Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

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Jorge Example: Jorge dies leaving his $1 million 401(k) plan to a trust for his son. The trustee is to pay the trust “income” to the son annually, and distribute the “principal” to the son when he reaches age 35. The 401(k) plan distributes a $1 million lump sum to the trustee a few days after Jorge’s death. This is not a “required” distribution; the trustee simply requested the distribution from the plan. Barring an unusual provision in the trust instrument or applicable state law, the entire $1 million plan distribution is considered the trust “corpus.” On the federal income tax return for the trust’s first year, the trust must report the $1 million distribution as gross income, because it is “income” for income tax purposes even though it is “principal” for trust accounting purposes. The trustee invests the money that’s left after paying the income tax on the distribution, and pays the income (interest and dividends) from the investments each year to Jorge’s son. B. Trust accounting income vs. RMD. See Chapter 1 and ¶ 6.2 – ¶ 6.3 regarding the “minimum distribution rules.” RMDs and trust accounting income are totally different and unrelated concepts. C. State law; the 10 percent rule of UPIA 1997. If the “trust accounting income” attributable to a retirement plan held by the trust is not the same as federal gross income, and is not the same as the RMD, what is it? Unless the trust has its own definition (which is the preferred solution; see ¶ 6.1.03 (B)), the answer is determined by state law. For example, the 1997 Uniform Principal and Income Act (“UPIA”), which was adopted by a majority of states, provides trust accounting rules for retirement plan distributions. UPIA § 409 governs the trust accounting treatment of (among other things) any “payment” from an IRA or pension plan. UPIA § 409(c), which governs IRA and most other retirement plan distributions, provides: If “all or part of the payment is required to be made, a trustee shall allocate to income 10 percent of the part that is required to be made during the accounting period and the balance to principal.” This is known as “the 10 percent rule.” A nonrequired payment is allocated entirely to principal. Unfortunately, the 10 percent rule will provide too little income in most cases, especially if the benefits are being paid out over a long life expectancy. For example, if the trust’s Applicable Distribution Period (ADP; ¶ 1.2.03 ) is the 40-year life expectancy of the oldest trust beneficiary ( ¶ 6.2.01 ), the first year’s RMD will be [account balance] ÷ [40], i.e., only 2.5 percent of the value of the retirement benefits. That is already a low percentage, and the “income” portion of the distribution under UPIA § 409(c) would be only 10 percent of that. It seems unlikely that a trust donor would choose this method of determining the amount of “income” distributed to the life beneficiary. D. Income for a marital deduction trust. Trust accounting sometimes matters for tax purposes; most importantly for estate planners, the definition of “income” matters for purposes of the federal estate tax marital deduction. Generally, the surviving spouse must be entitled for life to all income of a trust in order for such trust to qualify for the federal estate tax marital deduction. § 2056(b)(7) . This subsection “D” discusses what the “income” is that the spouse must be “entitled to” with respect to retirement benefits left to a trust, in order for such trust to qualify for the federal estate tax marital deduction. See ¶ 3.3.01 – ¶ 3.3.07 for how to meet the “entitled” (and other) requirements to obtain the marital deduction for retirement benefits left to a trust.