Ensuring that Inherited IRAs Benefit their Beneficiaries.

As we have discussed in previous posts, there are many forms of trusts used in the estate planning process. While many planning strategies have greater benefit to individuals with more complex financial situations today’s post addresses one form of stand-alone trust which can be very beneficial to a wide variety of clients.

An “IRA Trust,” is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing clients to create a situation where their beneficiaries can take advantage of their inherited benefits over their lifetime and enjoy extra protection from creditors and other potential problems.

The beneficiaries of the IRA Trust can be the same as those of the client's Living Trust. However, the distribution terms of an IRA Trust terms are often different from the Living Trust and frequently more restrictive in order to ensure that no matter what happens to the Living Trust assets, the IRA Trust assets will be available to help support children, grandchildren and other beneficiaries. Alternately, clients can use an IRA Trust to provide for a different group of beneficiaries than their Living Trust beneficiaries. For example, the Living Trust may benefit a second spouse while the IRA Trust has children and grandchildren as beneficiaries. Finally, an IRA Trust can help beneficiaries in more difficult or complex situations, such as beneficiaries who for any number of reasons are not prepared to handle large sums of money. In these situations, the IRA Trust Trustee can provide professional management of Trust assets, allowing the IRA assets to grow tax deferred, except for required distributions, and ensure that the beneficiaries do not waste those distributions.

Just like a Living Trust, the distribution provisions of an IRA Trust dictate how the beneficiaries receive distributions. One design option for an IRA Trust is the "conduit trust", under which the trustee has no power to accumulate plan distributions in the trust and must allocate any distribution received from the IRA or retirement plan to the beneficiaries. The conduit trust lessens the trustee’s ability to control the income but still allows control over principal distributions as necessary.

Alternatively, when it is desirable or necessary to impose greater control upon the dispersal of the Required Minimum Distributions (RMDs), an "accumulation trust" allows the trustee to hold the RMDs in trust for the beneficiary’s benefit. For example, if the beneficiary of the IRA Trust is special needs child, it is important to limit income distributions in order to avoid adversely affecting the beneficiary's right to receive state or federal benefits. It is important to remember however when using an accumulation trust that the federal government taxes income received from the IRA but not distributed to beneficiaries according to the potentially higher trust income tax rates.

Whether a client wants to provide for multiple generations, ensure a lifetime of income for a beneficiary in a difficult personal or financial situation, or simply ensure that different groups of beneficiaries receive the asset that provides them the greatest value, an IRA trust is an extremely useful tool for a wide variety of situations. Due to the complexities surrounding IRA and retirement plan distributions, it is important to work with experienced estate planning attorney familiar with those regulations in order for an IRA Trust to achieve a client's goals.

Matt

Planning for Charitable Gifts

Many clients wish to provide for their favorite charities in addition to their loved ones. While sometimes charitable giving is as simple as writing checks, with proper planning it is possible to make gifts to loved ones and charities in a manner that insures that each gains the greatest advantage from what they receive. 

As we discussed in our last blog, Arthur and Beth married after re-meeting each other after decades apart while volunteering with a favored charity. Their involvement with this organization continues to be a major part of their lives together and both of them wish to provide for the organization financially after their death. Thankfully, their lives apart resulted in a situation where both Arthur and Beth have the means to continue to save money during their retirement, despite rising costs in their lives, and therefore they should be able to fulfill their charitable inclinations without creating hardship for their surviving spouse. 

Both Arthur and Beth receive pensions from their former employers and this allowed them to delay receiving Social Security benefits and thus increasing the amount they receive from that benefit. Further, each benefited from wise investing after the death of their first spouse, giving them a sizable if not overly large nest egg. On top of these advantages, both Arthur and Beth have IRA accounts that they funded during their working years, and they now draw upon these accounts in the case of emergencies but otherwise only take the Required Minimum Distributions. While not everyone enjoys these advantages, Arthur and Beth were fortunate to have circumstances that allowed them to do so and now can take advantage of other strategies to help achieve their planning goals. 

Despite their financial stability, Arthur and Beth are unlikely to ever have an Estate Tax liability. This is especially true in light of the recent legislation that raises the exemption threshold for each of them to nearly $11 million. There are, however, other taxes that may impact their loved ones as they receive inherited assets; the most prominent of these is Income Tax. While most inherited assets will not have any related income taxation (or at least receive a stepped-up basis to limit potential taxation), when Arthur or Beth’s children receive distributions from an IRA inherited from their parent, those children will incur Income Tax liability at their individual rate on the funds distributed each year. This is a primary reason it is normally advisable to “stretch” inherited IRA distributions over the lifetime of a beneficiary. Arthur and Beth want to take another tactic with their planning, eliminating the potential tax liability and fulfilling a different goal.

Arthur and Beth have decided to name each other as the primary beneficiary of each of their IRAs, so that the survivor of them can roll over the account into their own IRA and continue to have access to those funds if needed after their spouse’s death. Each has then indicated that after the death of their spouse they will name their favored charity as the beneficiary of the remaining IRA assets, allowing those funds to pass to the charity. The benefit here is a substantial gift to a worthy charitable institution and the ability of the charity to take distributions from the IRA without incurring the Income Tax liability that an individual beneficiary would incur. It is worth noting that there are risks to this strategy as Arthur and Beth have structured their plan. 

By naming each other as the primary beneficiary of their IRAs, both Arthur and Beth risk their surviving spouse changing the contingent beneficiary designation from the charity of their choosing to another charity or even to other individuals. Arthur and Beth could avoid this risk by naming the charity as the primary beneficiary but they trust each other and feel it is important that the survivor of them have access to the IRA funds if necessary to address emergencies. It is important to note that this planning works with traditional IRA accounts, but is not generally advisable when dealing with Roth IRAs due to the differing tax consequences. 

As we continue to remind our readers, all of these planning opportunities arise due to working with experienced professionals, attorney, financial planners, and accountants who can guide you to success. None of the examples used in this blog are appropriate for every person and you should not attempt anything you read about here without consulting experts to avoid unanticipated (and costly) results.

Matt and Al

Planning for the Generations

In the previous blog we mentioned that our client, Edna, contemplated leaving gifts to her grandchildren that they would not receive outright until they reached retirement age. While Edna opted against this gifting option, other clients have seen value in restricting the distribution of gifts until beneficiaries attain physical, if not mental, maturity.

Harold is in his seventies and while he is now retired, he enjoys his time because he has significant investment income in addition to his Social Security. Harold’s investment income is sufficient to allow him the luxury of only taking the minimum distributions required by law from his IRA, allowing that account to continue to grow tax-deferred. Presuming that nothing changes, Harold will have the opportunity to provide for his loved ones after his death in a variety of ways.

Harold outlived two wives but was close with his own children, Isaac and Janice, as well as his stepchildren, Karen and Luke. While he wants to treat all four children equally, he recognizes that Luke has issues managing money, as evidenced by a recent bankruptcy. Additionally, Harold wants to provide for his grandchildren, but sees that each of them is at a different point in their lives and therefore it might not be appropriate to make gifts to them in the same manner. This sort of complex family situation is ideal for a Living Trust, because the Grantor (Harold) can divide assets as he sees fit and the successor Trustee has the responsibility of dispersing assets in the manner Harold chose.

In this case, Harold chose to divide the majority of his assets into four equal shares for the benefit of Isaac, Janice, Karen, and Luke. While the value of each of these shares is to be equal, the terms of distribution are not. Isaac, Janice, and Karen are to receive their shares over the course of five years, with the Trustee having the discretion to make distributions for their health, maintenance, or support if circumstances warrant. Luke’s share, in light of his ongoing bankruptcy, is to be held in trust with the Trustee having the authority to make distributions for Luke’s benefit, but not to distribute funds directly to Luke.

This difference in distribution terms will help to protect any inheritance Luke receives from garnishment by his bankruptcy proceeding, while still allowing Luke to benefit from the funds. Harold has provided that upon reaching age 65, Luke may receive whatever remains of his Trust outright. This additional restriction, lasting long beyond the current bankruptcy, helps ensure that as Luke gets older there will be  funds available for him in retirement. Due to the value of Harold’s trust, it is likely that there will be funds remaining at this time and Harold hopes that by 65 Luke will have the maturity to handle his own affairs.

To address Harold’s desire to provide for his grandchildren we established a separate “IRA Trust” that does not contain any assets during Harold’s lifetime, but the IRA Trust is named, in very specific fashion, as the beneficiary of Harold’s sizable IRA. The IRA specifically names sub-trusts created under the terms of the IRA Trust, each for the benefit of a particular grandchild, as a beneficiary. This designation, along with other terms that allow the IRA trust to comply with the law and regulations, allows the IRA Trust to serve as the beneficiary of the shares of Harold’s IRA while still using the separate ages of Harold’s grandchildren as the measuring ages for making the minimum distributions required under the law. As a result, each of Harold’s grandchildren, ranging in age from 30 to 12, will be treated slightly differently but all of them will benefit more from Harold’s IRA than if the IRA Trust did not exist.

First, the IRA Trust allows the Trustee to manage the assets and comply with laws, leaving the beneficiaries free to enjoy the boon from their grandfather. The IRA Trust also prevents a beneficiary from electing to take a large distribution from their inherited IRA without fully appreciating the consequences of that action. Finally, because the IRA Trust allows each beneficiary’s age to act as the measuring age for their required minimum distributions, the younger beneficiaries do not need to withdraw more funds in a year than necessary. This benefits the younger grandchildren by allowing more funds to grow tax deferred until age 65 when Harold has decided that his grandchildren will gain complete access to the funds.

Clearly, this level of complexity is not necessary for all clients but many clients like the idea of using particular assets to benefit certain beneficiaries and often there is a benefit to doing so in order to gain either tax savings or increased growth potential. The complexity of Harold’s plan is something that people should not attempt without consulting financial planners and attorneys experienced in complex estate planning as even simple errors in implementation may be very costly when it comes time to execute the plan.

Matt and Al

IRA Trusts as a Tool for Protecting Beneficiaries from Themselves

We all have clients who recognize their children's limitations and want to protect those children against their own shortcomings. These shortcomings may take the form of a drug or alcohol dependency, a gambling problem, or a spending problem. I once counseled a client who had two children who spent more than they made, often requiring my client to bail them out of financial trouble, as to how she could protect her children against themselves after she passed away. In addition, she wanted a portion of her estate held for the benefit of her grandson.

While this client had a number of assets, she had a particularly large IRA account. Because of her goals and the existence of this IRA account, I suggested the client set up an "IRA Trust".  An IRA Trust is a stand-alone trust, separate from a Living Trust, which acts as the beneficiary of IRAs or other retirement benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of stretching distributions of their inherited benefits over their lifetime, delaying taxation. Except for the required minimum distributions (RMDs), the IRA assets can continue to grow tax-deferred and protect beneficiaries against their own bad habits of misspending and mismanagement of money.

The IRA beneficiary designation specified that at the client’s death three separate sub-trusts would each be the beneficiary of one-third (1/3) of the IRA. This specific allocation allowed the Trustee to use each beneficiary's separate life expectancy to calculate the required minimum distributions, rather than the life expectancy of the oldest beneficiary of the trust. There was eight years difference in the daughters' ages, which allowed the younger daughter to take a smaller required distribution every year. This strategy was particularly beneficial to the grandson, who was only 13 at the time his grandmother passed away. This allowed the trustee to calculate his required distributions using 70 additional years of life expectancy, resulting in very small taxable distributions, thereby deferring tax.

We also designed the IRA Trust with different sub-trust provisions for each beneficiary. One daughter only would receive the greater of income earned by her sub-trust or the required minimum distribution. This restriction was always in force and that daughter could not accelerate any distributions. The second daughter, who was somewhat more responsible with her finances, also received the greater of income earned by her sub-trust or the required minimum distribution, but after three years was entitled to take up to 10% of the value of her sub-trust each year if she chose to request it. Finally, the share for the grandson was set up to provide for income and principal as needed, but if not used, remained in the trust for later use, such as education, purchasing a home, or starting a business.

Our client did express one final concern that her daughters would be unhappy with the limitations placed on them, but was comforted by the fact that by the time the children were aware of the restrictions she would not be in a position of having to listen to their complaints.

 Our client was somewhat less restrictive with distributions to her daughters from her Living Trust because she knew that even if the daughters spent those assets quickly, the terms of the IRA Trust still protected her daughters and grandson from completely running out of assets. The client was also able to make charitable distributions from her Living Trust without worrying that charitable beneficiaries would negate the "stretch out" of IRA distributions over the other beneficiaries' lifetime.

Clients are often reluctant to place restrictions on their children even if it is for their own good. It is often the difficult obligation of advisors to begin the discussion about ways to protect the beneficiaries from their own shortcomings and let the client eventually find comfort with specific strategies for protecting them. As with all estate planning strategies, careful consideration should be given not only to the relevant tax provisions, but also to understanding a client's true desires. 

Alan Ferrara and Matt Ferrara

Year End Charitable Gifting Strategies

As we discussed last week, many of our clients use this time of year to make annual gifts to family members. A number of those clients also plan their charitable gifting for the end of the year to take advantage of the deduction that such gifts provide against income tax liability. Some of our clients make direct cash gifts to their chosen charities, while others satisfy their charitable inclinations with gifts of property, such as artwork, real estate, or stock. These gifts allow them to deduct the charitable contributions, up to 50%, 30%, or 20% of their adjusted gross income, depending on the type of property contributed and the type of donee. Depending on the client’s financial situation, more advanced gifting techniques can provide greater benefit to both the client and the charity.

One of our clients, who will likely have some estate tax liability, uses Charitable Remainder Trusts (CRT) to maximize the value of her charitable gifts. The CRT stipulates that the client receives an annual payout of a percentage of the value of the trust during her lifetime, with charities receiving the remainder of the trust assets at her death. In addition to satisfying her charitable intentions over the long-term, she reduces her potential estate tax liability, obtains an income stream for her lifetime, and is eligible for an income tax deduction equal to the present value of the remainder interest, determined by using IRS tables. In her case, at age 70, a $1,000,000 transfer to a CRT with a 6% annual payout provided her with $60,000 of annual income for life, and give her a $466,370 charitable deduction.

Another client, who does not need additional current income, chose to take the opposite path and fund a Charitable LeadTrust (CLT). A CLT provides charities with an annual income stream for a period of time, with the remainder interest going to other beneficiaries. In this case, the client just sold a business, had a significant gain, and wanted a tax deduction in the year of sale. We set up the CLT to provide a 6% payout to charities for twenty years. At the end of twenty years, the remaining balance of the trust will be held for the benefit of his three children. This allowed our client to take an immediate charitable deduction of $2,124,000. In order to take the deduction in the year the CLT is funded, the taxpayer must report the income earned by the trust over the next 20 years, which our client was comfortable with because his income in future years would be much less than the current year. As with the CRT and additional benefit of a properly structured CLT is a reduction in the value of the client’s future estate tax liability.

Not all techniques require a long-term trust to facilitate gifting. One of our clients, knowing he was selling his business, sought advice regarding the best way to donate a portion of the proceeds to his favorite charities. To maximize funds received by the charities, we recommended that he donate a portion of the stock to a charitable trust set up for those charities. The trust then joined in the sale, received a portion of the proceeds tax-free, and distributed those proceeds to the charities. By contributing the stock first to the charitable trust and then having the charitable trust join in the sale, the charitable trust received the full amount of the proceeds without liability for income taxes. If the client had sold the stock first, he would have been liable for capital gains tax and there would have been fewer dollars available for the charitable contribution.

Finally, for those clients receiving distributions from an IRA, 2013 provides a unique opportunity. The tax rules provide that if a donor is at least 70 1/2 years of age, he or she can have the IRA distribute up to $100,000 per year directly to a charity and treat it as excludable from income. One of our clients, with a large IRA but little other available assets, has been using direct distributions from an IRA to charities for the last few years. This technique allows her to satisfy her chartable inclinations and reduce her own potential income tax liability. Unfortunately, due to a change in the law, 2013 is the last year this option is available.

There are a number of other creative ways to fund a client's charitable desires, provide them with income tax deductions, and limit liability for future estate taxes, but these techniques require proper planning. If any of your clients are interested in charitable gifting options for this year, they should consult with their advisors soon in order to provide sufficient time to implement strategies that maximize their charitable contributions.

Alan Ferrara and Matt Ferrara

Helping Clients with Their Homework

     Over the past year, we repeatedly referred to estate planning as an ongoing process requiring the participation of the attorney, client, and other affiliated professionals in order to achieve the best outcomes. Nowhere is this more evident than during the recent meeting with couple who have been long-term clients.

     Since the clients executed their documents in 2001, they have relied on us to inform them when the documents needed updating. Over the course of the last dozen years, much has changed in the clients’ lives, and we have kept their plan consistent with their goals. As we reached the end of the meeting and asked if the clients had any new assets that were not funded to their Trust, the husband, somewhat sheepishly, pulled out the funding instructions that they were given in prior meetings and said, "I know I was supposed to do something with this but I never really did. Is that important?" Because this has occurred with other clients, we now take an active role in the funding of our clients' Trusts. We work closely with our clients and there other advisors to insure that when the client leaves our office their assets are funded to their Living Trust.

     Upon discovering that the clients’ Trust owned little, we began discussing their assets, beginning with their real estate. In this case, the clients owned their home jointly. Historically when dealing with real estate most estate planning attorneys have advocated executing a quitclaim deed to a Living Trust but not recording that deed while both spouses are living. This strategy has resulted in many attorneys having filing cabinets full of unrecorded deeds. With the relatively recent adoption of the “quitclaim deed with reserved life estate to grantor”, more commonly known as the "ladybird deed”, unrecorded deeds are unnecessary. We prepared a ladybird deed for the clients’ residence so that they can continue to have the creditor protection of jointly owned property during their lifetime, and the property will automatically transfer to their Trust following the death of the second of them.

     Next, we looked at the clients’ mutual funds and other investments, with the goal to make sure that the clients' Living Trust was the titled owner of all of these accounts. By working directly with the clients’ financial planner we were able to obtain the forms needed to open a new account in the name of the clients' Living Trust, and completed them at our signing meeting. The clients actually had some mutual funds they purchased directly and we suggested they transfer these to their current planner, which the clients (and the planner) thought was a good idea. This allowed us to return the forms and a Certificate of Trust Existence to the planner, who then was able to the transfer of ownership to the Trust.

     We also reviewed the clients' beneficiary designations for retirement accounts and life insurance policies. For this particular client, both the 401(k) and life insurance policies named the wife as primary beneficiary but failed to name a contingent beneficiary in the event that the wife should predecease him. Again, we coordinated with the clients’ financial planner to have change of beneficiary forms ready at our signing meeting. These forms continued to name the wife as the primary beneficiary of the 401(k) plan account and then named the Living Trust as a contingent beneficiary. The new beneficiary of the life insurance policies was the Trust, because upon the death of the husband the wife had total control of the Trust.

     Initially the clients’ financial planner resisted naming the Living Trust as a beneficiary because he was aware of the general rule that required immediate distribution of retirement accounts if a nonperson was named as beneficiary of the 401(k). We made him aware of the important exception to that rule that allowed Trust beneficiaries to stretch distributions over the life expectancy of the oldest trust beneficiary if the Trust contained "see-through provisions", that allow the Trustee to stretch distributions from the 401(k) account over the lifetimes of beneficiaries of the Trust. By requiring that any IRA distributions pass through the Trust we were also able to protect one of the clients’ children, whose spending habits are of great concern to the clients, from electing to take their share of the IRA immediately or over a short period of time and spending it .

     Finally, we looked at the clients’ business interests. Recently the clients assisted one of their children by providing capital to open a small business. In exchange for the startup funds, the client was became a 50% owner of the business. The clients intended that their son would inherit any portion of the business the clients owned at their death, and not involve the other children in the business. To achieve this goal we prepared an Assignment of the L.L.C. interest to the Living Trust and added specific language in the Trust for distribution of that interest to the child in question.

     Trust documents and Trust funding go hand-in-hand. Because as planners we understand that many clients are unlikely to complete "homework assignments" that may be integral to the operation of their planning, it is incumbent on us to find ways to work together to make the process as simple as possible for our clients. For this reason, we strive to be as open and available to both our clients and their other advisors as possible so that we can ensure that the clients are receiving the greatest value from our services.

Alan Ferrara and Matt Ferrara

The Impermanence of Permanent Tax Changes

   While Congress may never pass many (or any) of President Obama’s 2014 Budget Proposals, there are a number of proposals in the President’s plan that would affect estate planning and bear watching. 

     The 2014 budget includes a proposal to restore the estate, gift, and generation-skipping tax (GST) rates and exemptions to their 2009 levels beginning in 2018. This would result in a top estate and gift tax rate and GST tax rate of 45 %, a $3.5 million estate tax applicable exclusion amount and GST exemption, and a $1 million gift tax exemption. 

     Another provision would require that all grantor retained annuity trusts (GRATs) have a minimum term of 10 years and some remainder value at the end of the term. This would greatly reduce the value of using a GRAT to pass value (including income) to other family members prior to death. 

     One proposal would affect the use of grantor trusts to transfer value and appreciation to other generations by treating as an incomplete transfer for gift and estate tax purposes a sale or exchange of property to a grantor trust deemed owned by the seller. 

     A fourth provision would limit using the GST exemption from the generation-skipping tax to a maximum of 90 years, where currently the protection is in perpetuity. Practically speaking this may not have much effect on the planning of most taxpayers but it is a significant theoretical cut back of protection. 

Other proposed provisions include: 

1. Requiring non-spouse beneficiaries of a decedent's IRA or retirement plan to take inherited distributions over no more than five years.
2. Limiting the amounts that can be contributed or accumulated within an IRA or qualified retirement plan to the amount necessary to provide the maximum annuity permitted for a tax-qualified defined benefit plan (currently $205,000).
3. Requiring that basis of property received by gift or from a decedent be determined consistently with the applicable gift or estate tax return. Currently there is no requirement that the recipient of a gift or bequest use the same value as that given to the gift or bequest under the applicable gift or estate tax return. For example, if the donor of the gift used a discounted value for gift tax purposes, the beneficiary can arguably use the full value of the asset in determining the basis and taxability for a sale of the asset.
4. Specifying that the GST exclusion for payments of medical and tuition costs applies only to direct payments by a donor to the provider of medical care or to the school in payment of tuition, and not to trust distributions. 

     While none of these proposals may find their way into estate planning law, they are a clear indication of the "impermanence" of the new "permanent estate tax law" passed late last year. It is important to be vigilant in reviewing what changes are possible and determine what steps might need to be taken to protect our clients.

Alan Ferrara

Leveraging IRA Accounts using Life Insurance

One interesting item in President Obama's latest budget proposal is limiting IRA accounts to $3 million, or some number calculated to purchase a maximum benefit of $205,000 at retirement. In addition to limiting the amounts that can be tax-deferred under IRAs, this would probably have the effect of minimizing the benefit of "stretch IRAs". While this idea may never be a part of the final budget it does bring to mind a planning option I have used with IRAs in the right circumstances.

Because IRAs eventually are generally fully taxable, a $3 million IRA, or even a smaller IRA, will be subject to significant income taxation. If the taxpayer's estate is above the $5 million lifetime exemption, the total tax burden on the IRA only gets worse.

If a client desires to maximize the amount going to their heirs, they may want to consider leveraging their IRA using life insurance. The strategy works as follows:

1. Presuming the client does not need IRA distributions to support their lifestyle, Instead of delaying IRA distributions until age 70 1/2, a client begins taking distributions after 59 1/2 when there are no longer penalties for early distributions.
2. After paying the income tax on the IRA distribution, the client gifts the remainder of the distribution to an Irrevocable Trust benefiting family members.
3. The Irrevocable Trust Trustee purchases a life insurance policy on the life of the client. After satisfying some legal requirements (Crummey Notices), the Trustee uses the funds to pay the annual premium of the life insurance policy.
4. At the death of the client, the Trustee collects the insurance proceeds, income tax-free, and uses them for the benefit of the client's family.

The client has succeeded in turning a heavily income (and possibly estate) taxed IRA account into a tax-free account, of significantly greater value, depending on the size of the insurance policy.

If the beneficiaries are minors or adults without a good record of handling money, the Irrevocable Trust can protect them from themselves and their creditors. If all of the beneficiaries are adults and the client is comfortable with their maturity, the client can simply make gifts to the family members who will then use it to purchase a life insurance policy on the client. Either way, the proceeds are income tax-free and, if properly structured, are not part of the client's estate.

The client can go a step further if he/she does not like the idea that the IRA benefits are going to be income and possibly estate taxable after death. The client and the client’s spouse can have full use of the IRA account during their lifetimes, and then provide that at the second death the IRA account be distributed directly to a charity, tax-free. The family members get their benefit, the charity gets its benefit, and the only entity that loses is the Internal Revenue Service.

Most of my clients are not inclined towards making significant charitable gifts, but with the right strategy, they love the idea that their loved ones are protected, they can satisfy any charitable inclinations, and the IRS is essentially paying for it. With proper planning and the help of qualified professionals, family members are better protected.

Alan Ferrara

Estate Planning for a Second Marriage

     Recently a colleague asked for information about the use of trusts in estate planning following a divorce and remarriage. Since we have not addressed this topic yet, a post on the subject seemed appropriate. It is important for client to consider estate planning issues following a divorce and remarriage to avoid inadvertently disinheriting either the new spouse or children of the first marriage. Clients (husband and wife) in their first marriage usually have common goals, such as providing for the surviving spouse during their lifetime and leaving any remaining assets to their children equally. This makes estate planning relatively simple, because a living trust holds the assets to limit tax liability, avoid probate, and ensure the assets pass to the surviving spouse for use during the spouse's lifetime and then on to the couple's children.

     Clients in second marriages, whether because of divorce or death, usually have a more complex situation with which to deal. In those circumstances there are concerns regarding the surviving spouse, children from the first marriage, the surviving spouse's children, and possibly children from the second marriage. Clients wish to ensure the surviving spouse has sufficient assets during lifetime, while also ensuring that the assets they brought into the marriage eventually pass to their children.

     A frequent concern of clients in their second marriage is ensuring that both their second spouse and their children receive gifts following the client's death. A common technique used to achieve this goal provides the surviving spouse with a regular stream of income from the trust assets, while reserving distributions of principal for the client’s children following the death of the surviving spouse. When using this technique, it is also common to provide the trustee with the discretion to make distributions of principal to the surviving spouse, under a limited set of circumstances, to ensure that the surviving spouse has sufficient assets to live on following the first spouse's death. It is important in these circumstances that the trustee understand that part of their responsibility is to balance the best interests of both the spouse and children from the first marriage in making distributions. It is a good idea for the client to discuss these issues with the named trustee.

     Alternatively, some clients opt to address this issue by distributing different assets to their surviving spouse and their children. For example, a trust might provide that the client’s children receive immediate distributions from the trust assets equal to the payout from a life insurance policy. The client may also provide that the children are beneficiaries of the client’s IRA or other retirement accounts. The trust then provides that the client's surviving spouse receive all income from the remaining trust assets, and gives the trustee broad discretion to make distributions of principal for the surviving spouse's needs. Any trust assets that remain following the death of the second spouse are distributed to the client’s children. This technique ensures that that the client’s children receive an immediate gift as well as the potential for additional assets should any remain after ensuring that the surviving spouse has sufficient assets during the their lifetime.

     A well-drafted trust is required to make use of these techniques because you need an entity maintain the trust assets instead of passing those assets directly to the surviving spouse. During a first marriage, a common technique for probate avoidance is to own property jointly with rights of survivorship. This allows the surviving spouse to remain the sole owner of the property following the first spouse's death without the property passing through probate. If this same technique is used following a second marriage, the surviving spouse becomes the sole owner of the property or bank account and then is free to do with that property whatever he or she chooses. This means that property the client intended for children to inherit following the second spouse's death could pass directly to the second spouse's children or family and completely disinherit the client's children from the first marriage.

     There is not always controversy about who inherits which assets. In many second marriages, spouses and their children from first marriages live in perfect harmony. Even in these circumstances, the spouses may wish to ensure that particular assets, such as vacation homes or collectibles, that each has brought into their second marriage are eventually inherited by their own children. With proper planning, it is possible to maintain these separate assets for both spouses’ use while ensuring that after the second death the assets will go to each spouse’s children, while assets earned jointly during the marriage are split equally amongst all the children.

     It is clear that the circumstances that exist when contemplating estate planning for a second marriage involve a level of complexity that generally does not exist when planning during a first marriage. These circumstances can become even more complex if either spouse’s children has special needs, dependency issues, creditor problems, or if there are significant personal conflicts between children and second spouses.  You may actually have a case where the new spouse has his or her own issues, which need to be addressed. An example of this occurs if the new spouse has an unpaid federal income tax liability and the spouse transfers a residence originally owned individually to the other spouse as joint tenants. Now the IRS can attach a lien to the residence. It is important to speak with an experienced attorney to ensure that the estate plan meets the goals of both spouses and is implemented with a minimum of conflict.

Other IRA Issues with Estate Planning

On Tuesday, I discussed funding retirement benefits to a Living Trust and some of the issues that may come about because of the funding. In response to that post I received a few comments and questions on related issues and thought it a good idea to expand on the topic in today's post.

The first comment talked about the opportunity of using a direct IRA beneficiary trust as well, to mandate a "stretch-out" of distributions and protect non-spouse beneficiaries from creditor claims. We discussed the IRA Trust in our post on November 20, 2012, but it is worthwhile discussing it again.  

The “IRA Trust”, is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement other benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of their inherited benefits over their lifetime. Using the IRA Trust allows the client to design a special trust specifically for the IRA assets and perhaps even for different beneficiaries then for the majority of the estate under the client's Living Trust. Except for the required minimum distributions (RMDs), the IRA assets can continue to grow tax-deferred and protect beneficiaries against their own bad habits of this spending in mismanagement of money. Additionally, if an IRA trust provides for more than one beneficiary, if the IRA beneficiary designation form specifies the percentage of the account that will go to a specific sub trust for each of the beneficiaries, each beneficiary can then use their own life expectancy in calculating the RMDs for a particular year.
     A second comment asked how one meets the "see-through" trust requirements when one of the trust beneficiaries is a charity or other non-individual beneficiary. When a client names non-individual trust beneficiaries, those beneficiaries can be "removed" as a beneficiary for the purposes of determining the “see through” status of the trust. To “remove” the non-individual beneficiary the trustee must either make a distribution of the amount allocated to that beneficiary or arrange for the beneficiary to disclaim their interest. The deadline for this “removal” is September 30 of the calendar year following the calendar year of the account owner's death (the "Beneficiary Finalization Date"). If this is accomplished, the regulations exempt the non-individual trust beneficiaries for purposes of determining individual beneficiaries.
One might ask why anyone would disclaim his or her interest in a Living Trust. In some cases an older beneficiary will disclaim their interest in the IRA assets of the trust, because it will allow the younger beneficiaries (perhaps grandchildren in their 20s) to extend the IRA distributions over the lifetime of the oldest life expectancy of that group. This is important because unless you eliminate the elder beneficiary, all of the beneficiaries must use the oldest beneficiary's life expectancy in calculating the RMDs. Alternatively, a charitable beneficiary may disclaim an interest in IRA assets in exchange for a larger immediate gift that it can invest or put to use immediately.

On a final note, if there are sufficient assets in addition to the IRA to protect loved ones, and the client is charitably inclined, client may want to consider designating one or more charities as the beneficiary of the IRA. This will satisfy their charitable inclinations will save significant income taxes because the IRA will not be subject to income tax when paid to the charity. This can save a large amount of tax, especially where the estate is taxable for estate tax purposes and then the IRA is taxed for income tax purposes as it is distributed to individual beneficiaries. Naming a charity as the IRA beneficiary excludes it from taxation for federal estate tax purposes and income tax purposes.

Again, it is important that a client discusses their desires with experience counsel prior to designating beneficiaries in order to protection of beneficiaries and minimize taxation of the account.

Funding Retirement Benefits to a Living Trust

As part of the trust funding process, I normally suggest that clients change the beneficiary designation of their IRAs and retirement benefits. Most of the time, I suggest that their spouse be the primary beneficiary and the Living Trust be the secondary or contingent beneficiary, because spouses receive better distribution rights under federal law with respect to retirement benefits. If the spouse predeceases the account owner, or if it makes sense for other reasons for the spouse to disclaim the retirement benefits, the benefits then fall to the Living Trust where, in all probability, the spouse remains the primary beneficiary and if the spouse has already died, the beneficiaries of the Living Trust become beneficiaries of the retirement benefit.

After contacting their financial professional, clients will often call me concerned because their financial professional warned them against designating the Living Trust as beneficiary of the retirement benefits because their children will not be able to "stretch out" the IRA over their lifetime, and the entire benefit will be taxable immediately. While this advice may be well meaning, it is often incorrect.

The Internal Revenue Code (the "Code") and Regulations provide that a "designated beneficiary" can use the provisions which allow a beneficiary to take minimum required distributions (MRD's) over their life expectancy. Normally, only an individual can be a "designated beneficiary", therefore a Living Trust ordinarily is not a "designated beneficiary" because it is not an individual. There is an exception to that rule and, if the trust document meets certain requirements, then the Living Trust is considered a "see-through" trust and the regulations treat the beneficiaries of the Living Trust as designated beneficiaries of the decedent's retirement account. To achieve “see through” status, the Living Trust must meet the following requirements:

1. The trust is a valid trust under state law, or would be but for the fact that there is no corpus.
2. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the account owner.
3. The beneficiaries of the trust with respect to the trust's interest in the employee's benefit are identifiable from the trust instrument
4. Required documentation has been given to the Plan Administrator. The Plan Administrator must receive a copy of the trust instrument and a list of all beneficiaries of the trust with a description of the conditions on their entitlement.

If the trust meets all the requirements then the Living Trust beneficiaries are deemed “designated beneficiaries", entitled to receive their MRDs over their life expectancy.

The next issue when a Living Trust is the beneficiary of IRA benefits usually arises at the account owner's death. At that point, clients want to know whether the beneficiaries can split the “inherited IRA” into separate IRAs and make their own decisions about how distributions are made. Generally, "inherited IRAs" received by beneficiaries other than a surviving spouse, cannot be rolled over to their own IRA, but the account can be split into separate IRAs for the trust beneficiaries using the designation "John Doe IRA for the benefit of Beneficiary A", etc. Beneficiaries can then decide the manner in which they want their IRA distributed. One beneficiary may take a lump sum distribution, pay the tax and invest or spend the rest. Alternatively, a beneficiary can decide to take MRD's over their designated life expectancy, deferring income tax until future distributions are made.

Along with the question of splitting an “inherited IRA”, is the question of whether the MRD's are based on each beneficiary's own life expectancy or on the life expectancy of the oldest beneficiary.

Regulations §1.401(a) (9)-8, A-2 provides the general rule that if the account owner's benefit is divided into separate accounts no later than the last day of the year following the calendar year of death, distributions subsequent to the division are treated as separate accounts and each beneficiary of each separate account can use his/her own life expectancy in determining minimum required distributions each year. However, this rule does not apply to beneficiaries receiving a "separate share" through a trust that was the beneficiary of an IRA. Therefore, even if beneficiaries split the IRA into separate accounts for each beneficiary, all the beneficiaries must use the life expectancy of the oldest beneficiary of the Living Trust in determining their MRD's.

The law and regulations governing “inherited IRAs” is both vast and complex, before designating beneficiaries of retirement benefits, you should consult with a professional expert in that area. At the death of the account owner, it is important to seek additional advice as to the best way to retitle the accounts or distribute the assets. These experts should take the time to understand your unique situation and provide you with an understanding of the consequences of decisions, not just provide you with the forms needed to make changes.

Dying with Debt

Up to this point, Plainly Legal has focused on topics dealing with the transfer of wealth, either through lifetime gifts or at death. Today's blog takes a detour to discuss the question of what happens with a person's debt when they die. Recently, a friend contacted me with a question about information she received from someone at her bank when she attempted to designate beneficiaries for her bank accounts. This bank employee (I did not ask which bank or the job title of the employee) told her that she should not designate a beneficiary because, if she were to die with debt that debt would then pass to her loved ones. Before continuing with today’s blog, it is important to emphasize:

THAT STATEMENT IS SIMPLY NOT TRUE.

The good news is that personal debt is non-inheritable. If a person incurs debt during their lifetime, the beneficiaries of the person’s estate, no matter if they are beneficiaries through a Will, Trust, or the Intestacy Statutes, are not personally liable for any debt left behind. This does not however mean that debt disappears at death.

When a person with personal debt dies, that person's debt becomes the liability of the person's estate. Creditors are then free to try to collect on that debt from the estate. It is the responsibility of the Personal Representative (and Trustee) to pay the enforceable debts of the deceased prior to making distributions to the beneficiaries. To ensure that creditors receive payment prior to making distributions beneficiaries, the Michigan Probate Code mandates that the personal representative of the estate is required to publish a death notice (to inform unknown creditors) and provide notice to known creditors. Those creditors then have four months to present their claims to the Personal Representative. After the four-month window, with some exceptions, the probate statute bars creditors’ claims against the estate.

When a creditor makes a claim against an estate it is the responsibility of the personal representative to determine if the claim is valid and, if so, to provide payment to the creditor. While the personal representative is responsible for making these decisions, they do so in a fiduciary capacity and upon determining that a claim is valid, pay the claim with the estate's assets. Absent extraordinary circumstances, the personal representative is never personally liable to pay the debts of the estate they represent. The practical result of this situation is that a personal representative may determine that a creditor’s claim is valid, but the estate lacks the assets to pay the debt. In that situation, neither the personal representative nor any beneficiaries of the estate become personally liable for the unpaid debt.

At this point, it is important to address a number of minor exceptions to these rules, the largest of which being that the four-month claim window becomes a three-year window if the Personal Representative fails to properly publish notice of the death or fails to inform a known creditor of the death (a "known creditor" is a creditor that's existence is known or reasonably discoverable by the personal representative). A second common exception is that the four-month claim window does not apply to any form of secured debt, such as a lien or mortgage. In almost every circumstance, the holder of a secured debt has the right to enforce their security agreement and take possession of the property in which they have a security interest. For example, a bank may repossess a house that is subject to a mortgage owned by the bank if the estate is unable to make payments on the bank’s loan.

Since probate law requires that creditors receive payment prior to distributions to almost all beneficiaries (there are exceptions for a limited number of distributions to a surviving spouse and minor children), it is possible that the estate assets can be exhausted before a beneficiary receives anything from the estate. In the event that the debts of an estate exceed the estate assets the beneficiaries receive nothing, however those beneficiaries do not incur liability for unpaid debt because of their status as beneficiaries.

While it is the responsibility of the estate to pay the deceased's debts prior to making distributions there are certain assets that are never accessible to the creditors of the estate, including retirement benefits and life insurance proceeds. While creditors cannot attach the assets of a person’s IRA in order to recover debt, once a person receives a distribution from the IRA, creditors can attempt to recover those funds if the person deposits them in a bank or other financial institution. When the owner of an IRA dies with debt the distributions to the beneficiaries of an inherited IRA are protected from the original owner’s creditors. This is true even if the IRA beneficiary is a Trust or the estate.

 We now reach the situation my friend encountered on her trip to the bank. Unlike IRA accounts, beneficiary designations on bank or investment accounts do not enjoy the same protection from the original owner’s creditors. While a beneficiary designation causes those accounts to pass directly to the individual named in the designation, such designations do not limit the rights of creditors of the previous owner. This does not mean that someone named as the beneficiary of a bank account becomes liable for the original owner’s debts. In practical terms this means that a creditor can recover assets in a bank or investment account transferred via beneficiary designation, but that creditor still may not recover in excess of the assets transferred from the deceased individual.

Substantial debt is an understandable concern for many people these days. It is important to remember that when you or your loved ones die, personal debt generally becomes the responsibility of the deceased person’s estate, for the Personal Representative to pay before making distributions to other beneficiaries. Payment of these debts can consume the assets of an estate, but in that circumstance the beneficiaries are not liable for debt in excess of the estate’s assets.

 It is just as important to consult reputable source when dealing with debt as it is when making decisions regarding other planning. While employees of financial institutions may seem like knowledgeable sources of information, you should be aware that not every employee receives the same training. If you have doubts as to the accuracy of information you receive, ask to speak with a manager, contact your attorney for a second opinion, or send us a message and we will attempt to address your issue, directly or in an upcoming blog. 

The Benefits of an IRA Trust

As we have discussed in previous posts, there are many forms of trusts used in the estate planning process. A special type of trust, known as an “IRA Trust,” is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of their inherited benefits over their lifetime.

While there is nothing barring a Living Trust from being the beneficiary of an IRA, due to the regulations that govern the distribution of retirement benefits it may be difficult if not impossible to take advantage of the most beneficial distribution rules or provide for a lifetime distribution of benefits using only a standard Living Trust. For example, if the Living Trust beneficiaries include charities the Living Trust will not qualify as an "individual beneficiary" and thus the non-charitable beneficiaries will not benefit from the ability to “stretch out” the IRA benefits. In addition, if the Living Trust benefits elderly relatives, the shorter life expectancy of those relatives limits the ability to stretch out distributions and delay or defer income taxation for younger beneficiaries because the regulations base MRD on the life expectancy of the oldest beneficiary. The provisions of an IRA Trust avoid these problems and ensure that the IRA Trust’s beneficiaries enjoy the greatest benefit from their inherited asset.

The beneficiaries of the IRA Trust can be the same as those of the client's Living Trust. However, the distribution terms of an IRA Trust terms are often different from the Living Trust and frequently more restrictive in order to ensure that no matter what happens to the Living Trust assets, the IRA Trust assets will be available to help support children, grandchildren and other beneficiaries. Alternately, an IRA Trust can divide assets between different groups of beneficiaries. For example, the Living Trust may benefit a second spouse while the IRA Trust has children and grandchildren as beneficiaries. Finally, an IRA Trust can help beneficiaries in more difficult or complex situations, such as beneficiaries who are:

1. Spendthrifts and unable to handle money
2. Children with addictions
3. Children with creditor issues
4. Children with bad marriages
5. Special care needs children, including those who qualify for government benefits
6. A surviving spouse who is  unable to say no when children ask for money

In these situations, the IRA Trust Trustee can provide professional management of Trust assets, allowing the IRA assets to grow tax deferred, except for required distributions, and ensure that the beneficiaries do not waste those distributions.

If there are multiple beneficiaries, IRA Trusts are drafted and coordinated with the beneficiary designation of the IRA to allow each of the beneficiaries to use their own life expectancy in determining the minimum required distributions. For example, the beneficiary designation after the death of the client should read as follows: “50% to the sub trust for the benefit of Jane Doe under the John Doe IRA Trust.” With proper drafting, an IRA trust can provide not only for children, but grandchildren and beyond, allowing multiple generations to take advantage of the IRA benefits. In those circumstances, the IRA Trust is often known as a "Dynasty Trust" because it can provide for multiple generations.

Just like a Living Trust, the distribution provisions of an IRA Trust dictate how the beneficiaries receive distributions. One design option for an IRA Trust is the "conduit trust", under which the trustee has no power to accumulate plan distributions in the trust and must allocate any distribution received from the IRA or retirement plan to the beneficiaries. The conduit trust lessens the trustee’s ability to control the income but still allows control over principal distributions as necessary.

Alternatively, when it is desirable or necessary to impose greater control upon the dispersal of the RMD, an "accumulation trust" allows the trustee to hold the RMD in trust for the beneficiary’s benefit. For example, if the beneficiary of the IRA Trust is special needs child, it is important to limit income distributions in order to avoid adversely affecting the beneficiary's right to receive state or federal benefits. It is important to remember however when using an accumulation trust that the federal government taxes income received from the IRA but not distributed to beneficiaries according to the potentially higher trust income tax rates.

Whether a client wants to provide for multiple generations, ensure a lifetime of income for a beneficiary in a difficult personal or financial situation, or simply ensure that different groups of beneficiaries receive the asset that provides them the greatest value, an IRA trust is an extremely useful tool for a wide variety of situations. Due to the complexities surrounding IRA and retirement plan distributions, it is important to work with experienced estate planning attorney familiar with those regulations in order for an IRA Trust to achieve a client's goals.

2012 Tax Planning - Splitting Inherited IRAs

For individuals who inherited a share of an IRA from an IRA owner who died in 2011, December 31, 2012 is an important deadline. This is because the regulations that govern distributions from inherited IRAs require that beneficiaries make decisions regarding the division of inherited IRAs on or before December 31 of the year following the death of the IRA owner. When there are multiple beneficiaries for an inherited IRA, splitting the IRA account into separate accounts for each of the beneficiaries has the potential to yield important tax and investment benefits.

Death beneficiaries of an IRA must take distributions from the IRA either (1) fully within five years or (2) in annual distributions over their life expectancy. The regulations that govern IRA distributions require that, whether the IRA owner died before or after his required beginning date (generally age 70 1/2), if the IRA owner was older than the beneficiaries, the remaining IRA balance is paid out over the remaining life expectancy of the beneficiary. Generally, when there are multiple beneficiaries of a single IRA, those beneficiaries must use the life expectancy of the oldest amongst them (i.e. the shortest life expectancy) when calculating the Required Minimum Distributions (RMDs). This requirement places younger beneficiaries at a disadvantage because the inherited IRA makes larger annual distributions over a shorter time, triggering potentially greater income tax liability.

For example, John designated his children, Bill and Mary, as equal beneficiaries of his IRA. John dies in 2011 at the age of 75 when Bill is age 55 and Mary is age 40. Under the default scenario, Bill's life expectancy dictates the RMDs for both Bill and Mary. Presuming they each are entitled to $500,000 from the account, in the first year the RMD using Bill's life expectancy is almost $17,000. If Mary could calculate the distribution using her life expectancy, her initial distribution would be only about $11,500. The size of the distributions will only accelerate as Bill gets older.

Fortunately for those younger beneficiaries, if they take advantage of the distribution regulations in a timely manner, they can split the IRA into separate accounts and the RMD rules will apply separately to each account. Following the split, each beneficiary will use their own life expectancy in determining the RMDs. Thus, Mary’s required distributions will be smaller than if she were required to use Bill's life expectancy. In addition, Mary would also have more freedom to invest her portion of the IRA, as her investment philosophy is likely to be more aggressive than Bill’s due to the difference in their ages.

In order to take advantage of this opportunity, recent IRA beneficiaries must direct the IRA trustee to split the inherited IRA into separate and equal IRAs no later than December 31, 2012, making each individual the sole beneficiary of their share of the IRA. Additionally, the trustee must allocate all post-death investment gains and losses for the period before the establishment of the separate accounts to each account on a pro rata basis in a reasonable and consistent manner. After establishing separate IRA accounts, each account owner can provide for separate and distinct investments depending upon the needs of the beneficiary's with gains and losses from the investment of the account allocated only to that account.

Time is running out for the beneficiaries of IRAs inherited in 2011 to make this decision. It is important that beneficiaries and their financial advisors communicate regularly to ensure the ability to take advantage of opportunities such as this. The law governing IRA distributions is both long and complex. This article addresses only the potential to split inherited IRAs into separate accounts for each beneficiary, if you have additional questions or concerns regarding IRA distributions please feel free to leave us a comment, send us an e-mail or call us.