Retirement Distribution Planning for the Surviving Spouse
In planning for distributions of retirement assets to a surviving spouse, there are several competing concerns. These will vary in importance to the client, and it is the task of the estate planner to ensure that his or her solution properly reflects the client’s needs. In short, there is no “correct” approach applicable to all situations, but rather an approach that best fits the client’s particular fact pattern. If one attends first to the deferral of income tax, the greatest flexibility is achieved in virtually every instance by the naming of the surviving spouse directly as the designated beneficiary. If the surviving spouse is the designated beneficiary, she has a number of options that are not available to any other potential beneficiary (for purposes of this outline, we will assume the decedent spouse to be male, and the survivor female, reflecting the actuarially more probable scenario). She can take distribution as a lump sum, and roll it over into her own IRA (excepting, of course, any distributions that the decedent spouse was required to take as a minimum distribution in the year of death). The surviving spouse may then defer distributions until her required beginning date. She may name one or more of her children (or grandchildren) as beneficiaries of her rollover IRA. If she then dies with IRA assets still undistributed, the designated beneficiaries will be able to defer distributions over their lifetimes. If the surviving spouse has designated a group as her beneficiary (perhaps consisting of her issue living upon the date of her death), the eldest of the group will provide the measuring life for purposes of determining the minimum distribution schedule. It is important to note, however, that the surviving spouse can divide her IRA into any number of IRA accounts, each naming an individual designated beneficiary, and in each case, such beneficiary’s actual life expectancy will be the measuring life for the purposes of determining minimum required distributions after the surviving spouse’s death. Even if the surviving spouse does not wish to roll over the distribution into her own IRA, she nonetheless has the additional latitude of postponing distributions until the deceased spouse would have reached age 70-1/2. Given this flexibility, naming the spouse directly as the designated beneficiary is most likely to result in greater income tax deferral opportunities than would other designations. It should be noted that, under the new proposed regulations, naming a spouse as the designated beneficiary can have yet one more benefit – this pertaining to the minimum required distribution rules during the lifetime of the first spouse. Under the new protocol, the participant has only one potential schedule for minimum distributions, this being distribution of the benefits over the lifetime of the participant, recalculated yearly. Although this is a fairly significant deferral, the outcome is even better if the participant has a spouse who is more than ten years his junior (this arrangement may also have other benefits, beyond the scope of this outline). In that case, the participant is permitted to use the longer distribution period measured by the joint life and last survivor life expectancy of the participant and spouse. Qualified plans are subject to the provisions of the Retirement Equity Act, or REA – a limitation not applicable to IRAs. The REA was designed to ensure that the surviving spouse receives an appropriate benefit from the participant’s plan, and thus to minimize the risk that a participant’s death would result in an impoverished survivor. Unless affirmatively waived by the participant’s spouse, the REA requires that a participant’s benefit be paid out in the form of a Qualified Joint and Survivor Annuity (QJSA), or, if the participant dies prior to retirement, a Qualified Preretirement Survivor Annuity, or QPSA. To increase deferral options, the participant’s spouse may waive annuity treatment. This way, the surviving spouse could receive a lump sum distribution upon the death of the participant, and effectuate a rollover into a spousal IRA, as described above. Consequently, distributions can be deferred over the lifetime of the survivor’s designated beneficiaries (upon the survivor’s death). Otherwise, post-death deferral of taxable distributions would, of course, be impossible. Much has been said about the benefits of preserving the spousal IRA rollover option, but there are certain situations in which a spousal rollover is not desirable. In the event that a participant dies and the surviving spouse is significantly below 59-1/2 years of age, it may be a hardship for the survivor to wait until that minimum retirement age before taking her distributions. If the spouse has inherited the account, the spouse may immediately begin to take distributions at any age, without penalty. If, however, the surviving spouse rolls over the account into her own IRA, then there may be a 10% penalty and distributions made prior to the minimum retirement age. Maximum income tax deferral militates toward a certain dispositional framework – i.e. the participant intending that the surviving spouse enjoy complete dominion and control over the retirement assets. If the spouse receives a lump sum distribution, it is within the spouse’s discretion to determine (1) the rate that the account will be making taxable distributions (subject to the minimum required distribution rules) and (2) to whom the remaining funds, if any, will pass upon the death of the survivor. This is often more latitude than the participant would prefer to give to the surviving spouse. It might be desirable, for example, to limit the survivor’s access to the required minimum distributions, thus maximizing both tax deferral and the likelihood that funds will be preserved for beneficiaries of the next generation. These concerns may arise due to a surviving spouse’s propensity to overspend, or a lack of sufficient financial sophistication on the part of the survivor (i.e. not comprehending the benefits of deferral and thus utilizing tax-benefited funds when other assets were available) or due to the profound dispositional problems that can arise in multiple-marriage situations. In such instances, a primary concern of the participant spouse may be that any remaining assets in an inherited retirement fund pass to his or her children, and not the offspring of the surviving spouse (or, worse yet, to a new spouse of the survivor, or to such interloper’s issue!). However, if any limitations are placed on the surviving spouse’s complete and free access to the assets in the retirement fund, one runs the risk of sacrificing the estate tax marital deduction. Obviously, the benefits of estate tax deferral until the death of the surviving spouse can greatly overshadow the income tax benefits of deferral. Therefore, great care must be taken to avoid the loss of a marital deduction when one is attempting to limit the surviving spouse’s right of access. Naming a decedent’s estate as the beneficiary of his or her retirement assets will subject such property to the dispositional scheme of the decedent’s will. However, the estate is not an “individual” for beneficiary designation purposes, and thus most deferral opportunities are forfeited. However, numerous private letter rulings have indicated that the IRS will allow one to look through the estate to consider the surviving spouse to be the designated beneficiary, if the estate directs that the specific assets be paid to the spouse, or if the surviving spouse is the estate fiduciary and has full discretion to allocate the retirement assets to herself (and does so). However, these requirements are not particularly helpful if the ultimate desire is to control and limit the surviving spouse’s access to the funds. For such controls, a trust is needed. And if a trust is to be used, it will be necessary to ensure that the trust both qualifies as a designated beneficiary and qualifies for the estate tax marital deduction. Treas. Reg. § 1.401(a)(9)-4, provides guidance as to the circumstances in which a trust will be deemed to constitute a “designated beneficiary.” Briefly, the requirements are as follows: First, it must be valid under state law. Thus, in Massachusetts it can’t last forever, nor can it name a pet as a beneficiary, nor can it violate public policy in some other way. This requirement is rarely problematic. Second, it must become irrevocable upon the death of the participant. Third, a copy of the trust or information certifying the identity of the beneficiaries must be provided to the plan administrator (see Treas. Regs. 1.401(a)(9) – 4, Q&A 6) (The new minimum distributions rules provide that the identity of the trust beneficiaries does not impact lifetime distributions unless one is using the trust for the sole benefit of a surviving spouse who is more than 10 years younger than the participant. In that case, one must provide the plan administrator with a copy of the instrument). Lastly, the beneficiaries must be identifiable, no one must have the power to change the beneficiaries’ identities, and the beneficiaries must be individuals. The determination of whether the beneficiaries are individuals is as follows: if all present and potential future individual beneficiaries live until their life expectancies (under IRS tables), then if all the trust assets will have to be distributed entirely to individuals under the terms of the trust, the trust will qualify. Trusts over which the surviving spouse has full, unrestricted access to principal and income “exercisable by her alone and in all events,” qualify for the marital deduction. Such trusts are useful in a number of ways: the assets held within them will escape probate at the death of the surviving spouse, the trust instrument may provide for centralized and simplified administration of the assets held within it, and
the trust may also be helpful in providing a fiduciary to administer the assets in the event of the incapacity of the surviving spouse. However, such trusts do not provide the posthumous control over the trust assets which many people desire or need. Therefore, a more restrictive mechanism, such as the “qualified terminable interest property” (QTIP) trust, must be used. The major requirements for a deductible QTIP trust are as follows: the surviving spouse must receive all of the income on a current basis, and the trustee must have no authority to make distributions to anyone but the spouse during her lifetime. Furthermore, the surviving spouse must have the power to require the trustee to invest in income-producing property. Since plans rarely restrict the participant’s right to take full distribution of his or her funds, one would assume that a QTIP trustee would have full authority to demand distributions from the plan, if the trust were to be named the designated beneficiary. The QTIP trustee would be required by the trust to distribute the income currently to the surviving spouse, and no one but the spouse would have access to the trust assets (and thus the plan assets), during the spouse’s lifetime. The surviving spouse’s right to require that the trust replace non-producing assets would indicate that the spouse could always cause the trustee to request appropriate distributions from the plan. Therefore, it would appear that a disposition of retirement assets to a QTIP trust would qualify for the marital deduction. The IRS, however, originally took the position that the retirement plan – not the QTIP trust - was actually “terminable interest property,” thus disqualifying it from the marital deduction. The tortured logic behind this position was based on the fact that the IRA arrangement under scrutiny did not require that all of the income be distributed from it currently. One would expect that no such requirement was necessary, since the beneficiary always has the authority to withdraw the entire account. However, the IRS was considering the IRA as an entity apart from the trust which was its beneficiary, and did not take into consideration that the trustee had the authority to take distribution of the IRA at any time. The IRS has recently clarified and relaxed this position somewhat. In a recent ruling, a marital deduction is allowed (provided the appropriate elections are made by the trust and plan) if the trust provides all income be payable to the surviving spouse on an annual basis; and that no one has the power to appoint trust principal to any other person than the spouse, and that she has the power, exercisable annually, to require the trustee to withdraw from the IRA an amount equal to the income earned on the assets held by the IRA during the year and to distribute that amount through the trust to the surviving spouse, and the IRA allowed the withdrawal of amounts in excess of the minimum required distributions. The important aspect of this ruling is that the surviving spouse needs only to have the right to demand distributions equal to the income earned in the retirement account – it does not require that she actually do so. Therefore, in the event that the trust holds assets other than the retirement account, these assets could be used to make the required income distributions (in the amount of the income earned in the retirement account), without actually withdrawing these amounts from the retirement account and causing a taxable distribution from the account. Obviously, however, these rights limit the ability of the decedent spouse to control the assets posthumously to the extent he may desire, as the spouse will always have the right to demand an amount equaling all of the retirement account’s income on an annual basis. Thus, if the plan’s income exceeded the minimum distribution requirements, larger distributions would have to be made from the trust than would otherwise be necessary. Although there are significant dispositive benefits to making a QTIP trust the designated beneficiary of retirement assets, greater income tax benefits are clearly obtainable by naming the spouse directly, because she can roll over the benefit, designate her own beneficiaries, and continue to defer income taxes on those assets remaining after her death. In contrast, if the assets are paid to her QTIP and she dies prior to receiving her full distribution, the remaining funds will be subject to minimum distribution requirements which continue to be based on her actuarial life expectancy. There is another negative implication of using the QTIP trust. Under most QTIP-type arrangements, the surviving spouse would not be the “sole beneficiary” of the trust – a requirement which must be fulfilled if the surviving spouse is to enjoy the same benefit under the trust as she would were she individaully named as designated beneficiary – i.e. the right to delay the start of distributions until after the decedent spouse would have attained the age of 70-1/2. Otherwise, she would have to commence taking distributions within one year of the date of death of the first spouse. A spouse is only the “sole beneficiary” of the trust if she is treated as the sole owner of all of the trust’s income and principal under the grantor trust rules - i.e. unlimited access to income and principal – or if the distributions from the plan must be made over her life expectancy and such distributions pass through the trust directly to the spouse. In the event that the first spouse does not have adequate assets to fund his or her Applicable Exemption Amount, it may be desirable for the surviving spouse to disclaim some or all of the assets passing from qualified plans and IRAs. Although utilization of the Applicable Exemption Amount with retirement assets, which are subject to income tax, is not the most effective use of the Exemption, it is nonetheless usually better to utilize the Exemption than lose it entirely.