Deferral is the Name of the Game: Funding a Trust With Retirement Assets

Many people today have a large concentration of their wealth in their IRA accounts and/or retirement plans, such as Pension, Profit Sharing and 401(K) plans. As a result, for married couples, it may be necessary to utilize these assets to fully fund the first spouse to die’s applicable exclusion amount. This article will highlight the income tax disadvantages associated with using such assets in this regard.

Under current law, the federal estate tax applicable exclusion permits taxpayers to transfer up to $2 million ($675K in NJ) at death to anyone other than a spouse without incurring a federal estate tax. The estate tax applicable exclusion is scheduled to increase to $3.5 million ($675K in NJ) in 2009. In 2010, the Federal estate tax is scheduled to be repealed, but only for one year. Starting in 2011, estates will once again be subject to estate tax at 2001 rates (top rate of 55%) with only a $1 million ($675K in NJ) exemption available.

Generally speaking, to maximize the applicable exclusion of the first spouse to die, Wills are drafted to provide that a trust is created automatically or via a disclaimer approach for the benefit of the surviving spouse and the decedent’s children and grandchildren and funded with the decedent’s then remaining applicable exclusion amount, taking into account any transfers the decedent may have made during his or her lifetime. These trusts are typically called bypass or disclaimer trusts. The balance of the decedent’s estate in most instances would pass to the surviving spouse.

If IRAs and/or retirement assets are used to fund the trusts as described above, there are significant income tax ramifications for the decedent and his or her family. If the surviving spouse is the beneficiary of the IRA and/or retirement assets, the surviving spouse has the ability to roll over these assets to his or her own IRA and treat it as a new IRA. Consequently, the surviving spouse is able to designate his or her own beneficiary. The new beneficiary designation means that at the surviving spouse’s death, the beneficiary can take required minimum distributions over that beneficiary’s life expectancy. In most circumstances, the beneficiaries of the surviving spouse’s IRA will be the next generation (i.e., children), so that the required pay out period will be based on the life expectancies of the children, which typically is a longer period of time.

While the surviving spouse is alive, required minimum distributions need to begin to be paid as of April 1 of the calendar year following the surviving spouse’s attainment of the age of 70 ½. After that date, in most cases, the required minimum distributions are based on IRS tables which factor in the life expectancy of the surviving spouse and a hypothetical beneficiary who is ten years younger than the surviving spouse.

The required minimum distributions are significantly accelerated if the beneficiary of the decedent’s IRA and/or retirement assets is the bypass or disclaimer trust under the decedent’s will, as opposed to the surviving spouse. First, during the surviving spouse’s life, assuming the surviving spouse is the oldest beneficiary of the trust, distributions during the spouse’s life must be taken over the spouse’s life expectancy, as opposed to the surviving spouse waiting until April 1 of the year following the attainment of age 70 1/2. In this event, the surviving spouse is not able to roll over the IRA and/or retirement assets and treat the IRA as his or her own IRA because he or she is not the beneficiary.

Second, at the surviving spouse’s death, while the beneficiaries are usually the younger generation, the required minimum distributions remain based on the surviving spouse’s life expectancy. The decedent’s family is not able to use the younger generation’s longer life expectancy to significantly delay distributions.

This is the major reason why IRAs and retirement assets should be the last resort to fund a bypass trust or a disclaimer trust to maximize the decedent’s applicable exclusion amount.

Generally speaking, the longer period of time a taxpayer can defer the payment of the income tax due from the IRA and retirement assets, the more the taxpayer will benefit. It is important to review your assets with your attorney to make sure your estate has the flexibility, to the greatest extent possible, to fund these trusts with non-retirement assets.

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