By: Irwin Scherago ischerago@mlg.com
& Howard M. Esterces hesterces@mlg.com

Retirement Plans often comprise one of the most significant assets owned by an individual at his or her death. The Qualified Plan (401) or the IRA (Sec 408 of the IRC) may comprise 30% to 80% of estates. Retirement plan assets of $1,000,000 or more, ranging from $1,000,000 to $2,000,000, even $3,000,000 to $5,000,000, while not the everyday situations, are appearing with a higher degree of frequency than ever before. Given the size of the retirement plans in individual estates, careful planning of beneficiary designations is essential to assure that the wishes of the IRA owner or the plan participant are carried out and that whole classes of beneficiaries are not unintentionally omitted from sharing in the retirement plan benefits.

NAMING THE BENEFICIARY: INDIVIDUAL OR TRUST

The beneficiary of a Retirement Plan can be an individual or a Trust for an individual.

DESIGNATIONS WHEN THERE IS A SURVIVING SPOUSE
OUTRIGHT TO SPOUSE

When there is a surviving spouse, the beneficiary usually is "to the surviving spouse outright and free of trust." The benefit of this designation is that the IRA, or other retirement plan, qualifies for the unlimited marital deduction, and can be rolled over by the surviving spouse into an IRA of her own. The surviving spouse can then name children or grandchildren as beneficiaries, and extend the period over which taxable minimum distributions must be taken to perhaps 30 or 40 years or more, depending on the beneficiary's age. While the surviving spouse is living, distributions are taken under "minimum distribution incidental benefit" rules over the life expectancy of the spouse and a hypothetical beneficiary 10 years younger. When the spouse dies, however, the period for taking distributions pops up to the beneficiary's remaining life expectancy.

MARITAL DEDUCTION TRUST (QTIP) AS BENEFICIARY

A marital deduction trust may be the beneficiary of a retirement plan benefit. An IRA owner may wish to protect the surviving spouse from his or her own financial shortcomings. Many husbands and wives are warm and loving mates but when it come to money, they are financial alimentary canals – in one end and out the other. By paying the IRA to the QTIP Trust, the participant provides all the basic benefits tor the surviving spouse – no immediate estate taxation and income taxation on distributions only when received by the trust and spouse.

In addition, by paying the IRA account to a QTIP Trust, if the surviving spouse remarries, the Trust asset may be protected from the second spouse's right of election (usually one-third of all the spouse's assets). IRAs are usually considered "testamentary substitutes" in New York and subject to a surviving spouse's right of election, unless a valid prenuptial agreement is in place.

The Marital Deduction Trust [QTIP under 2056(b)(7)] of the Internal Revenue Code and the IRA beneficiary designation should require the Trustee of the Trust to receive the greater of the income generated by the IRA during the calendar year or the minimum required distribution. In addition, the QTIP must provide that the surviving spouse is to receive all of the trust net income at least annually. On the death of the surviving spouse, the QTIP assets generally pass to the issue of the original IRA owner.

As a result of recent changes in proposed regulations, an IRA can now be payable to a QTIP created by Will or under a revocable trust agreement (as well as under an irrevocable trust agreement, as was previously required) without having an adverse impact on required minimum distributions.

CREDIT SHELTER TRUST UNDER WILL
OF PLAN PARTICIPANT

Frequently, the combined assets of a husband and wife are insufficient to fully use (absorb) the Federal Exemption Equivalent available to the first spouse to die. The Federal Exemption Equivalent is set forth in the table below.

Any taxpayer dying in the year 2000 can pass $675,000 estate-tax free to beneficiaries other than a surviving spouse. This Exemption Equivalent Amount, if not given directly to children or to a trust for children, is generally placed in trust for the surviving spouse. The trust provides income for the surviving spouse and possibly invasion of principal for the surviving spouse's health, maintenance, support, and other purposes. Upon the death of the surviving spouse, the trust ends and the principal balance passes, estate-tax free, to the children. This is sometimes called, in the trade, the "Credit Shelter Trust", "Exemption Equivalent Trust", or "Bypass Trust", because the assets in the trust are sheltered from estate tax and bypass estate tax in both spouses' estates.

THE CONUNDRUM – INSUFFICIENT
NON-RETIREMENT PLAN ASSETS TO FUND
CREDIT SHELTER TRUST

Many medium-size estates do not have sufficient assets to fully fund the Credit Shelter Trust unless Retirement Plans (IRA) Assets are used.

Before January 1, 1998, a plan participant or IRA owner who lived past his "Required Beginning Date" (generally April 1st of the year after reaching 701/2) could not, as a practical matter, use his exemption equivalent or credit shelter by directly naming a trust under his Will or a revocable trust as beneficiary. This was because these trusts were not considered to have any life expectancy. If named, then only the plan participant's or IRA owner's own life expectancy could be used in determining minimum distributions. Worse still, if the "recalculation method" were used, everything had to come out of the plan or IRA by December 31st of the year following the year of death. While the amount would be sheltered from estate taxes up to the Federal Exemption Equivalent, the account was immediately diminished by the income tax, and this could have been upward of 44% counting Federal and State income tax.

IRS RULES TRUST HAS LIFE
EXPECTANCY OF ITS BENEFICIARY

On December 30, 1997, the Internal Revenue Service revised its previously proposed regulations to allow using life expectancies of beneficiaries of revocable trusts (living trusts) and of trusts under Wills in setting minimum distributions (Prop. Reg 1.401(a)(9)-1, D-5(a) as amended on 12/30/97). Naming an estate as beneficiary is still not advisable - an estate has no life expectancy. A copy or summary of the trust (or Will) must be furnished to the plan administrator or IRA custodian, copies or summaries of amendments must be furnished, and final versions must be supplied within 9 months following death.

NAMING THE CREDIT SHELTER TRUST
AS PLAN BENEFICIARY

If a prospective decedent has insufficient non-retirement plan assets to fully fund the Federal Exemption/Credit Shelter Trust, he or she can now readily designate the whole, or any part, of the IRA or plan assets to be paid periodically, over the life expectancy of his or her surviving spouse, to the Credit Shelter Trust under his Will or living trust.

The first obvious advantage – there is no estate tax up to the Federal Exemption Equivalent.

The second advantage is that there is no requirement that the Credit Shelter Trust pay out all of the annual net income of the Trust to, or to the use of, the surviving spouse. This is not a marital trust which requires all of the income to be paid out annually to the surviving spouse. Thus, the underlying value of the plan asset or IRA account as it grows will escape Federal Estate Taxation upon the death of the second spouse to die.

CAVEAT: Minimum distributions are taxable income. To the extent net income is not paid out annually by the trust (or to the extent minimum distributions are considered as "principal" for trust accounting purposes, and thus cannot be passed down to a beneficiary), the trust may be subject to Federal income tax at the highest trust income tax rate, (39.6%).

EXAMPLE: IRA payable to Credit Shelter Trust is $675,000; Minimum Required Distribution based on Life Expectancy of surviving spouse is $28,603. The income tax on the Trust if the minimum distribution is not paid out is $10,363, leaving $18,240 to accumulate in the Trust.

TRUST INCOME TAX IS NOT SO BAD

Before one shrinks back in horror, simply compare the income tax on the surviving spouse at the 28% or 31% bracket.

The increase in tax cost by keeping the income in the Trust and paying the tax at the Trust levels ranges between 16% (at the 31% tax bracket for an individual beneficiary) and 29% (at the 28% tax bracket for an individual beneficiary). The lower the individual beneficiary's tax bracket, the higher the tax cost by allowing the Trust to pay the tax.

OVERALL ESTATE TAX BENEFIT OF THE CREDIT SHELTER TRUST RETAINING THE INCOME AND PAYING THE INCOME TAX AS OPPOSED TO PAYING OUT THE INCOME DIRECTLY TO THE CREDIT SHELTER TRUST BENEFICIARY WHO PAYS THE INCOME TAX

The foregoing illustrates the benefit of using the Credit Shelter Trust to accumulate the income and passing it on to children or grandchildren. If the income is not needed from the Credit Shelter, then there is a dramatic increase in assets available to the children and/or grandchildren.

CHANGING EXISTING IRA BENEFICIARY DESIGNATIONS
TO CREDIT SHELTER AS BENEFICIARY

DESIGNATION MUST BE SENT TO CUSTODIAN OF IRA OR THE PLAN TRUSTEE

We have found disclaimer provisions to be particularly useful, even before the change in proposed regulations. The IRA or plan death benefit is left to the surviving spouse. The spouse can decide - up to nine months after the first spouse's death - how much of IRA or plan benefits will be needed to fund the Credit Shelter Trust. The mechanics involve a disclaimer or refusal by the spouse to accept all or a portion of the IRA or plan death benefit. The beneficiary form would provide that anything disclaimed passes to the Credit Shelter Trust. Thus, our beneficiary designation might be as follows:

"Upon my death pay the balance of my account to MARY MONROE, my wife, if living, and if MARY MONROE, my wife, is living but disclaims or renounces the whole or any part of this IRA (retirement account), I direct that my custodian pay the disclaimed/renounced portion of my IRA (retirement account) periodically, not less than annually, in the amounts equal to the Required Minimum Distribution to the Trust at Clause FOURTH of my Last Will and Testament dated ___________, 2000 or to the Credit shelter Trust of any later Will existing at my death."

CAVEAT: Not all IRA custodians are willing to accept disclaimer provisions. In that case some other arrangement would have to be made, including possibly moving the IRA to a more accommodating institution.

WILL PROVISION

The Credit Shelter Trust must also have a detailed provision directing the Trustee to receive the periodic payment and giving the Trustee the discretion to either pay out the income to the surviving spouse or to retain the income and, after the income taxes are paid, to add it to principal. It is usually advisable to also permit the Trustees to pay principal to the survivor.

BENEFICIARIES OTHER THAN SPOUSES

There is a serious problem that is not being addressed in IRA beneficiary designation when there is no surviving spouse. IRA beneficiary forms provided by custodians often provide for payment "to my children who survive, share and share alike".

WHAT IS LEFT OUT IN RETIREMENT PLAN
AND IRA BENEFICIARY DESIGNATIONS?

If you look at the underlined material of the above quote, you will see the beneficiary designations overlooked grandchildren. The grandchildren are overlooked because the beneficiary designation forms of most brokerage houses do not provide space for the designation of beneficiaries beyond the spouse and children.

EXPAND THE BROKERAGE BENEFICIARY FORM

Rectifying the built-in shortcoming of the brokerage form can and should be done. Using the form itself, you can insert the underlined words:

Manny Monroe, son, ½, per stirpes

Maxine Monroe, daughter, ½, per stirpes.

But if the form does not give you "per stirpal" space, then add to the form by an addendum and the addendum, stapled to the brokerage form and separately signed (and we recommend witnessed) should read:

"To Manny Monroe and Maxine Monroe, children of the Participant, equally, share and share alike, and if either child is not living to said deceased child's then living issue, per stirpes."

PROCEDURE FOR GIVING NOTICE
TO BROKERAGE HOUSE

1. Sign and staple addendum to brokerage beneficiary form. Make sure form is witnessed or notarized.

2. Send the form with the addendum and a covering letter, certified mail, return receipt requested: Why go to such trouble? Brokerage houses have not been in the beneficiary designation business long enough to appreciate the significance of these forms. Many brokerage houses, unlike insurance companies, whose total business is beneficiaries, handle the designations cavalierly. Thus, you may very well need the extrinsic written proof, witnesses and/or notarized, with a proper mailing receipt, to have the brokerage house carry out your wish.

CONCLUSION

As we stated at the outset of this article, retirement plans often comprise the largest portion of many estates. Therefore, owners of retirement plans and their financial and tax advisors must give special and careful attention to beneficiary designations.