Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

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However, if the trustee’s compensation is based on differing percentages of trust income and principal, even a totally discretionary trust will have to resolve the income/principal question regarding the retirement benefits. Also, this approach generally cannot be used for a marital deduction trust ( ¶ 6.1.02 (D)). B. Draft your own definition of income. Another way to deal with the trust accounting problem is to provide, in the trust instrument, how retirement benefits are to be accounted for. This solution is recommended because even if the applicable state law definition at the time the trust is drafted suits the client’s needs, the state law could change. What should such a trust accounting provision say? First determine what the client is trying to accomplish. If the client wants his beneficiary to receive the “income” of the trust, find out what the client thinks that means with respect to the retirement benefits. Second, see ¶ 6.1.02 (D) if the trust must comply with the IRS’s definition of income. C. “Trust within a trust” approach. One approach, which works for IRAs and other “transparent” defined contribution plans where the trustee controls the plan’s investments, and can readily determine exactly how much income those investments earn and when, is to treat the retirement plan as a “trust-within-a-trust”: Investment income earned inside the plan is treated as trust income just as if it had been earned in the trust’s taxable account. The IRS has approved this approach for marital deduction trusts. ¶ 6.1.02 (D). Debra Example: Debra’s trust provides that after her death the trustee shall pay all “income” of the trust (including income of any retirement plan payable to the trust as beneficiary) to Debra’s son Winston annually. The trust is the beneficiary of Debra’s IRA, and also holds stocks and bonds in a taxable account. In Year X, the trust earns $4,000 of interest and dividends in the taxable account, and the IRA receives $3,000 of interest and dividends from its investments. The trustee withdraws from the IRA $3,000 (or the RMD for Year X, whichever is greater; see ¶ 6.2), and distributes $7,000 to Winston. The trust-within-a-trust approach will not work for a defined benefit plan ( ¶ 8.3.04 ), or any other plan where the trustee cannot readily get the information needed to compute the plan’s internal income. Thus, there must be some type of default rule to cover these plans. A unitrust approach is recommended for the default rule, if permitted by applicable state law; see ¶ 6.1.04 . A trend in trust drafting is to eschew “income” and “principal” concepts in favor of a “total return” (also called “unitrust”) approach: The life beneficiary receives a fixed percentage (unitrust percentage) of the value of the trust’s assets each year, rather than receiving the traditional trust accounting income of rents, interest, and dividends. The UPIA 1997 ( ¶ 6.1.02 (C)) permits the unitrust method of trust accounting. The IRS will accept a definition of income based on the unitrust method if that method is permitted by state law and the annual fixed percentage to which the income beneficiary is entitled is not less than three nor more than five percent of the trust’s value (with “value” either being determined annually or being averaged on a multiple year basis). Reg. § 1.643(b)-1 . Retirement benefits pose a valuation problem for the unitrust approach: Should the built - in income tax liability be deducted from the nominal value of the benefits? That issue can be “Total return” or “unitrust” method