Many recent Bar Association presentations on estate planning have included at least one speaker on the topic of “Coordinating a Retirement account into an Estate plan.”  The reason for the interest in this topic?  Generally, the reason that many attorneys are interested in the topic is the same reason that Willie Sutton robbed banks.  That’s where the money is!  A recent IRS pronouncement has relaxed the rules regarding one particular aspect of coordinating a retirement account with an estate plan.  This topic is extremely complex because it combines complicated income tax rules with estate tax rules.

By way of background, a distribution of money from a “retirement account” (pension plan, profit sharing plan, Section 401(k) plan or Individual Retirement Account/IRA) (hereafter collectively referred to as “IRA”) are subject to income tax upon distribution.  Since funds placed into the IRA represented some form of compensation to an employee, the income tax rules require that someone-- someday-- will pay the income tax on that balance.  In the event that an individual retires from employment, generally, the employer will allow the retiring employee to “rollover” the fund into an Individual Retirement Account (IRA) in the name of the employee.  This technique gives the employee substantial control over the IRA balance and allows for a deferral of income tax. 

Under the income tax rules, the employee will be required to begin to remove the funds from the IRA and pay income tax beginning in the year that contains the six month anniversary after the individual’s 70th birthday (i.e. age 70 ½).  These forced distribution rules are referred to as the “minimum distribution rules” and will require that a retirement account owner withdraw funds over some fixed period beginning at “retirement” (age 70 ½). The distribution for the first year can be made either in that calendar year or by the subsequent April 1. Each year thereafter, a greater percentage must be withdrawn. These rules (contained in I.R.C. Section 401(a)(9) of the Internal Revenue Code of 1986, as amended) force an individual into “retirement” and as such will end the income tax deferral that has been employed by the employee during employment and potentially thereafter.

In coordinating an individual’s estate tax plan, generally, there are several means of deferring the estate tax.  One such rule is contained in I.R.C. Section 2056 and allows for an unlimited deduction for estate tax to any asset given to a surviving spouse.  When an individual makes a gift or bequest to a surviving spouse, the amounts so gifted, will not be subject to an estate tax until the underlying assets are included in the estate of the surviving spouse.  The use of the federal gift and estate tax “marital deduction” of Section 2056 is a means of coordinating the IRS view of a married couple as a single economic unit (through the use of filing joint income tax returns) with the transfer tax (estate and gift) structure. 

There are significant income tax advantages granted to a person that owns an IRA if that IRA is payable (at death) to the surviving spouse.  First, beginning at age 70½ (referred to as the “Required Beginning Date”), the joint life expectancy of the owner and the surviving spouse can be used to compute the time period over which the fund must be withdrawn under the income tax minimum distribution rules.  Withdrawal of the IRA essentially forces the income tax to be paid.  Using a longer joint life expectancy defers the income tax.  Second, in the event that the IRA owner passes away prior to withdrawing all of the funds, the surviving spouse has the opportunity to “rollover” the remaining retirement account and defer the income tax.  The surviving spouse can make new calculations regarding the minimum distribution rules and additional deferral can be achieved.

For estate tax purposes, there are several methods to obtain the estate marital deduction. An outright bequest to a surviving spouse will give the surviving spouse total control over the underlying balance in the account at death of the survivor. This will allow the estate tax marital deduction and the income tax benefit of “rollover.”  Nevertheless, for estate tax purposes, property can qualify for the estate tax marital deduction in a variety of other forms.  One very popular means of benefiting from the estate tax marital deduction (thus creating an estate tax deferral) and yet allow for the control over the underlying assets at the death of the surviving spouse is through the use of a “Qualified Terminable Interest Property” or “QTIP” trust.  The theory behind the QTIP Trust is that if the surviving spouse is granted the use of the funds during his or her remaining lifetime, the estate tax is deferred.  In order to achieve this “QTIP” benefit, the executor of the estate of the predeceasing spouse must elect to treat the funds as QTIP property.  In that event, the amount contained in the trust at the death of the surviving spouse will be subject to an estate tax as property of the surviving spouse. 

In order to qualify for “QTIP” treatment, the surviving spouse must be granted a “qualifying income interest for life” (see I.R.C. § 2056 (b)(7)(B)(ii)), which means that the spouse must have a right to all income from the trust property for life payable annually or at more frequent intervals.  Further, no one can have the power to appoint the property to any person other than the spouse.

The use of a “QTIP” trust is an excellent estate planning vehicle as it allows for a spouse to leave property to a surviving spouse, but yet allows for control to the ultimate remaindermen.  In practice, QTIP Trusts are useful in two common situations. One situation where a QTIP Trust is very important is where the children/heirs of the decedent are not also the children/heirs of the surviving spouse.  As a result of divorce and remarriage in our society, many estate planners are confronted with this dilemma frequently.  The second situation where the use of a QTIP Trust is common is where the clients are relatively young.  For example, a 40-year old client may feel uncomfortable leaving funds outright to a surviving spouse, considering the fact that the surviving spouse may have a long remaining life expectancy and may, in fact, remarry or have additional heirs.  An outright bequest leaves open the possibility that the surviving spouse may change his or her feelings about the heirs of the decedent spouse and subsequently, alter the testamentary plan.  As such, the use of the QTIP Trust is finding much more practical application in estate planning practice.

The objectives of these two different goals (i.e., income tax deferral and estate tax control) collide when an individual wishes to pay a retirement account to a QTIP Trust.  In a significant recent IRS pronouncement, IRS Revenue Ruling 2000-2, 2000-3 I.R.B. 305, the IRS indicated a willingness to ease up on previous stringent requirements set forth in an earlier pronouncement, Revenue Ruling 89-89, 1989-2 C.B. 231.

As stated above, in order to achieve the maximum income tax benefits, a plan participant can name a spouse as beneficiary to both allow the use “joint” life expectancy of the owner and the beneficiary, as well as the use of a “rollover” at death.  If retirement funds are payable to a QTIP Trust, the use of joint life expectancies can be utilized; however, the use of a “rollover” at death is not available.  Instead, the funds would be taxed to the trust (i.e., to the Trustee of the Trust).  The use of the joint life expectancy method must be attended to at age 70 ½ (the required beginning date) through procedures outlined in Proposed Treasury Regulation 1.401(a)(9)-1 which was modified in 1997.  The exact details of the steps are beyond the scope of this article.  However, to pay an IRA to a QTIP Trust, careful attention to this Regulation is needed.

When the IRS first addressed the question of whether an IRA could be payable to a QTIP Trust, it considered the estate tax marital deduction issues attendant to creation of the trust.  In that situation, the IRA was to be paid to the trust over a period of time.  The “income” from the trust and the “income” earned on the “undistributed portion of the IRA balance payable to the trust” were to be distributed from the IRA, to the trust and to the surviving spouse on an annual basis.  As such, the IRS concluded that the surviving spouse possessed the requisite “qualifying income interest for life” and thus satisfied the requirements for QTIP treatment. 

Generally, the question of when a distribution from an IRA is treated as “income” is based upon “fiduciary accounting income” a matter governed by State law.  In New Jersey, our version of the “Revised Uniform Principal and Income Act,” N.J.S.A. 3B:19A-10 provides that “receipts from a qualified pension plan…received or paid in installments…shall be principal, except to the extent of interest or other income earned on the proceeds after the death of the decedent” (emphasis supplied).  While there is no clear definition of what this provision means, it appears under New Jersey law that any “income” inside the IRA must be distributed annually to the trust and to the surviving spouse in order to satisfy the “income” distribution test.  If the trust provides that all “income” is to be distributed to the surviving spouse- as a QTIP Trust must- income tax will be accelerated.  But see N.J.S.A 3B: 19A-32, which allows for equitable adjustment by a trustee between principal and income receipts. 

It is with this background that many planners advised client that for an IRA paid to a QTIP Trust they must make “income” payments from the IRA for estate tax deferral reasons. IRS Private Rulings subsequent to Revenue Ruling 89-89 enumerated that, in addition to making sure that the “income” test is met, the IRA beneficiary designation must also provide that the distributions from the IRA comply with the continuing obligation to meet the minimum distribution rules for income tax purposes as provided for by I.R.C. § 401(a)(9).  These rules require, among other things, that the IRA be paid “at least as rapidly” as the decedent had elected at the required beginning date of age 70 ½.  When an individual passes away prior to attaining age 70 ½, the required beginning date is generally death. 

This January, the IRS released Revenue Ruling 2000-2 that relaxed the requirements for making distributions from the IRA to a QTIP Trust.  In taking a closer look at the estate tax marital deduction provisions (specifically the requirements for a QTIP Trust) the IRS noted, under facts similar to Revenue Ruling 89-89, that as long as the surviving spouse is entitled to the income and can compel the income from distribution of the IRA, the balance in the IRA and Trust would qualify for the estate tax marital deduction.  As such, the spouse can leave funds inside the IRA for a longer period of time, thus achieving a greater income tax deferral.  The distributions from the retirement account must still satisfy the minimum distribution rules (“at least as rapidly”), however, generally the distribution from the IRA can be slower if the “income” earned on the entire balance is not forced from the IRA into the taxable income of the spouse beginning with the death of the IRA owner. 

While this ruling eases the restrictions on making payments of retirement funds to a QTIP Trust, two important cautions should be noted.  First, since 1993, a trust is subject to pay income tax on its taxable income at the highest marginal rate (39.6%) when the income level exceeds approximately $8,500.00.  Since the underlying “principal” amount of the IRA will remain taxable to the trustee, it is expected to be subject to income tax at the trust marginal income tax bracket.  Accordingly, in many situations the overall income tax to be borne on the IRA will be higher at the trust level than if the funds were merely paid to an individual member of the decedent’s family.

The second important caveat related to the relaxed rules of Revenue Ruling 2000-2 are related to the gift tax consequences to the surviving spouse.  When the surviving spouse leaves the “income” portion of the IRA in the IRA, a question arises. Has the surviving spouse made a “gift” of the “income” to the remainder beneficiaries?  Generally, a trust beneficiary is not subject to gift tax consequences where the “release” or “lapse” is less than 5% of the trust corpus each year.  See I.R.C. § 2514(e).  Accordingly, there may be uncertain gift tax consequences to the surviving spouse by failing to exercise his or her option to remove the “income” from the IRA each year, unless there are other assets within the trust to make a payment to the surviving spouse.