Leaving retirement benefits to trusts: pitfalls for the unwary.

• Author: O'Connell, Frank J., Jr.

For high-net-worth clients, the assets within the client's retirement plan often constitute a significant portion of his or her net worth. Because of their tax-deferred status, these retirement plans are effective vehicles to provide for retirement, and they can be passed on to a surviving spouse and other heirs while maintaining their tax-deferred status. Designating a surviving spouse as beneficiary of a retirement plan is usually the preferred choice. However, there are a variety of reasons an individual may decide to leave his or her retirement plan benefits to a trust for the benefit of the surviving spouse--i.e., multiple marriages, dysfunctional families, a spendthrift spouse, or differing dispositive intentions of the retirement plan owner, to name a few.

Before advising clients in any of the above situations to leave their retirement plan benefits to a trust, advisers and their clients need to be aware of several pitfalls associated with this technique.

Designated Beneficiary

The first hurdle to consider is that the trust must qualify as a designated beneficiary. A trust that does not so qualify limits the deferral otherwise available to the plan benefits. If the participant dies before his or her required beginning date (RBD), the plan benefits will have to be completely withdrawn by December 31 of the year containing the fifth anniversary of the participant's death (the five-year rule). If the participant dies after the RBD, the plan payout will be over the hypothetical remaining single life of the participant using the less-favorable fixed-term method. To avoid these undesirable scenarios, it is important to properly draft the trust document so that it will meet the designated beneficiary requirements.

Regs. Sec. 1.401(a)(9)-4 spells out the five requirements the trust must meet to be considered a designated beneficiary:

* The trust must be valid under the laws of the state in which it is created;

* The trust must be irrevocable or will become irrevocable by its terms upon the death of the participant;

* The beneficiaries of the trust who are beneficiaries with respect to the trust's interest in the participant's benefits are identifiable from the trust instrument;

* All trust beneficiaries must be individuals; and

* Certain documentation must be provided to the plan administrator.

The most difficult part of testing the trust for designated beneficiary status is determining if all trust beneficiaries are individuals. In many cases, trusts are created to leave assets to other trusts upon the occurrence of some future event, such as the death of the surviving spouse. It is necessary to...