Virginia State Bar

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Trusts and Estates

A Section of the Virginia State Bar.

Summer Newsletter 2016

Newsletter - Trusts and Estates

Volume 22, No. 14

Moving Beyond Grandpa’s Pension:
Estate and Tax Planning with Retirement Benefits
By Michelle L. Evans

There was a time when most clients’ retirement benefits consisted solely of defined benefit plans administered by employers from which the client formally retired.  Typically, by virtue of the terms of such plans and the elections made by the employee, the employee received an annuity for life and a portion of such payments would continue for the benefit of a surviving spouse.  In many cases, the employee’s elections were irrevocable and, therefore, could not be changed to adapt to the client’s evolving estate planning goals.  Accordingly, there was little, if any, opportunity for the estate planning attorney to adjust the disposition of a client’s retirement benefits to fit within the recommended estate plan.

Times have changed—and clients’ retirement benefits are no exception.  Today, most clients have several employer-provided defined contribution plans (e.g., 401(k) plan) and Individual Retirement Accounts (IRAs), in which the client has greater flexibility in naming and changing beneficiaries from time to time.  The client retains vested benefits in a defined contribution plan even if the client changes employers without retiring.  As a result, retirement benefits make up an increasing percentage of each client’s net worth.  For these reasons, the disposition of retirement benefits deserves specialized attention when developing and implementing the client’s estate plan.

The purpose of this article is to provide a broad overview of some of the issues to watch for when planning with retirement benefits and some of the planning opportunities that can be maximized with retirement benefits.

Confirm the Details

Before the estate planning attorney can properly advise the client regarding how the client’s retirement benefits fit within the estate plan, it is important to identify the types of plans involved and the current beneficiaries of such benefits. 

Type of Retirement Benefits

In an era where clients have a diverse array of retirement benefits, it is important to identify the types of benefits that need to be addressed within the client’s estate plan.  The planning opportunities and recommendations may differ depending upon whether the retirement benefit is a qualified plan covered by the Employee Retirement Income Security Act of 1974 (ERISA)1 (e.g., most 401(k) plans) or a non-covered plan (e.g., most IRAs), whether the retirement account is designated as a “traditional” retirement account or a Roth retirement account, and whether the retirement account is the client’s own retirement account or an inherited account.  The type of plan will inform the estate planning attorney about numerous factors that must be considered, including, but not limited to: (i) whether the married client can unilaterally change the primary beneficiary of the client’s retirement plan to a beneficiary of the client’s choice2; (ii) whether the client or the client’s beneficiaries will incur income tax on distributions from the retirement account3; and (iii) whether the plan documents or prior events have already established the distribution schedule for the benefit independent of the client’s choice of beneficiary.4

Current Beneficiaries

In order to determine whether the client’s beneficiary designations need to be updated, the estate planning attorney will often want to know who the client currently has named as the primary and contingent beneficiaries of all retirement benefits.  Asking the client about the beneficiary designations is an obvious first step; however, the client may only consider the beneficiary designations for retirement plans when starting a new job, changing the custodian of the retirement account, or upon a significant life event (such as marriage or birth of a child).  As a result, the client may not accurately recall whom the client has named as the beneficiaries of each retirement plan.  For example, the client may have forgotten to remove a former spouse as primary beneficiary on an IRA, specifically named the oldest of several children as contingent beneficiary on a retirement plan without updating the beneficiary designation as additional children were born, or failed to return the beneficiary designation form to the plan administrator or account custodian resulting in no named beneficiary at all.  For these reasons, it is advisable for the estate planning attorney to assist the client with naming new beneficiaries or request that the client provide the estate planning attorney with copies of the beneficiary designations on file with the plan administrator or account custodian.

Think Outside the Will and Trust

When developing a client’s estate plan, the estate planning attorney puts a considerable amount of thought into crafting the dispositive provisions of the client’s Last Will and Testament and Revocable Trust (the “testamentary documents”).  After dedicating so much time and effort to the terms of the client’s testamentary documents, the estate planning attorney may be inclined to apply the same terms to the client’s retirement benefits.  For example, if the client’s testamentary documents distribute all assets to a Marital Trust for the benefit of the surviving spouse, the Marital Trust seems like the obvious choice for the primary beneficiary of the client’s retirement benefits. 

Before carrying the same dispositive provisions from the client’s testamentary documents through to the client’s retirement benefits, the estate planning attorney should pause to consider whether the unique income tax aspects of the retirement benefits warrant treating such assets differently within the overall estate plan.  For instance, there are special rules that apply to a surviving spouse as the beneficiary of many retirement benefits.  Most important, the surviving spouse usually has the unique option to rollover benefits into a retirement account in the surviving spouse’s own name.5  This rollover option is significant because it will generally allow the surviving spouse to continue to delay required minimum distributions from the account until the surviving spouse would otherwise be required to take such minimum distributions (e.g., age 70 ½) and allow the surviving spouse to calculate the required minimum distributions over a longer distribution period, thereby deferring the recognition of income on such assets.6   In certain circumstances, these income tax benefits could outweigh the other considerations that led to the use of a Marital Trust for the client’s other assets—which is why the disposition of the retirement benefits should be analyzed separately.7

Charitable Planning Opportunities

Taxable retirement benefits (i.e., non-Roth accounts) can be particularly valuable assets to use to satisfy a client’s charitable intentions both during life and at death.

Qualified Charitable Distributions

In 2015, Congress enacted the Protecting Americans from Tax Hikes (PATH) Act of 2015, which permanently extended the qualified charitable distribution (QCD) rules.8  The QCD rules allow taxpayers over age 70 ½ to transfer up to $100,000 directly from an IRA to a public charity.9  Under the QCD rules, the qualifying distribution from the IRA is not included in the taxpayer’s income, but the distribution counts toward satisfying the taxpayer’s required minimum distribution for the year.10  

Although the QCD adds another income tax planning tool for taxpayers with charitable intentions, several commentators have noted that charitable donations of appreciated securities are still likely to produce a greater income tax benefit for most taxpayers.11  For the estate planner, however, the QCD provides an opportunity to achieve significant income tax benefits both during life and after death.  If the client continues to retain the appreciated securities until death, the client’s beneficiaries will generally enjoy a basis adjustment that eliminates the unrecognized gain on the securities.12  Conversely, the assets within the traditional IRA will not receive a basis adjustment at the client’s death and the client’s beneficiaries will ultimately be required to pay income tax on the distributions they receive from the IRA.13  Accordingly, in an environment of higher estate tax exemptions—where clients are increasingly more interested in achieving a basis adjustment for their beneficiaries at death—the QCD can be a valuable estate planning tool.

Charities as Beneficiaries of Retirement Benefits

Many clients wish to leave money to charity at death.  In some circumstances, a specified amount is set aside for charitable beneficiaries and in other cases charities are the primary beneficiaries of the client’s estate plan.  In either case, the estate planning attorney should consider whether there is an opportunity to use the client’s taxable retirement benefits to satisfy such charitable bequests. 

Using retirement assets to satisfy charitable bequests while leaving other assets to non-charitable beneficiaries generally results in greater overall tax savings.  The amount distributed to charity qualifies for the estate tax charitable deduction regardless of whether the distributed assets are retirement benefits or non-retirement assets.14  The tax planning opportunity arises from the income tax consequences associated with the choice of assets used to satisfy charitable bequests.  If taxable retirement benefits are left to non-charitable beneficiaries, the beneficiaries may be able to defer some of the income tax liability, but will ultimately be required to pay income tax on any distributions received from the retirement asset.15  Conversely, if the retirement account is paid directly to a charitable beneficiary, the benefits are included in the charity’s income16 and avoid income taxation by virtue of the charity’s income tax exemption.17  As a result, the client is able to provide the full intended benefit to the charitable beneficiary while preserving non-income tax producing assets for the client’s other beneficiaries.

Although using retirement benefits to satisfy charitable bequests is simpler when charity will benefit from a significant portion of the client’s estate, the estate planning attorney should not automatically foreclose the possibility of using retirement benefits to satisfy pecuniary or fractional bequests to charitable beneficiaries.18

Follow Through

The hard work done to identify the ideal beneficiaries for the client’s retirement benefits becomes irrelevant unless those beneficiaries are properly identified on the beneficiary designation form, the completed beneficiary designation form is submitted to the plan custodian, and the custodian processes the change. 

Complete the Beneficiary Designation Form

The estate planning attorney should take an active role in completing the client’s beneficiary designation forms for retirement benefits.  Beneficiary designations can be complicated, particularly if trusts are being named as beneficiaries.  Even if the desired beneficiary designation is not particularly complicated (e.g., outright to descendants), the change of beneficiary form provided by the plan administrator or account custodian might have specific procedures that have to be carefully followed (e.g., check a separate box to have assets pass “per stirpes” to a deceased beneficiary’s descendants) to ensure that the benefits pass in accordance with the client’s wishes.

Just as the estate planning attorney would not recommend that the client draft the testamentary documents, the attorney should not expect the client to complete the beneficiary designation forms for retirement benefits as these forms can dispose of a significant portion of the client’s wealth.  Ideally, the client will provide the attorney with all of the relevant change of beneficiary forms and the attorney should complete each form for the client’s signature.  In the alternative, the attorney should provide the client with sample language to be inserted on or attached to the client’s change of beneficiary form.

Submit Signed Beneficiary Designation Forms

To be effective, the completed beneficiary designation form must be properly signed and submitted to the plan administrator or account custodian.  If the estate planning attorney was able to obtain the change of beneficiary form and complete the form for the client’s signature, the attorney should take the extra step of submitting the form to the plan administrator or account custodian so that the form is not forgotten amongst the pile of papers constituting the client’s updated estate plan.  Otherwise, the estate planning attorney should send the client a written reminder to submit the completed beneficiary designation form and obtain confirmation of the change from the plan administrator or account custodian.

Conclusion

Estate and tax planning with retirement benefits is far more complicated now that we have moved beyond just dealing with Grandpa’s pension; however, it also presents the estate planning attorney with the opportunity to maximize the use of such assets within the client’s estate plan.

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Michelle L. Evans is an associate at McArthur Franklin PLLC in Washington, DC.  Ms. Evans assists clients with creating estate plans to achieve their personal and financial goals.  She also advises fiduciaries with respect to estate and trust administration in Virginia and the District of Columbia.  Ms. Evans is a graduate of Washington and Lee University School of Law in Lexington, Virginia, where she was a senior articles editor for the Washington and Lee Law Review.

Endnotes


1Pub. L. No. 93-406, 88 Stat. 829 (1974).  ERISA was amended by the Retirement Equity Act of 1984 (REA).  Pub. L. No. 98-397, 98 Stat. 1426 (1984).  Together, these laws set minimum requirements that employers must comply with regarding private employer-sponsored retirement plans and provide important protections for such plans. 
 

2For plans that are covered by ERISA/REA, certain changes affecting the designation of the primary beneficiary require the consent of the participant’s spouse if the participant is married.  See, e.g., I.R.C. § 417(a)(2).

3Roth retirement accounts (including Roth IRAs under I.R.C. § 408A and qualified Roth contributions under I.R.C. § 402A) are retirement accounts for which the taxpayer does not receive an income tax deduction upon contribution, but accruals and withdrawals (subject to certain limitations) from the account are not includible in the taxpayer’s (or beneficiary’s) gross income.  I.R.C. § 402A(c), (d); I.R.C. § 408A(c), (d).

4Some plan documents may require a lump sum distribution or set the distribution period preventing the beneficiary from “stretching” payments over the beneficiary’s life expectancy.  In other circumstances, the characterization of the retirement benefit will indicate to the estate planning attorney that a distribution period has already been set.  For instance, if a client has an inherited IRA from a non-spouse, the applicable distribution period was set at the time the client inherited the IRA and that applicable distribution period will continue regardless of the identity of the successor beneficiary.  See Treas. Reg. § 1.401(a)(9)-5, Q&A-7(c)(2) (made applicable to IRAs by Treas. Reg. § 1.408-8, Q&A-1(a)).

5See, e.g., I.R.C. § 402(c)(9) (relating to qualified plans); Treas. Reg. § 1.408-8, Q&A-5(a) (relating to traditional IRAs); Treas. Reg. § 1.408A-2, Q&A-4 (relating to Roth IRAs).

6Natalie B. Choate, Life and Death Planning for Retirement Benefits 208–09 (7th ed. 2011).

7See, e.g., id. at 225–27 (describing the income tax benefits that are sacrificed when retirement benefits are paid to a trust for the benefit of the surviving spouse).

8Pub. L. No. 114-113, Division Q, Title I, Subtitle A, Part 2, § 112.  The QCD rules were introduced in the Pension Protection Act of 2006, but were set to expire in 2008 and were only temporarily renewed for several years.  See Pub. L. No. 109-280, § 1201, 120 Stat. 780, 1064 (2006); I.R.C. § 408(d)(8)(F).  Under the PATH Act, these rules are now permanent.

9I.R.C. § 408(d)(8).

10Id.

11Tim Steffen, Qualified Charitable Distributions Not Always the Best Way to Give, InvestmentNews, Jan. 4, 2016, available at http://www.investmentnews.com/article/20160104/FREE/160109988/qualified-charitable-distributions-not-always-the-best-way-to-give; Michael Kitches, Donating Appreciated Securities Vs Qualified Charitable Distributions (QCDs), Jan. 31, 2013, available at https://www.kitces.com/blog/mailbag-is-a-qualified-charitable-distribution-qcd-from-an-ira-better-than-donating-appreciated-securities/.

12I.R.C. § 1014(a).

13See id. § 1014(c) (“This section shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under section 691.”).

14Id. § 2055(a)

15Id. § 691(a).

16Id. § 691(a).

17Id. § 501(c).

18See Choate, supra note 6, at 484–87 (discussing the use of retirement benefits for satisfying such bequests and tips for avoiding pitfalls that may arise in such circumstances).