Life and Death Planning for Retirement Benefits

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282 Life and Death Planning for Retirement Benefits
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 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 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. 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 , 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; se
6.1.04 “Total return” or “unitrust” method
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 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.
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