With retirement plans bursting at the seams with new money, changes in the law can make it easier to pass that money on to heirs. But there are several red flags to watch for.
The past 12 months have seen very important developments relating to naming beneficiaries of retirement plan assets-401(k)s, 403(b)s, 457s and other employer-sponsored plans, as well as individual retirement accounts.
The amounts in these plans continue to swell, making retirement plan assets the largest asset that many of our clients own. A recent study by the Investment Company Institute indicates that, for 2005, $14.5 trillion is invested in retirement assets. This amounts to 38% of the financial assets held by United States households. Roughly two-thirds of these assets are contained in 401(k)s and other company plans (rather than IRAs and other non-ERISA plans).
Rollovers By Nonspouses
The most talked-about development has been authorization of the nonspousal rollover. Section 829 of the Pension Protection Act (PPA) creates a new section 402(c)(11) of the Internal Revenue Code (IRC) that now allows a nonspousal beneficiary to stretch out the minimum required distributions (MRDs) over a much longer period of time. As discussed below, these new rules apply to anyone who inherits a retirement asset on or after January 1, 2006.
Under the old law, every distribution to a nonspouse beneficiary was subject to the rules of the plan or IRA owned by the decedent. This always resulted in a taxable distribution. The only issue was when the money had to be distributed. Many plans require a lump sum distribution to the beneficiary. At best, a beneficiary could wait until five years after the year of death to receive the entire amount-the maximum time period allowed under the IRC 401(a)(9)(B)(ii). Any period of tax deferral beyond that was lost.
This has now changed, although this development may not be as advantageous as it first appeared. The PPA permits a nonspousal beneficiary to inherit a retirement asset and to receive MRDs based on the life expectancy of that beneficiary. For instance, a 50-year-old beneficiary will take his distributions based on his life expectancy of 34.2 years, as set forth in the IRS' Single Life Table. This is much better than the maximum five-year period allowable under the old law.
Practitioners need to be aware of some points that were overlooked or mischaracterized by many commentators. First, it is not really a rollover like a spouse can do. Rather, it is a transfer from one account to another that must remain titled in the name of the decedent. In January 2007, the IRS issued Notice 2007-07, stating that the account should be titled as "Tom Smith as beneficiary of John Smith." With a spousal rollover, title is in the name of the spouse, as if she had owned it all along.
Second, this transfer must be a direct trustee-to-trustee transaction. A nonspousal beneficiary cannot receive the funds and then deposit them in an IRA within 60 days, as can a spousal beneficiary. The funds must be deposited into a new, stand-alone IRA. The nonspousal beneficiary cannot deposit these funds in a preexisting IRA that holds other qualified funds.
Third, a nonspousal beneficiary cannot wait until reaching the age of 701?2 years before receiving the annual MRDs, like a spousal beneficiary can.
Exactly when the MRDs must begin and how much they should be has created considerable confusion. Recent pronouncements from the IRS have not helped. One must first determine if the decedent died before or after his required beginning date (RBD).
If the death was before the RBD, then the general rule is that the nonspousal beneficiary is bound by the terms of the plan. If a lump sum is required, then the nonspousal beneficiary must take it. Otherwise, the nonspousal beneficiary will have the previously mentioned five years to receive the entire account balance.
But there is an important exception of which all practitioners must be aware. If the five-year period applies and if the nonspousal beneficiary has done the rollover before Dec. 31 of the year following the date of death, then the life expectancy of the beneficiary can be used in determining MRDs. This means all practitioners must now be on the lookout for nonspousal beneficiaries who have not yet rolled over the account.
But the downside of the exception is that it will only apply to decedents who died in 2006 or later. The IRS specifically ruled on this in a special edition of the Employee Plans News issued in February 2007. If a beneficiary inherited a plan in 2005 or earlier, it is now too late to use this rule. That beneficiary will be able to delay distributions only until the expiration of the five-year deferral period.
It is less complicated if the decedent died after his RBD. The customary MRD regulations are not changed. The nonspousal beneficiary will be able to use her life expectancy or that of the decedent, whichever is longer.
However, there may be problems if the decedent had MRDs that were never taken. The rule has always been that an MRD must be taken for the year of death. If the decedent did not receive the MRD while alive, that amount cannot be rolled over. Practitioners must be on the alert for this since the solution is simple if recognized: Have the beneficiary take the MRD from the decedent's plan or IRA and then roll the balance into the new inherited IRA. But if this problem is discovered after the rollover, the MRD amount will need to be treated as an excess contribution and backed out of the new IRA.
Another frequent source of questions concerned whether a plan administrator or custodian was required to offer the option of a nonspousal rollover. This is critical because the rollover must be directly from trustee to trustee. If the plan administrator or custodian will not agree to this, no rollover can occur. This has now been answered in Notice 2007-07: There is no requirement for a rollover option.
This has caused a great deal of anguish among commentators fearing that this could eviscerate Congress' intent. The concern is that plan administrators and custodians will be reluctant to incur the time and expense to amend their plans and custodial agreements to provide the rollover option. Amendments mean further training of staff. Administrators and custodians will not want the added headache of determining MRDs that may not be based on the life expectancy of their customer.
The hope is that employers will see the added benefit to their employees and their families and will insist that the amendments take place. But there is a considerable amount of skepticism as to whether this will occur. Practitioners have to see how this develops.
Note that all of this only applies if the participant has died. Practitioners should be advising their clients to roll over their qualified funds from a 401(k) or other company plan into an IRA while the clients are alive. Plan participants will normally be allowed to roll their funds out of a company plan when the participant reaches the age of 591?2 or ceases employment with the company. Once this point is reached, account owners can, with spousal consent, name whomever they please as beneficiary, who can then use that beneficiary's life expectancy for MRD purposes.
Trusts As Beneficiary-The Good News Continues
Several recent pronouncements from the IRS continue the string of favorable rulings involving trusts as beneficiaries of qualified assets.
Private Letter Ruling 200615032 is the most recent ruling allowing a surviving spouse to roll over her deceased spouse's IRA. The decedent's estate was named as beneficiary. The decedent had a pour-over will that created a trust in which the spouse was sole trustee and sole beneficiary, and had an unrestricted right to withdraw the IRA. In such cases, the trust is considered to be a "see-through" trust, with the spouse being treated as if she were named as the beneficiary on the form.
This same concept was adopted in Q&A 16 of Notice 2007-07 with the new nonspousal rollover. If a trust names a nonspouse as the sole or primary beneficiary of the trust, then the trust will qualify as a "see-through" trust and the nonspouse will be able to execute a rollover as set forth above.
The IRS took this approach a step further in Private Letter Ruling 200616040, where the decedent named his wife as beneficiary of his IRA. The wife died shortly thereafter, and her estate disclaimed the IRA. The decedent's daughters were not named as contingent beneficiaries because of a lapse by the custodian, who admitted to the mistake. The daughters obtained a court-ordered reformation of the beneficiary designation form naming them as contingent beneficiary. They then sought authorization from the IRS to allow the account to be transferred to the two separate accounts established for them, and the life expectancy of the oldest daughter was used for MRD purposes. The IRS agreed. (Note that by creating two separate accounts, one for each daughter, they could have used each daughter's life expectancy for their respective accounts. It is not clear why this was not done.)
Most recently, in Private Letter Ruling 200708084, a mother left her IRA to a trust that, in turn, created two subtrusts for each of her two children, who were the only beneficiaries of each. The terms of the trust dictated that the IRA be used to fund the two trusts. It further provided for outright distributions once each child had reached the age of 45 years, which had already occurred. Since it was clear that the two children's subtrusts would be entitled to the IRA, it was deemed to be a "see-through" trust and the children were able to take title to the IRA in their own names as beneficiaries.
Another important ruling is Private Letter Ruling 2006200025, which involved a special needs trust. The beneficiaries of the decedent's IRA were the decedent's four sons, one of whom was disabled and receiving Medicaid benefits. The ruling acknowledged that the disabled son could not inherit his share of the IRA without becoming ineligible for Medicaid. The son's mother was his guardian, and she petitioned the probate court to create a special needs trust to hold the son's share of the IRA. The IRS addressed two issues, both favorably for the beneficiary.
First, the private letter ruling said that the special needs trust would qualify as a grantor trust, as set forth in IRC Section 671 et seq. This meant that the assignment of the beneficiary's interest in the IRA to the trust was not a taxable event.
The second issue was whether the special needs trust qualified as a "see-through" trust, allowing the trust to use the son's life expectancy for MRD purposes. The ruling said that it did qualify. However there is the recurring problem, as already noted with nonspousal rollovers, that an IRA custodian does not have to agree to do this. It is doubtful that many of them will, since this is an unusual situation for an IRA custodian.
QTIP'ing An IRA
When naming beneficiaries of retirement benefits, the overriding objective is to keep it simple. Revenue Ruling 2006-26 shows the perils of being creative in this area.
This ruling dealt with naming a QTIP trust as beneficiary of a qualified account. In order to qualify a QTIP trust for the marital deduction set forth in IRC 2056, the surviving spouse must be entitled to all of the income generated by the trust while the survivor is alive. A frequent headache for practitioners has been deciding whether an MRD can be considered as income for QTIP purposes. The problem is that determining the amount of an MRD has nothing to do with the amount of income or gain generated by the IRA or company plan in a particular year. It is simply a percentage of the prior year-end's account balance.
Section 409(c) of the 1997 version of the Uniform Principal and Income Act attempted to resolve this by permitting a trustee to allocate 10% of an MRD as income and the remaining 90% as principal. In Arizona, this is codified in ARS 14-7418(b). Unfortunately, Revenue Ruling 2006-26 states that the IRS will not adopt this approach in determining whether the QTIP trust qualifies for the marital deduction. Instead, the IRS requires that all income generated within the IRA or qualified plan must be distributed to the QTIP trustee who, in turn, must distribute the entire amount to the surviving spouse as beneficiary.
This means two tests must be met: 1) The IRA custodian or plan administrator must make sure that all income, and not just simply the MRD, is distributed to the QTIP trust; and 2) The QTIP trustee must distribute that amount to the surviving spouse.
A solution for practitioners drafting QTIP trusts is provided in the Revenue Ruling. The QTIP trust will qualify if there is language entitling the surviving spouse to the greater of the MRD or "the income of the IRA."
But the best planning point is to avoid this mess altogether and not name a QTIP trust as beneficiary. Instead, look for other assets to fund the QTIP.
Traps For The Divorced Participant
A recent Kentucky case, Greenebaum, Doll & McDonald PLLC v. Sandler, demonstrates the danger of not following through with the terms of a prenuptial agreement. David Sandler remarried with two children from a prior marriage. He and his new wife executed a prenuptial agreement in which both parties expressly waived any interest in the other party's retirement accounts. However, Sandler never changed his beneficiary designations and never had his wife submit a spousal waiver to the plan administrator. Ten years after the marriage, Sandler died, and the plan administrator filed an interpleader action in federal district court for a ruling as to who should be paid-the wife or the children from the prior marriage.
The court ruled in favor of the spouse, holding that the provisions of the plan must be strictly followed and that the prenuptial agreement did not meet the plan's requirements for designation of a new beneficiary or of a spousal waiver. ERISA requires that, upon the death of a plan participant, the account balance of a retirement plan must be paid to the surviving spouse unless there is a spousal waiver filed in conformance with the terms of the plan. Since that did not happen, the wife was entitled to the proceeds.
The children also sought recovery based on a breach of contract theory, i.e., that the wife had an obligation to submit the requisite forms. But the court ruled against the children, finding that there was no evidence that Sandler had ever presented his wife with a form to sign. The court stated that, had such a form been presented to her, the outcome would have been different.
This was not a surprising result since there is a line of cases, beginning with the U.S. Supreme Court's well-known Egelhoff v. Egelhoff case from 2001, that require strict adherence to the rules of the plan when designating a beneficiary. This means that an otherwise valid prenuptial agreement is not enough for retirement plan purposes. The new spouse must also submit the requisite forms and must do so after the marriage, not before the marriage when the prenuptial agreement is signed.
Another threatening situation arising from a divorce that practitioners are likely to see more of occurred in the 2006 case-which received surprisingly little attention-of DaimlerChrysler Corporation Healthcare Benefits Plan et al. v. Ann Durden and Rita Lorraine Marshall-Durden, decided by the 6th U.S. Circuit Court of Appeals. Douglas Durden, a lifelong Chrysler employee, died in 2003. He married his first wife, Ann Durden, in Toledo, Ohio, in 1966. In 1982, the couple broke up and Ann moved to Memphis. In 1985, Durden married his second wife, Rita, with whom he lived until his death.
But after Durden died, Ann made a claim to his Chrysler retirement benefits-his pension, his life insurance policy and his health-care benefits. Ann had filed divorce papers at one point but she didn't follow through and the case was dismissed. Ann argued that since she never obtained a divorce, she remained Durden's spouse. Durden didn't know that Ann hadn't followed through with the divorce, and he named Rita as beneficiary of the benefits.
The trial court, ruling in favor of the second spouse, held that there was a presumption under ERISA that the spousal beneficiary designation is correct and that, under Michigan law, the first wife had to prove that the second marriage was invalid.
The 6th Circuit disagreed, ruling that there was no presumption that the beneficiary was correctly named. Applying Ohio law, it ruled that the second spouse had the burden of proving that the prior marriage had been dissolved, which she failed to prove. The first wife was entitled to the benefits.
The lesson to be learned for practitioners is to make sure their divorced clients have in fact been divorced. This situation (what one colleague of mine has called "the accidental bigamist") may not be as unique as it initially appears. Many spouses are divorced via default proceedings in which only one spouse actively participates in the dissolution action. The defaulting spouse is essentially assuming that the other spouse is proceeding in the correct manner. But, as demonstrated here, that is not always so. The easiest way to verify that a divorce has occurred is to have the client provide the practitioner with a copy of the divorce decree. If the client complains about having to retrieve one, particularly from another state, remind the client that his or her current spouse may need this to properly claim benefits. Both the client and the new spouse need to know this.
Naming beneficiaries of retirement assets remains an area that is fraught with (often needless) complications. This article addresses only a few of them: the need for direct trustee-to-trustee transfers, the need to avoid transferring an inherited IRA into an existing IRA and the need to be on the lookout for MRDs that have not been taken in the year of death, and so on. It should not be so complicated, but practitioners will have to deal with it. However, the upside for practitioners is that rendering competent advice in this area can be very valuable to a client. Insuring income-tax deferral for many years or decades can be worth tens of thousands of dollars to a client. The recent developments discussed here mean that many more clients can take advantage of this important benefit. Savvy practitioners will note the practice development possibilities that this creates.
Thomas J. Murphy is an estate planning, probate and elder law attorney practicing in the Ahwatukee area of Phoenix. He encourages comments and suggestions. He can be reached at 480-838-4838 or at mailto:email@example.com.