over. Roll assets into a new IRA in the name of the Employee’s Spouse and thereby differ distribution to Employee’s Spouse’s RBD. The Employee’s Spouse effectively becomes the Employee for purposes of the new IRA. Treasury Regulation 1.408-8, A-5; IRC 402(c)(9). But, this restricts the ability of the Employee’s Spouse to take distributions immediately.

Rule #23 – Spouse May Treat as Employee’s Retirement Account . The Employee’s Spouse may generally roll the Retirement Account into a new Retirement Account identified as inherited using the name of the deceased Employee and

  • (a) differ distributions until the deceased Employee’s RBD; Treasury Regulation 1.401(a)(9)-3, A-3(b)(2); or
  • (b) commence taking distributions immediately even if the Employee’s Spouse is younger than 59 ½ without early withdrawal penalty; Treasury Regulation 1.401(a)(9)-3, A-3(b)(1). IRS Private Letter Ruling 200450057.

Rule #24 – Spousal Consent for Qualified Plans. If the plan is a qualified plan under ERISA, the Employee’s Spouse must consent to the designation of a beneficiary other than the Employee’s Spouse. If the plan is an IRA, the Employee’s Spouse does not have to consent to the designation of a beneficiary other than the Employee’s Spouse, but see Rule #25 below. Treasury Regulation 1.417(e)-1(b).

Rule #25 – Invalidating Beneficiaries of IRAs. If the plan is an IRA and if it is community property, then the Employee’s Spouse may set aside the designation of a non-spouse beneficiary as to the Employee’s Spouse’s 50% community property interest. Probate Code 5021-5022.

Rule #26 – Terminating Interest of Pre-Deceased Employee’s Spouse. If the plan is a qualified plan under ERISA, and the Employee’s Spouse dies first, then interest of the Employee’s Spouse passes to the Employee. The Employee may generally name a new beneficiary as to 100% of the plan. Boggs v. Boggs (1997) 520 U.S. 833. ERISA Supersedes California community property law.

Rule #27 – Limited Ability of Employee to Change Beneficiaries of IRA after Death of Spouse. If the plan is a community property IRA and the Employee’s Spouse dies first, then the Employee may only change the beneficiary as to 50% of the IRA, unless the Employee’s Spouse has given in writing to the Employee the ability to change the IRA beneficiary as to 100%. Probate Code 5022.

Rule #28 – Taxable Gifts by Employee’s Spouse. If more than 50% of the community property IRA passes on death of the Employee to someone other than the Employee’s Spouse, then the Employee’s Spouse has made a gift to the other beneficiary of a portion of the Employee’s Spouse’s community property interest in the IRA.

PART V. PLANNING INSTRUMENTS

To make certain that all planning options are available, the planner should have in his or her arsenal a general understanding of how the following documents may assist in the planning process:

  1. Attachment to beneficiary designation form;
  2. Contract Re: Testamentary Device;
  3. Disclaimer;
  4. Aggregate Community Property Agreement;
  5. Consent to Nonprobate Transfer of Community Property;
  6. Premarital Agreement;
  7. Conduit Trust;
  8. Accumulation Trust with spendthrift provisions;
  9. Limited Durable Power of Attorney for Retirement Benefit Planning; and
  10. Petitions for Reformation and other Court actions.

PART VI. HELPFUL HINTS

(1) Talk to the plan administrator about attachments to beneficiary designation forms ahead of time. You may want to move the account from an unhelpful financial institution.

(2) Don’t forget the income tax deduction for estate taxes paid that is attributable to the Retirement Account. IRC 691. This benefits high income individuals (or Trusts) more than low income individuals. It benefits the recipient of the Retirement Account, even if the estate taxes on the Retirement Account were paid from a different source (i.e., the residue).

(3) Coordinate the tax proration clauses among all Trust and non-Trust assets, including Retirement Accounts. If the Retirement Accounts must be liquidated to pay the estate tax, then the liquidation defeats the tax deferral opportunities.

(4) If multiple individuals are named as beneficiaries of a single IRA, consider dividing the IRA into separate IRA accounts for each beneficiary before December 31 of the calendar year following the year of the Employee’s death. Rule #12.

(5) Avoid inadvertent naming of Family Trust as beneficiary of Retirement Account. Consider naming individuals as beneficiaries with an attachment to put the shares of beneficiaries under age 25 into custodial accounts under CUTMA for the beneficiaries.

(6) Consider post-death Court reformation of the Trust to convert an Accumulation Trust into a Conduit Trust. IRS Private Letter Ruling 200620026.

(7) Where the Family Trust has been named as the beneficiary and the Employee’s Spouse is the Trustee, consider having the Employee Spouse as Trustee allocate in writing the Retirement Account entirely to the Survivor’s Trust, followed by the Employee’s Spouse executing a document exercising her withdrawal right over the Survivor’s Trust and its Retirement Account, and further directing the transfer of the Retirement Account into a new Retirement Account in the name of the Employee’s Spouse by way of an IRA to IRA transfer. Consider seeking Private Letter Ruling in advance. IRS Private Letter Ruling 2007004033. You may also want to consider seeking a Court order from the probate court confirming the intended result and forcing compliance by the financial institutions.

(8) Consider cashing out a non-individual beneficiary before September 30 of the year following the year of the employee’s death to remove the beneficiary from consideration in determining RMDs. Rule #11.

(9) If the Retirement Account must likely be liquidated immediately after death to pay estate taxes or liquidated for another reason, considering liquidating immediately before death to trigger the income tax liability. The income tax liability constitutes a debt of the estate, which is a dollar for dollar reduction in the size of the taxable estate on the IRS Form 706. The income tax deduction for estate taxes paid under IRC 691 is less beneficial since there is no corresponding California income tax deduction. You will need a durable power of attorney that specifically gives the agent the power to make decisions concerning Retirement Accounts, such as liquidating the Retirement Account, if the Employee is incompetent. The Uniform Statutory Form DPA permits Retirement Plan Transactions. Probate Code 4462

(10) Read every provision of any Trust that is receiving Retirement Account assets. Don’t skip over the boiler plate.

(11) Don’t forget the non-probate transfer rules if Employee’s Spouse dies first and it is a non-qualified plan – it’s an IRA. Probate Code 5000- 5032. These rules apply specifically to a “compensation plan, pension plan, individual retirement plan and employee benefit plan.” Specifically, look to Probate Code 5023(b)(2) restricting the ability of the Employee to change the beneficiary as to the Employee’s Spouse’s 50% community property interest after the death of the Employee’s Spouse.

(12) Don’t forget you can draft around PC 5023(b)(2) and give the Employee the ability to change 100% of the beneficiaries after the death of the Employee’s Spouse. PC 5023(b)(3).

(13) Other options without Trust constraints, include:

  • a. Contract Regarding Testamentary Device under Probate Code 21700. This can be used to restrict the Employee’s Spouse from naming new beneficiaries of the inherited IRA or roll over IRA. However, this doesn’t preclude early termination by Employee’s Spouse unless so specified.
  • b. Aggregate Community Property Agreements.

(14) Using Disclaimers.

(15) Problems with pecuniary formulas and triggering IRD. Use fractional share formulas or direct designations to subtrusts.

(16) Consider leaving to charity. Biggest bang for the buck. No income or estate tax.

(17) If leaving retirement accounts to charity, do it directly and not through the revocable trust. IRS Legal Memorandum 200644020

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