Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

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Roddy Example: Roddy dies leaving his $10 million IRA to the Roddy Living Trust. The trust provides that, upon Roddy’s death, the trustee shall distribute $3.5 million to the Credit Shelter Trust; this is a flat dollar amount (pecuniary) gift, not derived from any formula. The trustee is to distribute the balance of the trust property to Roddy’s surviving spouse. The combined federal and state income tax rate applicable to the trust is 45 percent. The trustee withdraws $6,363,636 from the IRA, thus creating $6,363,636 of gross income to the trust. The trustee distributes $3.5 million to the credit shelter trust. This distribution does not “carry out DNI” because it is in fulfilment of a pecuniary bequest that is not payable in three or more instalments, so the trust gets no DNI deduction. The trustee then pays $2,863,636 of income taxes on the IRA distribution. The credit shelter trust is now funded with $3.5 million of after-tax money. The balance of the IRA ($3,636,364) is transferred to Roddy’s widow ( ¶ 6.1.05 ) in fulfilment of her residuary marital share. The trustee can distribute to the beneficiary only what the trust authorizes the trustee to distribute. This is not an income tax rule; it is part of the law of trusts. If the trust instrument requires the trustee to distribute to the individual trust beneficiary all retirement plan distributions received by the trust (whether such plan distributions are considered income or corpus for trust accounting purposes), the DNI resulting from the plan distributions would be carried out and taxable to the beneficiary. § 643(a) , § 661(a) , § 662(a)(2) ; Reg. § 1.662(a)-3 . The problem is that some trusts are drafted without thought of the income tax consequences of the retirement plan distributions. Trustees can find themselves in the unhappy situation of not being able to pass out retirement plan distributions to the beneficiary because the trust instrument does not authorize it: Paul Example: Paul leaves his IRA to a credit shelter trust that requires the trustee to pay all income of the trust to Paul’s wife for life, and hold the principal in trust for distribution to Paul’s issue upon his wife’s death. The trustee receives a required minimum distribution RMD) from the IRA. Under the state law applicable to Paul’s trust, 10 percent of the RMD is allocated to trust income and the balance to principal; see ¶ 6.1.02 (C). The trustee has no authority to distribute more than 10 percent of the RMD to Paul’s wife; the other 90 percent must be retained in the trust, and will be taxed at trust income tax rates. Even if the trust says the trustee can distribute principal to Paul’s wife “if her income is not sufficient for her support,” the trustee cannot give her more than the 10-percent “income” amount unless she actually needs more for her support. Accordingly, when drafting a trust that may receive retirement benefits, if you want the trust to take advantage of the DNI deduction to reduce income taxes on distributions from the retirement plan, the trust instrument must give the trustee discretion to distribute principal (or at least the part of principal that consists of distributions from retirement plans) to the individual beneficiaries. If you want the trust to be forced to take advantage of this deduction, see “conduit trusts” at ¶ 6.3.05 . Trust must authorize the distribution

Trusts and the IRD deduction

If a retirement plan distribution to the trust is IRD when received, the trust is entitled to the applicable § 691(c) deduction, if any (see ¶ 4.6.04 ), unless the IRD is passed out to the trust