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This is an area of the law, in regard to retirement assets like IRA, 401k, Roth IRA, that can be especially complicated. The reason for this complication is because we not only have to deal with the IRS and their complex and confusing regulations, but also with Treasury Department regulations. This article will attempt to give a basic understanding of estate planning for retirement assets such as 401k, 403b, Tax Sheltered Annuities, Roth IRA and traditional IRA, and the use of Revocable Living Trusts.
Some folks have retirement assets such as an Individual Retirement Account (IRA) or Roth IRA and other folks have their retirement assets in a company sponsored plan known as 401k (corporate employees), 403b (government workers) or Tax Sheltered Annuities (TSA). Note, a TSA has similar requirements as corporate and government plans but are held in the name of the participant employee like an IRA instead of the name of the plan.
These corporate 401k, government 403b or TSA savings vehicles are termed "qualified" plans by the IRS. In either case, the goal is to put away as much pre-tax money as possible in order to take advantage of tax deferred accumulation of wealth. In some cases, 401k or 403b employer plans may even contribute a matching amount up to a certain percentage of the employee's income.
The owners of such retirement assets as 401k and 403b accounts (the employees), are called "plan participants." These participants usually sign up for the savings program upon becoming eligible after hiring in with the company or unit of government. If the participant maximizes his or her contribution each payday, they can accumulate a massive amount of wealth over the course of 10, 20, or 30 years of employment. Of course the longer the money is kept in the account, the larger it grows.
Upon signing up for these programs, the participant must designate a spouse or other beneficiaries who are to take the retirement assets in the event the participant dies before all the money is distributed post retirement. However, what most participants do not know is that, unlike a Roth IRA or traditional IRA, most 401k and 403b plans or other such "qualified" plans do not allow trusts of any sort to receive payouts to beneficiaries over a life expectancy.
Instead, the trust must receive the entire plan account balance shortly after the owner's death and this can result in immediate income tax consequences. In contrast, a Roth IRA or traditional IRA offer the most flexibility to stretch out payments over the life expectancy of a much younger beneficiary when the IRA designated beneficiary is a revocable living trust that qualifies as a "Look Through Trust" (see below for discussion of look through trusts).
Minimum Required Distribution (MRD). This is the minimum amount of money that must be withdrawn from a retirement assets account after the required beginning date under IRS Code rules section 401(a)(9). The MRD is calculated using the Single Life Expectancy Table to obtain the life expectancy factor and multiplying the fair market value of the account by the life expectancy factor to come up with a dollar amount. If the MRD is not taken in a given year, then there is a 50% penalty imposed by the IRS (The IRS has waited a long time to collect tax on the participant's tax deferred account and they will not be denied).
Required Beginning Date (RBD) (Treasury Regulation 1.401(a)(9)-5)is the date at which a plan participant (and IRA holders) must begin taking MRD withdrawals from their retirement assets accounts. The goal here is to take the minimum required distribution in order for the remaining principal balance of the 401k, 403b, IRA or Roth IRA, to continue to grow in size even while making these withdrawals. The RBD can vary slightly from plan to plan but it is usually when the plan participant turns age 70 1/2 .
If a plan participant or IRA owner dies prior to the RBD, then the law requires a full distribution of the retirement asset account funds by December 31st of the fifth year following the participant's death. This is called the 5 year Rule. The imposition of this rule can mean a huge income tax burden for a younger surviving spouse. If the participant dies after his RBD, then the MRD will be made over the participant's life expectancy had he lived. In either event, the rules require distribution of the accumulated funds over a much shorter period of time thus, a much higher income tax must be paid.
So, What to do about the tax issues and qualified retirement assets plans? One way to give a spouse or non-spouse beneficiary a way to avoid paying onerous income taxes to the IRS under the MRD or 5 year rule on an inherited qualified plan, is by naming a trust as a "designated" beneficiary. A designated beneficiary (Treasury Regulation 1.4019a)(9)-4, A-1) is defined by the IRS as a life in being (living breathing person) whose life expectancy will be used to calculate the MRD from the account each successive year.
This designated beneficiary is the person who has the shortest life expectancy among the named beneficiaries and will be used to determine the life expectancy factor to calculate the MRD withdrawals. Further, under IRS rules, all retirement assets beneficiaries must be "identifiable" which is government speak for living breathing people. In other words, you cannot name charities, churches, estates, or other entities that do not have life expectancies as beneficiaries of a trust to receive 401k, 403b, IRA, Roth IRA or other plan benefits.
Generally, a trust is not a designated beneficiary so MRD rules would apply. Some plans however, may provide that a trust can be named as a beneficiary of the plan. This designation is allowed only if the trust qualifies as a "look through trust". Then, the joint lives of the participant and a beneficiary of the trust may be used in determining the MRD schedule. If the trust does not satisfy the "look through" requirements, a participant is treated as though he or she did not have a designated beneficiary and the minimum distributions of retirement assets will be made over the participant's life expectancy if the participant dies after his or her RBD. If a participant dies prior to his or her RBD, then the 5 year rule will apply.
Look Through Trust under IRS regulations. A trust must satisfy four requirements in order to be eligible for look through treatment. 1) The trust must be valid under state law. 2) The trust must be irrevocable or must, by its terms become irrevocable upon the death of the participant. A revocable living trust will satisfy this requirement. 3) The beneficiaries of the trust must be identifiable from the trust document. Note that beneficiaries may be members of a class such as "children" or "grandchildren" 4) On or before the date when distributions are required from the plan, the participant must provide a copy of the trust document to the plan administrator.
The caution here is that the drafter of the trust must be careful not to include non-living entities as contingent beneficiaries. A "contingent" beneficiary takes the money if the primary beneficiaries all predecease the participant. Charities, churches or estates listed as contingent beneficiaries or remainder beneficiaries will cause the trust to fail as a look through trust. The IRS will look at ALL beneficiaries to determine the shortest life expectancy for MRD. If a non-life entity is named anywhere, then look through treatment is lost and the Five Year Rule applies.
What to do if your plan does not permit naming a trust to be named as a beneficiary? Then, upon retirement, the participant can rollover his or her 401k or 403b into an IRA which WILL permit naming a trust as beneficiary. This way, the new IRA will pay the MRD to the look through trust and the money will be distributed to the beneficiary over that person's life expectancy. Again, the trust must qualify as a look through trust.
If the participant dies before retirement, it may be possible for the surviving spouse (and only a spouse) to roll over the qualified plan into an "inherited" IRA in the name of his or her spouse if they are too young to draw on it without tax penalty. Otherwise, the spouse can roll over the plan account into his or her own IRA if they are age 59 1/2 or over.
The lesson here is, that if you have not looked at your plan since the day you signed up for it, then get it out, dust it off and READ IT! Be aware of the rules of distribution of your qualified plan and incorporate it into your estate planning.