The Use of Disclaimers for Flexibility in Planning for Qualified Retirement Assets
Estate planning attorneys prepare wills and trust agreements for the purpose
of minimizing federal estate tax. The most common plan for a married couple involves the preparation of a credit shelter trust and marital deduction trust for both husband and wife. This is commonly known as an AB plan. The AB plan allows the couple to presently use two unified credits1 and shelter up to $1,300,000 following the death of the second to die.
Once the plan is prepared, the attorney will then work with the couple to fund their estate plans. This process requires the clients to retitle their assets and redesignate their insurance policies and qualified retirement assets.2 In most situations, the couple will need to determine the primary and contingent beneficiaries of their qualified retirement assets. The couple’s nonqualified retirement assets3 will determine the importance of the beneficial designation for the qualified retirement assets. If the couple has nonqualified retirement assets that exceed twice the unified credit, then the beneficial designation is less important. If the couple does not have nonqualified retirement assets that exceed twice the unified credit, then the beneficial designation is more important.
This article will discuss the prototype estate plan for couples that have assets that exceed one unified credit which include qualified retirement assets. The article will then discuss the estate tax and income tax issues as they apply to the qualified retirement assets. The article finally will propose the best method to designate the beneficiaries of the qualified retirement assets in order to maximize both income tax and estate tax planning.
Disclaimer
A disclaimer is a tool used by estate planning attorneys to redirect property at the death of an individual. The person who makes the disclaimer must make it within nine months of the death4 of the decedent in order to be a qualified disclaimer for federal estate tax purposes. In addition, the individual who disclaims the property cannot receive any benefits from the property prior to making the disclaimer. If the disclaimer is properly made, then the individual who made the disclaimer will be deemed to have predeceased the decedent and the property will go to the next beneficiary.
The use of a disclaimer for estate planning needs to be properly planned so that the surviving spouse will choose to execute the plan including the use of the disclaimer. In the context of qualified retirement assets, disclaimers typically are used to maximize an AB estate plan. The following case example demonstrates the planning for the use of a disclaimer.
Case Example
Jim and Sally Smith meet with you to discuss estate planning. Jim is 55 years old and is currently working. Sally is 53 years old and is currently working. The Smiths have three children ages 18, 23, and 25. They own a house with a fair market value of $300,000 and no mortgage. They have a stock portfolio of $350,000 and joint bank accounts of $200,000. Jim’s 401k is worth $750,000 and Sally’s 403b is worth $450,000. The Smiths do not own any life insurance and they are uninsurable due to their health. They wish to leave their estate equally to their three children, utilize revocable trusts in their planning, and shelter the maximum amount from federal estate tax.
The estate planning attorney prepares an AB estate plan based upon their needs and prepares revocable living trusts, wills, and durable powers of attorney5 for both Jim and Sally. The terms of the revocable living trust provide for a credit shelter trust and a marital deduction trust. In connection with executing the Smiths’ estate plan, the estate planning attorney needs to discuss the funding of the plan. In that discussion, the attorney advises the Smiths that the house should remain titled as tenants by the entireties for homestead purposes. The stock portfolio and bank accounts should be divided such that one-half will be titled in Jim’s trust and one-half titled in Sally’s trust.
The discussion then turns to the 401k and 403b plan. The Smiths ask who should be the primary and contingent beneficiaries for the plans. In addition, they are concerned with the estate and income tax issues.
Funding the Smiths’ AB Plan and Estate Tax Issues
The Smiths’ assets present a problem for most estate planning attorneys. Their assets would typically be divided as follows:
The above charts demonstrate that either Jim’s 401k or Sally’s 403b must be used to shelter both unified credits. If Jim died first, then the following assets totaling $1,175,000 would be included in his federal gross estate: 1) 401k $750,000; 2) stock portfolio $175,000; 3) bank account $100,000 and one-half interest in house $150,000. The house would qualify for the marital deduction leaving $1,000,000 to fund the credit shelter trust. The nonqualified retirement assets total $275,000; therefore, $375,000 of the 401k is needed to fill up the balance of the credit shelter trust. If Sally died first, then the following assets totaling $875,000 would be included in her federal gross estate: 1) 403b $450,000; 2) stock portfolio $175,000; 3) bank account $100,000 and one-half interest in house $150,000. The house would qualify for the marital deduction leaving $700,000 to fund the credit shelter trust. The nonqualified retirement assets total $275,000; therefore, $375,000 of the 403b is needed to fill up the balance of the credit shelter trust.
The estate planning attorney must determine who will be the beneficiaries of the 401k and 403b so that they can be used at the first death. The first question that the estate planning attorney must address is should the spouse or trust be the primary beneficiary. If the spouse is the primary beneficiary, then the next question is should the children or the trust be the contingent beneficiary.
Income Tax and Estate
Tax Issues for Qualified Retirement Assets
Qualified retirement assets are defined as assets in §§401 through 408 of the Internal Revenue Code. They include: 401k plans, individual retirement account (IRA), simple IRA, TSP plans, 403b plans, and Keough Plans. Each plan requires the owner to begin withdrawing the monies at age 70 1/2 under the minimum distribution rules.6 The modes for withdrawing the monies are based upon four methods: 1) single and nonrecalculating;7 2 ) single and recalculating;8 3 ) joint and nonrecalculating;9 and 4) joint and recalculating.10 The method must be selected at age 70 1/2 and will determine the term that the monies will be withdrawn.11
The single and nonrecalculating method allows the account owner to withdraw the account over a fixed period of time. For example, if the account owner is 71 and has a life expectancy of 15.3 years, then the account will be withdrawn over 15.3 years. The account owner will reduce his life expectancy by one year and then divide the balance by his current life expectancy.12 The account owner will continue to use this method until the entire account is withdrawn at the end of the term.
The single and recalculating method allows the account owner to withdraw the account based upon his life expectancy for that year.13 for example, if the account owner is 71 and has a life expectancy of 15.3 years, then he will withdraw an amount by dividing the account balance by his life expectancy for that year. In the subsequent years, the account owner will continue to recalculate his life expectancy in order to determine the minimum distribution for that year.
The minimum distribution rules for both nonrecalculating and recalculating for joint life expectancies have special rules depending on whether the account owner’s spouse is the beneficiary. If the spouse is the beneficiary, then the account owner and spouse will use their actual ages to determine their joint life expectancy.14 for instance, if the account owner is 71 and his spouse is 50, they will use both ages. If the account owner’s beneficiary is someone other than his spouse, then for purposes of determining life expectancy, the beneficiary will be deemed not more than 10 years younger than the account owner.15 for instance, if the account owner and the beneficiary’s ages are 71 and 50, then the rules state that the person who is 50 will be deemed to be age 61 for purposes of calculating their joint life expectancy. If there are multiple beneficiaries, the beneficiary with the shortest life expectancy will be used to determine the joint life expectancy.16 In addition, should the beneficiary die and a replacement beneficiary is used to determine joint life expectancy, then the substitute’s age cannot extend the original beneficiary’s life expectancy.17 for instance, if the beneficiary is age 64 when she dies and the new beneficiary is age 60, then the account owner will continue to use the joint life expectancy based upon the 64-year-old.18 Conversely, the life expectancy can be shortened.19 for example, if the beneficiary died at age 66 and the new beneficiary is age 69, the account owner will use his age and the 69-year-old age to calculate life expectancy. The same rules that apply to single and recalculating and single and nonrecalculating are used to determine the amount of the minimum distribution.
At the death of the account owner the primary beneficiary owns the account. If the beneficiary is the surviving spouse, then the spouse has three options: 1) withdraw all the money and pay the income tax;20 2 ) roll over the account to the spouse’s IRA; or 3) continue to withdraw the monies using the same schedule that the owner was using prior to his or her death.21 If the beneficiary is a person other than the surviving spouse, then the person can either withdraw the account and pay the income tax22 or withdraw the money based upon a schedule using the recipient’s age and accounting for the number of years that the decedent received monies after he attained age 70 1/2.23 If the beneficiary is not a natural person and is not a qualified trust agreement, then the beneficiary can withdraw the money and pay the income tax24 or withdraw the monies over a five-year period.25 If the beneficiary is a qualified trust, then the beneficiary can either withdraw the money and pay the income tax26 or withdraw the monies over a period based upon the oldest beneficiary of the trust agreement.27
Returning to the Smiths, the estate planning attorney suggests that Jim and Sally select each other as the primary beneficiary and their children as the contingent beneficiary of their 401k and 403b. The estate planning attorney explains that Sally, thereby, will have three options at Jim’s death: 1) roll over Jim’s 401k into her IRA; 2) continue to take the money out based upon Sally and Jim’s life expectancy until Sally dies; or 3) disclaim a portion of Jim’s 401k so that the children will receive it as the contingent beneficiaries.
The estate planning attorney informs the Smiths that a rollover of the 401k will reduce Jim’s credit shelter trust by $375,000. He further states that this will result in additional estate tax of $164,750 at the death of Sally.28 He also tells the Smiths that Sally will lose control and use of any monies that she disclaims, but that the use of the disclaimer will eliminate the additional estate taxes which would be due.
The Smiths responded by asking what will happen if they designate the trust as the primary beneficiary of their qualified retirement assets. Designating the trust as the primary beneficiary allows the complete use of the credit shelter trust; however, Jim or Sally will lose their ability to rollover the amount which exceeds the credit shelter trust and thereby will lose the benefit of the additional period of deferment of the payment of income tax. In this case, Jim would be required to continue to use Sally’s distribution schedule on $75,000,29 and Sally would be required to continue to use Jim’s distribution schedule on $350,000.30
The estate planning attorney finally recommends that the Smiths designate each other as the primary beneficiary and their trusts as the contingent beneficiary of their 401k and 403b. Designating the trust as the contingent beneficiary allows the complete use of the credit shelter trust by allowing Jim or Sally to disclaim the portion of the 401k or 403b that is needed to utilize the balance of the credit shelter trust, if that result is desirable at the death of the first spouse. The balance of the 401k or 403b could then be rolled over to either Jim or Sally’s IRA so that they could select a new primary beneficiary.
Interplay Between Income Tax and Estate Tax for Qualified Retirement Assets Using Trust Agreements
A nongrantor irrevocable trust31 is taxed pursuant Subchapter J of the Internal Revenue Code. The rules provide a conduit method for paying income taxes. Trusts have a compressed tax brackets and reach the 39.6 percent tax bracket at $7,500 of income.32 In addition, trusts are subject to the same capital gains tax rates as individuals. If the trust distributes all of its income to the beneficiaries for the current tax year, then the trust receives a deduction equal to the distribution, and, therefore, it does not pay income tax on that amount.33 If the trust does not distribute all of its income to the beneficiaries, then the trust will pay the income tax on the monies.34 for example, if the trust earns $50,000 of income in 1999 and distributes 100 percent to the beneficiaries, then the beneficiaries will pay the tax and the trust will pay nothing. If the trust only distributes $10,000 of income to the beneficiaries and retains $40,000 of income, then the beneficiaries will pay the income tax on the $10,000 and the trust will pay income tax on the $40,000.35 If the beneficiaries are in a lower income tax bracket than the 39.6 percent tax bracket for trusts generating income in excess of $7,500, it generally is beneficial to distribute the income to them instead of paying the tax at the trust’s income tax bracket.
Qualified retirement assets which are either owned by or designated to a nongrantor irrevocable trust have unique income tax issues. The monies that are paid from the qualified retirement asset to the trust pursuant to the minimum distribution rules are deemed to be income for federal income tax purposes.36 The actual distribution will be allocated to income and principal for fiduciary accounting purposes. The monies that are distributed from the qualified retirement assets to the credit shelter trust in the early years will consist mainly of income for fiduciary income tax purposes. The monies paid in the later years will consist mainly of principal for fiduciary income tax purposes. This creates an inherent conflict between preservation of the principal of the credit shelter trust and distributing monies to the surviving spouse to reduce the income tax burden.
In the event that Jim died first, Sally would disclaim $375,000 of Jim’s 401k to the credit shelter trust created in Jim’s trust agreement and Sally would also rollover the $350,000 balance of Jim’s 401k to her IRA. In the event that Sally died first, Jim would disclaim $375,000 of Sally’s 403b to the credit shelter trust created in Sally’s trust agreement and Jim would also rollover the $75,000 balance of Sally’s 403b to his IRA. Under either situation, $375,000 of either Jim or Sally’s qualified retirement assets would thereby make up part of the credit shelter trust.
The minimum distribution rules will apply if both Jim and Sally have attained the age of 70 1/2 at the date of the first to die. Assume that the minimum distribution that is made to the credit shelter trust is $50,000 and that the qualified retirement assets produce $35,000 of income. In this situation, Jim or Sally’s trust would require a distribution of $35,000 and the trust would retain $15,000. For income tax purposes, Jim or Sally would pay the tax on the $35,000 and the trust would pay the tax on the $15,000. Therefore, the trust would actually retain at least 60.4 percent of the $15,000. As the years progress, a greater portion of the monies will be retained by the trust under the minimum distribution rules. If Jim or Sally is in the 39.6 percent income tax bracket there will be no difference on how much the children will ultimately receive. If Jim or Sally is in the 28 percent income tax bracket, then the trust will lose 11.6 percent ( i.e., 39.6 minus 28) of the monies.
Conclusion
Estate planning for the use of qualified retirement assets poses many problems and, therefore, requires flexible planning for the surviving spouse. First, the estate planning attorney must identify whether or not the qualified retirement assets will be used to fund the credit shelter trust at the death of the first spouse. Second, the assets must be correctly designated so that the surviving spouse will be able to redirect the qualified retirement assets without losing control and use of the assets. Third, the surviving spouse must consider the income tax impact should a portion of the qualified retirement assets be used to fund the credit shelter trust. Finally, the surviving spouse needs to determine whether or not their interest should be paramount over the interests of the children as the ultimate recipients of the qualified retirement assets.
q
1 I .R.C. §2010. The term “unified credit” was changed to the applicable credit amount in the Taxpayer Relief Act of 1997 (Pub. L. 105-345). For ease of terminology, the author means the applicable credit amount when he refers to the unified credit. The unified credit for decedent’s dying in tax year 1999 will shelter $650,000 of property. The credit is increasing and will shelter $1,000,000 of property for decedent’s dying in tax year 2006.
2 The term “qualified retirement assets” does not include a pension plan or any other plans that will terminate at the death of either the decedent or the decedent’s spouse.
3 The term “nonqualified retirement assets” are defined as any asset which are not contained in I.R.C. §§401 through 408. The term includes real estate, stocks and bonds, personal property, and any other assets owned by the decedent at the time of his death.
4 The author acknowledges that a disclaimer must be exercised within nine months of the creation of the property right or within nine months of the death of the decedent, whichever shall occur first. I.R.C. §2518. This article will only discuss disclaimers that must be exercised within nine months of the decedent’s death.
5 A properly drafted durable power of attorney will allow the attorney-in-fact to execute disclaimers on behalf of an incompetent individual. Absent a durable power of attorney, a guardian would need to be appointed for the incapacitate individual in order to execute a disclaimer.
6 I.R.C. §401(a)(9).
7 I.R.C. §401(a)(9)(A) and Prop. Treas. Reg. §1.401(a)(9)-1(c) Question B-1.
8 Id.
9 I.R.C. §401(a)(9)(D) and (E).
10 Id.
11 I.R.C. §401(a)(9)(C).
12 Prop. Treas. Reg. §1.401(a)(9)-1(d).
13 Id.
14 Prop. Treas. Reg. §1.401(a)(9)-1(b) Question and Answer E-1.
15 Prop. Treas. Reg. §1.401(a)(9)-2.
16 Prop. Treas. Reg. §1.401(a)(9)-1(b) Question and Answer E-5.
17 Prop. Treas. Reg §1.401(a)(9)-1(c)(1).
18 Id.
19 Id.
20 I.R.C. §401(a)(9)(B).
21 I.R.C. §401(a)(9)(B)(iii).
22 I.R.C. §401(a)(9)(B)(i).
23 I.R.C. §401(a)(9)(B)(iii).
24 I.R.C. §401(a)(9)(B)(i).
25 I.R.C. §401(a)(9)(B)(ii).
26 I.R.C. §401(a)(9)(B)(i).
27 I.R.C. §401(a)(9)(B)(ii) and (iii); Prop. Treas. Reg. §1.401(a)(9)-1(c) Question and Answer D-5.
28 This is based upon an increase of $375,000 of Jim’s 401k which could have been sheltered by the credit shelter trust. This assumes figures for 1999 and that Sally dies 10 months after Jim.
29 This is based upon $725,000 of assets (excluding the house) less a unified credit of $650,000 for 1999.
30 This is based upon $1,000,000 of assets (excluding the house) less a unified credit of $650,000 for 1999.
31 If the trust is deemed a grantor trust pursuant to I.R.C. §§671-678, then the grantor will pay income tax on the income until the power is either released or terminated.
32 I.R.C. §1(e).
33 I.R.C. §651(a).
34 I.R.C. §661(a).
35 Id.
36 The author acknowledges that the taxpayer can have a tax basis in the qualified retirement asset. For purposes of this article, all qualified retirement assets are subject to income tax and the taxpayer does not have a basis in the account.
Benjamin A. Jablow is a board certified tax attorney who is an associate of the Boca Raton law firm of Hunt, Cook, Riggs, Mehr and Miller, P.A. He received his J.D. from Creighton University and his LL.M. in taxation from the University of Florida. His practice areas include tax and estate planning.
This column is submitted on behalf of the Tax Section, David E. Bowers, chair, and Michael D. Miller and Lester B. Law, editors.
