Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

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income in excess of $11,200 (2010 rates). For an individual, the top income tax bracket applies only to taxable income above $373,650. Regarding scheduled future income tax rate increases, see ¶ 2.1.02 . Thus, in all but the wealthiest families, income paid to a trust will be taxed at a higher rate than would apply to the individual family members, unless the high trust tax rates can be avoided or mitigated by one of the following means:  Pass income out to individual beneficiaries. A trust is entitled to an income tax deduction for distributions it makes from the trust’s “distributable net income” (DNI) to individual trust beneficiaries, if various requirements are met. See ¶ 6.5.02 .  Charitable deduction. A trust is entitled to an income tax charitable deduction for certain distributions it makes to charity. § 642(c) . See ¶ 7.4.03 .  Transfer the retirement plan to a beneficiary. A trust can transfer the retirement benefits, intact, to the trust beneficiary. ¶ 6.1.05 . Following such a transfer, distributions will be made directly to the former trust beneficiary and (in most cases) taxed directly to such former trust beneficiary. See ¶ 6.5.07 – ¶ 6.5.08 .  Grantor trust rules. If the individual trust beneficiary is a U.S. citizen or resident, and has the unlimited right to take the retirement benefits out of the trust, the trust is considered a “grantor trust” as to that beneficiary, and distributions from the retirement plan to the trust would be gross income of the beneficiary rather than of the trust. ¶ 6.3.10 .  Use the IRD deduction. If the participant’s estate was liable for federal estate taxes, the trust gets an income tax deduction for the estate taxes paid on the retirement benefits. See ¶ 6.5.04 . A trust gets a unique deduction on its way from “gross income” to “taxable income”: The trust can deduct certain distributions it makes to the trust’s individual beneficiaries. § 651 , § 661 . These distributions are then includible in the beneficiaries’ gross income. § 652 , § 662 . The trust’s income tax deduction is limited to the amount of the trust’s distributable net income or DNI, so this is usually called the “DNI deduction.” § 651 , § 661 . If the trust’s income resulting from retirement plan distributions can be passed out to the individual beneficiaries of the trust as part of DNI, the income tax burden is shifted to the individual beneficiaries, and overall income taxes will be lowered if those beneficiaries are in a lower tax bracket than the trust. Unfortunately, the DNI deduction is not as simple as some practitioners might wish. First the good news: Retirement plan distributions received by a trust, like other items of IRD, become part of the trust’s DNI. See definition of DNI at § 643(a) ; Reg. § 1.663(c)-5 , Examples 6 and 9; and CCA 2006-44016. Accordingly, distributions of such IRD are eligible for the DNI deduction when passed out to the trust beneficiary, and are includible in the beneficiary’s income. § 661(a) ; § 662(a)(2) ; Reg. § 1.662(a)-3 . Even though IRD, like capital gain, is a form of gross income that is usually allocated to “principal” for trust accounting purposes ( ¶ 6.1.02 ), IRD is not subject to the special rules that limit a trustee’s ability to pass out capital gain as part of DNI. IRD goes straight into DNI just as interest and other “ordinary income” items do. CCA 2006-44016. In contrast, capital gains are not Trust passes out taxable income as part of “DNI”