Accommodation of Qualified Plans and IRA Interests

• Author: Jerold I. Horn
• Profession: Lawyer
• Pages: 419-512

419

Interests in individual retirement accounts (“IRAs”) and qualied plans, and the interface

between the interests and private trusts, affect millions of people and perhaps trillions of

dollars. Nevertheless, many years after the enactment of the governing statute, the rate at

which an interest is distributable to a private trust remains unclear in important respects.

The last change in the Code that materially affected the rate at which an interest is dis-

tributable to a beneciary was effective as of the beginning of 1984. See Code § 401(a)(9).

The IRS issued proposed regulations in 1987, modied them slightly at the end of 1997,

issued a new set of proposed regulations in January of 2001, and issued nal regulations

in April of 2002. The law, such as it is, consists mostly of Treasury regulations and pri-

vate rulings that purportedly have no precedential importance. Accordingly, essential

parts of the law remain relatively opaque as they apply to trusts as beneciaries.

Unless an interest in a qualied plan or IRA is payable to a “designated beneciary,” dis-

tribution of the interest after the death of the participant or owner cannot extend beyond

(i) if the participant or owner dies upon or after his or her required beginning date (that

is, usually April 1 of the calendar year after the calendar year in which the participant or

owner attains age 70½), the life or life expectancy of the owner or (ii) if the participant or

owner dies before his or her required beginning date, the ve-year period that concludes

at the end of the year that includes the fth anniversary of the death of the participant

or owner. Any longer period (that is, an extended period) of distribution is a function of

(i) the existence of a designated beneciary and (ii) if a designated beneciary exists, the

life expectancy of the designated beneciary who has the shortest life expectancy. Reduced

to its essentials, the uncertainty relates to whether, and to what extent, features that are

common to private trusts preclude the existence of a designated beneciary.

Virtually all of the features to which the uncertainty relates are central, not peripheral,

to why property owners create trusts. Without limitation, the features include

i. the ability of a trustee to use trust property to pay death costs,

ii. the discretion of a trustee to allocate trust property among dispositions,

16

Accommodation of Qualied

Plans and IRA Interests

Cha pter 16420

iii. the ability of a trustee to use trust property to benet a nonindividual,

iv. the ability of a trustee to distribute trust property to the estate of a beneciar y,

v.

the discretion of a trustee to distribute or accumulate income and to distribute

principal,

vi. the ability of a donee to appoint trust property, and

vii.

the ability of a trustee to retain trust property beyond the life expectancies of those

who are living at the creation of the trust.

The uncertainty emanates from the conuence of interests in IRAs and qualied plans,

on the one hand, and private trusts, on the other. Obviously, a lawyer can eliminate the

uncertainty by avoiding the use of trusts as beneciaries. However, for reasons that are

discussed in Part I, below, the writer rejects that solution.

PART ON E

INTEGRATION OF QUALIFIED PLANS

AND IRAS INTO THE ESTATE PLAN

Assuming that other things are equal, a rst objective is to integrate interests in qualied

plans and IRAs with other assets in the estate plan. A second objective is to defer income.

The rst objective is a short-hand reference to the objectives that a property owner seeks

to apply to his or her other assets. Except as indicated otherwise, “IRA” will serve as a

short-hand reference to any individual retirement account and any separate account in

a qualied plan, “Revocable Trust” will mean the revocable trust of the IRA owner, each

Revocable Trust will become irrevocable upon the death of the IRA owner, and each Revo-

cable Trust will serve administrative functions similar to some functions of a probate estate

and will be disposed according to its dispositive provisions. One focus of this chapter is

upon selected issues that relate to disposition of an IRA according to a revocable trust.

The most notable characteristics of qualied-plan and IRA interests are that (i) they

permit deferral of income for income tax purposes (and, thus, they permit income-tax-

deferred growth) until distribution and (ii) maximization of the period of tax-deferred

growth maximizes value. The most notable characteristics of Roth IRAs, a species of IRA,

are that (i) Roth IRAs avoid income for income tax purposes (and, thus, they permit income-

tax-free growth) and (ii) maximization of the period of tax-free growth maximizes value.

IRAs present difcult issues. A conict (or at least a tension) exists between (i) a rst

objective of integrating IRAs with most other assets in an estate plan and (ii) a second

objective of maximizing deferral of income from IRAs for income tax purposes or, in

the case of Roth IRAs, maximizing the duration of income-tax-free growth. Principles

that apply to IRAs (including, to a lesser extent, Roth IRAs) for income tax purposes

conict with principles that apply to IRAs and other assets for estate tax, gift tax, gener-

ation-skipping tax, and nontax purposes. The available planning reects choices (that

is, trade-offs) that are attributable to the tension.

421Accommodation of Q ualied Plans and IR A Interests

If a predeceasing spouse designates his or her surviving spouse as the primary ben-

eciary of IRA interests, and the surviving spouse rolls the IRA interests over to an IRA

of the surviving spouse, distributions after the death of the surviving spouse can occur

over the life expectancy of the eldest of the beneciaries of the surviving spouse. Thus, by

designating the spouse rather than a trust as the primary beneciary, the predeceasing

spouse can benet the surviving spouse and yet, compared to designating a trust instead

of the spouse as the named beneciary, enhance value for other beneciaries after pay-

ment of income tax. Absent the designation of the spouse and the roll-over, only the IRA

interests of the surviving spouse (that is, not also the IRA interests of the predeceasing

spouse) are subject to extended distribution.

As suggested in the preceding paragraph, the designation of a surviving spouse as the

primary beneciary can defer income optimally for income tax purposes. However, if the

other assets of the predeceasing spouse are insufcient, the designation of the surviving

spouse as the primary beneciary can reduce the use of otherwise-available exemptions

and, thus, can increase estate tax and generation-skipping tax. Portability can mitigate

this effect in the case of the United States estate tax. However, the exemptions for pur-

poses of the generation-skipping tax and the estate taxes of at least certain states are not

portable to a surviving spouse.

Income tax benets that result from the designation of the surviving spouse as

the primary beneciary can exceed any estate tax and generation-skipping tax detri-

ments. As mentioned, the United States estate tax exemption is portable from the

predeceasing spouse to the surviving spouse. Further, although the generation-

skipping tax exemption is not portable, any saving that results from it might not

occur for many years, if ever. Thus, a generation-skipping tax exemption might have

less utility than deferral of income. Additionally, although an estate tax exemption

of a particular state is not portable, the rate of a state estate tax generally is less than

the rate of income tax.

At least as applied to beneciaries other than rst spouses, the rst objective (that

is, integration) often is more important than the second (that is, deferral of income). If

trusts are vehicles of choice for other assets, perhaps they also are vehicles of choice for

interests in IRAs. Payment outright to a spouse might work little or no violence to val-

ues that are implicit in integration. However, payment outright to anyone other than a

rst spouse appears more likely to undermine the values.

If IRA interests pass to a trust, the planning will tend to accomplish the rst objective

but might not accomplish the second. If the IRA interests are payable directly to one or

more individuals outright rather than to a trust, the arrangement will tend to permit

accomplishment of the second objective but might prevent accomplishment of the rst.

The anecdotal experience of the writer is that nonlawyers (such as accountants, nan-

cial planners, trust ofcers, life insurance underwriters, and stockbrokers) who give

advice about IRAs tend to focus solely upon deferral and to ignore integration. This