When Is Retirement; 'Dynasty' Trusts

Natalie Choate

Question: My client is a professor at X University. She turned 70½ this year (2011), and her last day of work at XU will be Dec. 31, 2011. She does not have to take minimum required distributions from the XU pension plan until the later of April 1 of the year after the year she turns 70½ (i.e., April 1, 2012) or April 1 of the year after the year she retires. Can we say she is "retiring" in 2012, so as to push her required beginning date back to April 1, 2013? After all, she is working every day right through the end of 2011, so it does seem that the first year she is "retired" is 2012. ... It seems very arbitrary and unfair that she has to take her first required minimum distribution just three months after she retires, whereas if she worked for even one day in January 2012, she wouldn't have to take any distributions until April 2013.

Answer: The usual assumption is that a person who works through 2011 but does not work a single day in 2012 is considered to have retired in 2011. If you want to fight with the IRS and the plan administrator about this, be my guest. And yes it's arbitrary, but any rule based on birth dates and retirement dates will end up having "unfair" results for some people. This has been happening since kindergarten when children born just one day apart might end up in totally different grades because they happened to be born on either side of a cutoff date.

Question: Would the following trust provisions work to establish a "see-through" trust, the beneficiary of which would be the "Designated Beneficiary" for purposes of determining the Applicable Distribution Period for an IRA payable to the trust? I am trying to establish a "circle" trust similar to that discussed in section 6.4.05(B) of the new edition of your book (page 455). The initial beneficiary would be my daughter Janice. The trust is a lifetime trust for her benefit. The trustee is to use income and principal of the trust as the trustee deems best for Janice's benefit during her lifetime. Though all payments to Janice are discretionary with the independent trustee, there are no other beneficiaries during her lifetime, and the trustee is instructed to consider her health, support, education, and well-being as significant goals of the trust. Upon Janice's death, whatever is left in the trust will pass to such persons among the class consisting of my progeny as Janice shall appoint by will, provided

that she cannot appoint to anyone who is older than she. If she fails to exercise the power, the property will pass to her offspring, or (if she has left no offspring; she has no offspring now living) to my descendants then living who were born after Janice. In either case, the property will be held in life trusts for the individuals on terms similar to the terms of the trust for Janice.

If at any time there is only one descendant of mine living who is either (1) Janice or (2) an individual younger than Janice, the trust will immediately

terminate and the trust property will pass outright to such last surviving descendant.

Answer: The law on this question consists of a vague statute and a brief regulation, fleshed out by one or two private letter rulings. Based on this paucity of authority, I cannot offer meaningful reassurance regarding any particular trust. My view is, there are some situations where the statute and regulation clearly support see-through trust status; and in all the other cases "your guess is as good as mine." Your example falls in the latter category.

With regard to a "circle trust," if you have a specified group of living individuals who are the prime (and intended to be the sole, barring unforeseen

circumstances) beneficiaries, such as the participant's children, and these beneficiaries are going to get the trust and benefits outright at a certain age that is well within their life expectancy, such as 25, 35, or even 45, then the circle provision (calling for early termination if all but one of the class members dies while there is still money in the trust, with outright distribution to that last surviving class member) meets the letter and spirit of the statute and regulations.

Obviously it shouldn't even be necessary to have such an early termination provision if all the money is to be paid outright to these known named individuals by the time they reach the specified age. In the case of the typical minor's trust, the actuarial likelihood that the minor beneficiaries will reach age 25, 35, or 45 is close to 100%. However, the IRS regulations look for "immediate outright" beneficiaries, and do not recognize "outright upon attaining age 25–45" as equivalent to "outright immediately regardless of age." Until the IRS adopts a more reasonable position on minors' trusts, the circle/early termination device seems to satisfy the IRS's requirement that the taker in default (who takes if the minors die before reaching the specified age) be an individual who is no older than the group members. So that is why the circle trust was invented and that's why it works.

In your example, however, you are not trying to get the retirement benefits to the beneficiary (Janice), while just holding them back until she reaches an

appropriate age. You are trying to do the opposite ... you are trying to keep the benefits away from her, except to the extent the trustee deems it advisable to use them for her benefit, and tie the money up forever in trust for your descendants.

The views expressed are the author's.

, 12/09/2011

Natalie Choate answers reader questions about retirement date determination for minimum required distributions and establishing a circle trust.

Understanding Employee Stock Option Plans

The boom days of the 1990s may be over, but stock option programs continue to be popular with public and private companies. Employees certainly can benefit from them, if they take some time to learn the basics.

Got stock options from your employer? Be sure to know the rules before exercising.

In the dot-com boom years of the 1990s and early 2000s, many companies made liberal use of employee stock option plans (ESOPs) to both reward and retain valued staff, from executives to temporary administrative help. While the current economic climate has produced fewer "company stock millionaires" these days, stock option programs continue to be popular with public and private companies. And employees certainly can benefit from them, if they take some time to learn the basics.

 What Is a Stock Option?

If you've been granted stock options, you've been given the right to purchase shares of your company's stock at a certain price under certain conditions set by company management.

•          If you have immediate options, you can purchase your alloted shares at any time.

•          If your options are vested, you can only purchase a set number of shares after you've worked at the company a certain period of time.

•          If your options are performance-based, they will vest once certain goals are met.

The two most common types of ESOPs are incentive stock option (ISO) and nonqualified stock option (NSO) plans. Usually, key executives are granted ISOs, while less senior employees are given NSOs. The chief difference between the two is tax treatment.

•          An ISO can be taxed under long-term capital gains, assuming the employee holds the stock for at least two years from the option grant date and one year from the exercise date. They are also taxed only when the stock is sold, making them tax-deferred plans. Note that ISOs can trigger the alternative minimum tax (AMT).

•          NSOs are taxed as both income and capital gains -- and the tax is owed once the options are exercised. This is an important consideration to anyone who is thinking of exercising options. If you don't have enough cash on hand to cover the tax bill, you may need to sell shares you've just purchased to cover the costs.

Exercising Options

Most stock options have an exercise period of 10 years; that is, you have 10 years from the time you receive the options to actually purchase the stock. You are not obligated to buy any shares, particularly if your company's stock price is trading below your set exercise price. If you don't make a purchase during the exercise period, your options will expire worthless.

Companies have the flexibility to exchange option grants if its stock has been negatively affected by market activity. For example, if your stock options are priced at $25 a share and your company stock has been trading at only $20 a share for a prolonged period, the company may exchange your $25 strike price options for a new set that gives you a lower strike price.

If you are participating in an ESOP, be sure to consult with a financial and/or tax professional who can help you decide when to exercise your shares and how to deal with the tax consequences.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

November 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Jim Ellman ChFC and Barry Mendelson, CFP local members of the FPA.

When Should You Collect Social Security?

When should you begin collecting Social Security? The answer depends in part on how long you think you'll be around to collect it.

Those choosing to collect before their normal retirement age face a reduction in monthly payments by as much as 30%.

A growing number of Americans have been forced to delay their planned retirement date due to job and savings losses suffered during the past five years. According to a survey, 40% of U.S. workers said they have resolved to retire later due to concerns about outliving their savings and fears of rising health care costs.¹ Postponing retirement not only means working longer, but also delaying when you start collecting Social Security. Currently, workers can begin collecting Social Security as early as age 62 and as late as age 70. The longer you wait to start collecting, the higher your monthly payment will be. Your Social Security monthly payment is based on your earnings history and the age at which you begin collecting compared with your normal retirement age. This normal retirement age depends on the year you were born.

Year Born	Normal Retirement Age
1937 or earlier	65
1938	65 and 2 months
1939	65 and 4 months
1940	65 and 6 months
1941	65 and 8 months
1942	65 and 10 months
1943-1954	66
1955	66 and 2 months
1956	66 and 4 months
1957	66 and 6 months
1958	66 and 8 months
1959	66 and 10 months
1960 or later	67

Those choosing to collect before their normal retirement age face a reduction in monthly payments by as much as 30%. What's more, there is a stiff penalty for anyone who collects early and earns wages in excess of an annual earnings limit ($14,160 in 2011).

For those opting to delay collecting until after their normal retirement age, monthly payments increase by an amount that varies based on the year you were born. For each month you delay retirement past your normal retirement age, your monthly benefit will increase between 0.29% per month for someone born in 1925, to 0.67% for someone born after 1942.

Which is right for you will depend upon your financial situation as well as your anticipated life expectancy. Anyone with a good pension or substantial savings may want to delay a bit. Similarly, if you're in no hurry to retire, you may want to continue working longer and collect later.

Likewise, those with a family history of longevity who expect to live a long time stand to gain more by delaying. If you think it unlikely to survive beyond age 78, you may want to start collecting at age 62. And if you expect to survive beyond age 82, you might consider a delayed collection.

Whenever you decide to begin collecting, keep in mind that Social Security represents only 38% of the average retiree's income.2  So you'll need to save and plan ahead -- regardless of whether you collect sooner or later.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

October 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Jim Ellman ChFC and Barry Mendelson CFP,  local members of FPA.

Ask the IRA Gurus

 

By Natalie Choate

September 2011

Sometimes I get an IRA question to which I don't know the answer. That's when I turn to my nationwide circle of IRA experts. I call them the "IRA gurus." With their astounding collective experience and knowledge, they can often help. So keep those questions coming!

Question: Our client's father, "Homer," is in his 90s. Since he was 70 1/2, he had his IRA minimum distributions sent to him by monthly automatic transfer into his bank account. This had been arranged for him each year by his IRA provider. Last year, he moved closer to his son's (our client's) home because of some serious health problems and in the process moved his IRA to a different provider.

However, he neglected to reinstate the automatic sending of the required distributions. His health issues contributed to a declining ability to manage his affairs. As a result, he failed to take the required distributions for the year 2010. Homer's son helped him with his 2010 tax return, and had him file "Form 5329" as part of the return, reporting the missed distribution and requesting a waiver of the 50% penalty. Now, the IRS has just sent him a notice that the penalty is due--with no mention of the waiver request. Is there anything Homer can do at this point to avoid that penalty?

Answer: I don't have experience with this situation so I turned to my IRA gurus. These enormously knowledgeable and productive people manage to not only speak and write about retirement benefits, they also actively consult with, advise, and/or represent clients who have retirement benefit issues with the IRS. They had plenty of practical suggestions for Homer.

Barry Picker of Brooklyn, N.Y., author of Barry Picker's Guide to Retirement Distribution Planning, speaks nationally and actively practices in the retirement benefits tax area. He says, "The IRS response sounds like a computer-generated notice caused by the filing of the 5329. I've had this before. Don't pay; respond with a letter to the address on the notice explaining the situation and requesting the waiver. Chances are good you'll succeed."

Bob Keebler, CPA, of Green Bay, Wis., nationally known speaker and author of multiple publications dealing with the tax treatment of IRAs and Roth IRAs, heads his own accounting firm that specializes in helping individuals solve their IRA versus IRS problems. Bob has drafted more than150 successful IRS private-letter ruling requests in the retirement benefits area. He was succinct: "I agree with Barry!"

Denise Appleby, author of the invaluable Appleby IRA Quick Reference Guides, reminds the questioner that, "It's not enough to explain why you missed taking the minimum required distribution. You also must 'take steps to remedy the shortfall,' meaning that Homer must take the 2010 distribution now, in 2011, before asking the IRS to waive the penalty. Both steps are required before the IRS will consider granting a waiver." PAGEBREAK  

Ed Slott, publisher of the terrific Ed Slott's IRA Advisor newsletter, who trains financial advisors how to use retirement benefits expertise to expand their practices, agreed with all of the above: "I would have originally advised him to take the missed 2010 distribution immediately and file the 5329 not only asking for the waiver of the penalty, but also showing that he made up the missed distribution--that he took immediate corrective action upon discovering the error.

"Also state the reason for the oversight, which in this case is logical and, I believe, would warrant a waiver of the penalty. But now he has an IRS notice which must be answered. I would respond that the missed distribution was made up, state the reason for the honest oversight, ask for the penalty to be abated, and it should be abated. In addition, mention that before this, he had a perfect track record of never missing a required distribution because they were withdrawn automatically. Once IRS puts this all together, the penalty should be waived and he should be fine. However, it might take a few letters to get this resolved."

Steve Trytten, an estate-planning lawyer in Pasadena, Calif., with special expertise in retirement benefits (and my co-panelist on an upcoming "Retirement Benefits Myth-Busters" seminar), wonders whether the IRS rejection "is not a denial of the penalty waiver but instead an erroneous action based on older form instructions. The instructions to Form 5329 used to require full payment before a waiver could be considered. Several years ago, the instructions were revised to delete this requirement. Perhaps the next step is to resubmit the 5329 along with a copy of the current instructions and renew the request for waiver of penalty."

Seymour "Sy" Goldberg, a well-known speaker and author on the tax treatment of retirement benefits, also tangles regularly with the IRS on behalf of clients. His stated, "The approach I use with respect to a penalty case in general is to respond to the IRS computer-generated penalty notice several times, and if that does not resolve the penalty issue, then I request an appeal to the local IRS Appeals Office. Based on the facts of this case, the penalty should be waived at either the IRS Service Center or the IRS Appeals Office."

Mike Jones, of Monterey, Calif., speaker, writer, and practitioner, and chair of the editorial advisory board for retirement benefits for Trusts and Estates magazine, concurs that if all else fails, Homer can "Exercise the right to go to IRS appeals with this. If that doesn't work, a suit for abuse of discretion could be needed; such suits are authorized by statute. Given the taxpayer's long history of compliance, it could be an abuse of the IRS' discretion not to waive the penalty."

I am a big fan of my IRA gurus. If they don't know the answer, there is no answer!

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed are the author's.

The Pros and Cons of Custodial Accounts

Once you establish an UGMA or UTMA, the assets you gift cannot be retrieved.

Setting up a custodial account can be a savvy move for adults who want to gift their assets and help their children become financially independent. But there are many considerations -- and consequences -- to weigh before opening an account. Here are some key points to keep in mind.

1.       The account options: UGMA and UTMA. The two types of accounts you can use to gift assets to your youngster are called a Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Which one you use will depend on your state of residence. Most states -- with the exception of Vermont and South Carolina -- have phased out UGMA accounts and now only offer UTMA accounts. UTMA accounts allow the donor to gift most security types, including bank deposits, individual securities, and real estate. UGMA accounts limit gifts to bank deposits, individual securities, and insurance policies.

2.       There are no contribution limits. Parents, grandparents, other relatives, and even non-related adults can contribute any amount to an UGMA/UTMA at any time. Note that the federal gift tax exclusion is currently $13,000 per year ($26,000 for married couples). Gifts up to this limit do not reduce the $1 million federal gift tax exemption.

3.       The assets gifted are irrevocable. Once you establish an UGMA or UTMA, the assets you gift cannot be retrieved. Parents can set themselves up as the account's custodian(s), but any money they take from the account can only be used for the benefit of the custodial child. Note that basic "parental obligations," such as food, clothing, shelter, and medical care cannot be considered as viable expenses to be deducted from the account.

4.       Taxes are due -- potentially for both you and your child. Some parents may initially find custodial accounts appealing to help them reduce their tax burden. But it's not that simple. The first $950 of unearned income is tax exempt from the minor child. The second $950 of unearned income is taxable at the child's tax rate, which could trigger the need for you to file a separate tax return for your child. Any amounts over $1,900 are taxable at either the child's or the adult's tax rate, whichever is higher. Note that state income taxes are also due, where applicable.

5.       Your child will eventually gain complete control. Once your child reaches the age of trust termination recognized by your state of residence (usually 18 or 21), he or she will have full access to the funds in the account. Be warned that your child could have different priorities for the assets in the account than you do. Money that parents had earmarked as paying for college tuition could instead be used to purchase a sports car or fund a suspect business venture.

6.       It could impact financial aid considerations. For financial aid purposes, custodial assets are considered the assets of the student. If the assets in the account could jeopardize your child's chances of receiving financial aid, speak to your tax and/or financial professional. One of your options could involve liquidating the UGMA/UTMA and establishing a 529 account.

Before making any decisions about establishing a custodial account, be sure to talk to your tax and financial professionals.

This communication is not intended to be tax advice and should not be treated as such. Each individual's tax situation is different. You should contact your tax professional to discuss your personal situation.
© 2011 McGraw-Hill Financial Communications. All rights reserved.
Sept 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by James P Ellman, ChFC and Barry Mendelson, CFP, local members of FPA.

Debunking IRA Urban Legends

Investors in IRAs often need a reality check when it comes to these common misconceptions.

by Natalie Choate

It's time to drive a stake through the heart of some widely held but very mistaken beliefs about planning for retirement benefits.

The Myth: By leaving your IRA to a perpetual or "dynasty" trust that also qualifies as a "see-through trust" under the Internal Revenue Service's minimum distribution trust rules, you can obtain a perpetual stretch-out for your IRA, or (even better) a perpetual tax-free family investment pool with a Roth IRA.

The Reality: It's true that certain states now permit clients to establish perpetual or 1,000-year trusts. But leaving your IRA or Roth IRA to such a trust in no way lengthens the maximum payout period permitted under the Tax Code's minimum distribution rules--even if the trust does manage to qualify as a "see-through trust" under the IRS' "minimum distribution trust rules." The minimum distribution rules require that all benefits be distributed, beginning the year after the participant's death, in annual installments over the life expectancy of the designated beneficiary. The longest payout period possible under that rule is about 81 years (the life expectancy of a one-year-old beneficiary). So if the perpetual trust qualifies as a see-through, and the oldest beneficiary of the trust is a newborn baby, the payout period for the benefits will be about 81 years. The trust can last forever, but the IRA (or Roth IRA) payable to that trust cannot last beyond the life expectancy of the oldest trust beneficiary.

The Myth: We can get a perpetual stretch-out of our IRA death benefits by leaving them to an individual (say the participant's child), who at his later death leaves the account to a next-generation beneficiary (say the participant's grandchild), who at his later death leaves the account to the next younger generation (the participant's great-grandchild), and so on.

The Reality: Well, it's true that the original beneficiary can name a successor beneficiary for the account, and thus pass it on to, say, the original beneficiary's own child. And it's even true that each successor beneficiary can leave what's left of the account on such beneficiary's death to still another successor beneficiary. But no matter how many successor beneficiaries there are, the account will still have to be distributed over the life expectancy of the FIRST beneficiary--he is the original "designated beneficiary," and his life expectancy is the payout period for the inherited IRA regardless of whether he survives for that entire life expectancy or dies prematurely and passes the account on to a successor beneficiary. So you can see it is unlikely that the account will even exist past the life expectancy of the first beneficiary (because he will probably survive to his life expectancy and therefore he will withdraw 100% of the account). It is extremely unlikely that the account will exist for multiple generations--that would require that each successive generation of beneficiaries dies within the life expectancy of the original beneficiary.

The Myth: The client can leave his retirement accounts to a "conduit see-through" trust for the benefit of his surviving spouse. During the surviving spouse's overlife, the applicable distribution period will be the surviving spouse's life expectancy. When the spouse ultimately later dies, the remaining benefits can be paid to the children over the life expectancy of the oldest child.

The Reality: No they can't. When retirement benefits are paid to a trust, if the trust qualifies as a see-through trust, the applicable distribution period is the life expectancy of the oldest trust beneficiary (the surviving spouse in this example). Even if the trust is the special type of see-through trust known as a "conduit" trust, there is no way for the trust to "flip" over to using the children's life expectancies as the applicable distribution period for benefits remaining in the plan at the surviving spouse's later death. By the way, it's very unlikely there will even be anything left in the retirement plan at that point--that would happen only if the spouse did not survive for her entire life expectancy.

If you want the payout period to "flip" to the children's life expectancy at the death of the surviving spouse, there's only one way to get that result: Leave the retirement benefits outright to the surviving spouse, and she rolls them over to her own IRA. By doing that you eliminate the requirement of distributing the benefits over the spouse's life expectancy (instead, she can defer all distributions until she reaches age 70 1/2, then withdraw using the Uniform Lifetime Table, which is much more favorable than a payout over her single life expectancy). At her death, she can leave the remaining balance of the rollover IRA to the children as her designated beneficiaries. As designated beneficiaries, they will qualify for a payout over their life expectancies.

All of these myths arise out of forgetting the basic bedrock principle of the minimum distribution rules: The retirement plan account cannot stay in existence longer than the life expectancy of the original owner (the participant) and his or her designated beneficiary. The money doesn't all have to be spent; the participant and beneficiary can save and invest the distributions they receive (after paying taxes on them, of course, in the case of non-Roth accounts). But at the end of that Code-mandated payout period, all of the money must be out of the plan.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.

Four Risks to Your Retirement Future

Because younger retirees typically are planning for a time horizon of 20 years or more, it is important that their portfolios include a source of growth that is likely to exceed inflation over the long term.

As Americans live longer, the task of managing money after retirement gets more complex. A retiree in his or her mid-60s typically has a different risk profile than an individual approaching 90. It may be helpful to look at various types of risk from the vantage point of how they affect retirees at different life stages. Here are four key risks to consider.

1. Investment Risk -- Balancing risk and return takes on a different meaning for individuals as they age. A negative rate of return during the early years of retirement could leave an individual with a significantly smaller nest egg when compared with negative returns later in the retirement life cycle. Your financial advisor can help you craft an investment mix with the goal of smoothing out returns over the long term and increasing the chances that your assets will last throughout your lifetime.

2. Longevity Risk -- Withdrawing too much from a portfolio during the early years of retirement may heighten the chance of depleting your assets during your later years. For this reason, many financial advisors recommend limiting annual withdrawals to 5% or less of a portfolio's value, adjusted for inflation, to make assets last as long as possible.

3. Inflation Risk -- Because younger retirees typically are planning for a time horizon of 20 years or more, it is important that their portfolios include a source of growth that is likely to exceed inflation over the long term. To complement this potential growth, many retirees rely on more conservative investments that may generate income and help to balance risk and potential return.

4. Health Care Risk -- It is not unusual for medical costs to increase as retirees age, and it may be prudent to plan for these costs before the need is immediate. Preretirees and younger retirees may want to explore options for medical insurance that supplements Medicare, as well as long-term care insurance, to reduce the possibility of dipping into personal assets to finance illness- or accident-related expenses. Also, remember that those who retire before age 65 need to find an alternate source of medical insurance prior to becoming eligible for Medicare.

Reviewing these and other challenges associated with retirement planning with your financial advisor may increase your confidence that you have considered all scenarios. While it may not be possible to prepare for every situation, planning ahead may help you cope with financial issues that come your way.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

June 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by James P Ellman, ChFC and Barry Mendelson, CFP  local members of the FPA.

Late Retirement and Minimum Distributions

The IRS offers a frustrating lack of guidance on how to tell whether someone is 'retired.' by Natalie Choate 06-09-11 |

Certain people who are still working after age 70 1/2 get to postpone the "required beginning date" for required distributions from their retirement plans. What can be frustrating is the lack of IRS guidance about how to tell whether someone is "retired."

Question: "Joe" is leaving his job this year, at age 79. He does not now own and has never owned any stock of the corporation he works for. When must he start taking distributions from the company's retirement plan? If he goes back to work for this company later, can he suspend taking those minimum distributions until he retires again?

Answer: Because Joe has never had any ownership interest in the employer, it's easy to figure out when he must start taking distributions. His "required beginning date" for distributions from his employer's retirement plan(s) is April 1 of the year following the later of the year he reaches/reached age 70 1/2 and the year he "retires." He reached age 70 1/2 several years ago, so the "later of" year is this year, the year he retires. Accordingly, 2011 is his "first distribution year," and he can take that first year's minimum required distribution anytime in 2011, or in 2012 (on or before April 1).

If he owned an interest in the employer (now or in the past), we would have to take more steps to verify that he would not be considered a "5-percent owner." A 5-percent owner, unlike other employees, is not entitled to postpone the start of minimum distributions past age 70 1/2, regardless of whether he is "retired."

Unfortunately, the plan apparently cannot suspend minimum distributions if he goes back to work for the company. The statute and regulations key the start of minimum distributions to the year the employee "retires," and there's no mention of any way to stop minimum distributions once they start. If Joe rolled his company plan benefits into an IRA, then went back to work for a different company, and rolled the IRA into his new employer's plan, that might do the trick--because he would not yet be "retired" under the new company's plan!

 Question: "Chris" is receiving deferred compensation from the company he used to work for. He is not and never has been a "5-percent owner" of that company. He is completely retired as far as I can tell, but he would like to postpone taking any minimum required distributions from the company's qualified retirement plan. He thinks he is entitled to such postponement because the nonqualified deferred compensation he is receiving is reported to the IRS on Form W-2. Because Form W-2 is reporting his income to the IRS as "wages" (W-2 is the "Wage and Tax Statement" form), he says the IRS would not regard him as "retired," therefore he is not subject to minimum required distributions yet. Is his argument valid?

Answer: "Chris" is not going to be making this decision all by himself. The plan administrator of the company retirement plan and the person who prepares Chris' federal income tax return both also have a stake in getting the right answer here.

The plan administrator of the qualified plan is responsible for making sure the plan stays "qualified." One element of qualification is complying with the minimum distribution rules. If the plan is required to distribute to Chris because he is (1) over age 70 1/2 and (2) retired, then the plan had better make the distribution or risk disqualifying the entire plan. If the plan administrator has done the necessary research and/or gotten an IRS ruling that Chris is not "retired," then Chris and the plan and Chris' return preparer can all rest easy with Chris' decision to postpone distributions.  

However, contrary to Chris' belief, there is no authority supporting the position that a person is not "retired" so long as he is receiving compensation that is reported on Form W-2. It's true that Form W-2 is used to report compensation for current services. But it is also used to report certain types of deferred compensation--and believe it or not, the IRS is aware of that fact! A Form W-2 that reports no compensation other than deferred compensation does not support the position that the individual is still working--in fact it supports the opposite conclusion, namely, that the person is retired.

We have something analogous we can look at--namely, the question of what constitutes "compensation" for services for purposes of supporting a contribution to an IRA. "Compensation" for this purpose "does not include any amount received as deferred compensation." Rev. Proc. 91-18, 1991-1 C.B. 522, recognizes that amounts reported on Form W-2 generally constitute "compensation for services" for purposes of supporting an IRA contribution, and accordingly the IRS will accept the "compensation" amount shown on Form W-2 as a "safe harbor" with respect to supporting an IRA contribution--unless the amount is also shown as deferred compensation.

Box 1

of Form W-2 ("Wages, Tips, and Other Compensation") reports the individual's total compensation for services during the year.

Box 11

of the 2010 Form W-2 ("Nonqualified Plans") reports how much of the

Box 1

amount is deferred compensation. Have a look at Chris' W-2. See whether the amount reported as total W-2 compensation for the year (Box 1) is also reported in

Box 11

. If it is, the IRS is unlikely to be fooled into thinking that Chris is not "retired."

If Chris fails to take a minimum required distribution, such failure must be reported on Form 5329 attached to his personal income tax return, with the attendant 50% penalty carried over to line 58 of the Form 1040 ("additional tax on IRAs, other qualified plans, etc."). The preparer of Chris' federal income tax return needs to consider this issue when preparing his return.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits.


The views expressed in this article are the author's.

Estate Planning for Second Marriage

by Natalie Choate | 05-13-11

Question: My client, who has a significant 401(k) plan through his small business, is getting remarried at age 64. Following the marriage, his estate planning goal is to have his new spouse (now age 58) be named as life beneficiary of his plan benefits, entitled to receive only the minimum required distribution, with any balance remaining at the spouse's later death to pass to the client's children (currently ages 40 and 35). He wants the benefits to qualify for the marital deduction for estate tax purposes, but does not want the wife to be able to access a lump sum distribution or change the successor beneficiaries. Further complicating this, when my client dies, the business will come to an end and have to be liquidated, which involves terminating the plan. Another problem is how we can get the future wife to accept this estate plan prior to the marriage.

Answer: The plan this client wants poses a number of legal hurdles and income tax disadvantages.

Perhaps there is a need to step back from these complications and look for a better way to

accomplish his goals. The plan he has in mind would require naming a trust as beneficiary of the retirement plan. The trust would provide that the wife would receive, each year, the income of the trust's non-retirement assets (if any), plus the "greater of" the minimum required distribution from the retirement plan for that year or the "income" of the plan for such year. Upon her death, the balance of the retirement benefits

(if any are left) would pass to the client's children. This type of trust is called a "QTIP trust" (for "qualified terminable interest property"), a name derived from the Internal Revenue Code section dealing with marital deduction trusts. If the trustee withdraws from the plan in any year more than the income/minimum distribution amount, the excess would be held in the trust for later distribution to the children. While that sounds fairly straightforward, this proposed plan would have to clear numerous hurdles.

After he and his family pay hefty legal fees to prepare and implement this plan, the client might then look down from heaven some years hence to see that his children receive exactly nothing from his retirement plans and his wife received much less than she could have received if things had been done a little differently.

Here are the obstacles to success with the QTIP trust plan; a suggested alternative approach at the end of this outline avoids these problems.

Federal spousal rights. Under federal law, once he and his new wife have been married for one year, he cannot designate anyone other than his surviving spouse as beneficiary of this plan unless she consents to allow him to name someone else. So, after the one-year period, he cannot leave his 401(k) plan to a QTIP trust without his spouse's consent. (Many retirement plans don't bother with the one-year waiting period; they give the spouse this consent right immediately upon the marriage.)

This right cannot be waived in a prenuptial agreement, according to the Department of Labor. Having the spouse agree, in a prenuptial agreement, that she will later waive these benefits might work, especially if she is given a significant financial incentive to consent, but that outcome is not guaranteed.

See-through trust rules. A QTIP trust named as beneficiary of the plan would need to qualify as a "see-through trust" under the IRS' "minimum distribution trust rules" in order for the trust to obtain a "stretch" payout of the benefits over the life expectancy of the oldest trust beneficiary (the wife). If the trust does not so qualify, then the benefits will have to be distributed out of the plan or IRA and into the trust within five years after the participant's death. Thus, the trust would need to be drafted by an estate planning lawyer familiar with the tricky see-through trust rules.

Wife must receive greater of minimum distribution or income. If the trust provides that the wife will receive only the minimum required distribution, it will not qualify for the federal estate tax marital deduction. To qualify for the marital deduction, the trust needs to provide that the wife will receive, each year, at least the income of the retirement plan (which could be more or less than the minimum required distribution in any particular year), as well as the income of any other trust assets. Again, we are faced with the need for an estate planning attorney who is experienced in drafting trusts for retirement benefits.

Benefits must be rolled to an IRA after the client's death. Because the 401(k) plan will

terminate at the client's death, the benefits will need to be either cashed out in a lump sum or "direct rolled" into an inherited IRA when he dies. A rollover to an inherited IRA is the only way to preserve the option of a "stretch" (life expectancy) payout at that point. That option will be available if the plan beneficiary is either the surviving spouse, the children, or a see-through trust. This option is not available if, for some reason, the trust that is named as beneficiary "flunks" the IRS' minimum distribution trust rules. There is nothing wrong with post-death beneficiary direct rollovers, but the client should be aware that this is an additional complication of his plan--one that would not arise if he rolled the benefits to an IRA prior to his death.

Booby prize: Nothing left for the children. What do you get for successfully meeting all of those challenges? If the benefits are left to a QTIP trust as contemplated by the client's proposed plan, and the wife lives to her late-80s or later, there will be nothing left for the children at the wife's death--even if the trust qualifies as a see-through trust, and even if the wife has consented to allow the trust to be named as beneficiary! That's because the client has specified that the entire minimum distribution is to be distributed to the wife each year. Minimum distributions will be based on the wife's life expectancy. Under the IRS tables, the wife's life expectancy would run out when she reaches approximately age 85. At that point the entire plan would have been distributed (and taxed) to the wife, so there would be nothing left for the children. To counteract that effect, the trust would have to provide that the wife does not receive the entire required minimum distribution; she just receives the "income" of the trust (as required by marital deduction rules). But in that case, the amount held back and retained in the trust for future distribution to the children will be taxed at trust income tax rates. A trust goes into the highest bracket (currently 35%, scheduled to rise starting in 2013) at a mere $11,800 or so of taxable income. So accumulating retirement plan distributions inside a QTIP trust for future distribution to the children comes at a very high price.

Plan sacrifices major deferral potential: By leaving benefits to a QTIP trust, the client is throwing away all of the potential deferral benefits of the spousal rollover as well as of a life expectancy payout based on his children's young ages. Thus, the plan is not only complicated in terms of its legal structure and requirements, it is very beneficial to the IRS. The client may want to consider another approach. Because of the spousal consent rule, the client is not free to leave the benefits either to his children or to a QTIP trust--the wife is the mandatory sole beneficiary (at least she will be after they are married for a year), and a prenuptial agreement waiving that right could be problematic. The client can remove this "blackmail" factor by rolling the benefits to an IRA prior to the marriage. Then the couple can agree upon a fair estate plan and disposition of the benefits via a prenuptial agreement that is clearly enforceable. (The federal spousal consent rules do not apply to IRAs.) Even if the husband continues to have future accruals under the 401(k) plan, and these become subject to spousal consent, the main bulk of the retirement plan money will have been rolled to the IRA and thus will have a "secure future."

Then, instead of leaving the benefits to a QTIP trust, the client should consider purchasing (through a trust) enough life insurance to provide everything for his wife that he wants to provide for her, while naming his children as beneficiaries of the IRA. The insurance trust would be structured to be outside the client's estate. The wife would receive the trust's income for life plus principal in an amount specified by the client (such as for health and support, or equal to a minimum dollar amount or percentage each year).

If the benefits are left outright to the children, the distributions can be spread over the children's long life expectancy. That's not possible with a QTIP trust, because the wife is the oldest beneficiary. The distributions can be taxed at the children's tax rate (normally lower than the tax rate applicable to a trust; humans don't get into the highest tax bracket until they have more than $370,000 of taxable income).

This plan costs more in terms of insurance premiums. The tax savings after the client's death should outweigh the premium cost during his life--and his children will get something from their father instead of nothing!

The views expressed in this article are the author's.

Financial Planning Strategies for Individuals & Families

Please see this presentation - updated through the end of the 1st Quarter, that Barry Mendelson, CFP(R) gave in February to the East Bay chapter of the American Society of Women Accountants.

Financial Planning Strategies for Individuals & Families

View more presentations from Barry Mendelson.

Estate Transfers: IRA to Beneficiary

The "stretch" or "life-expectancy-of-the-beneficiary" payout is available only to a "designated beneficiary."

 by Natalie Choate 04-08-11 |

Judging by the number of questions I get on this topic, this is one of the hottest issues out there. I've consolidated the most common questions into one typical scenario:

Question: "Yuri" died in 2010 at age 68 without having named a beneficiary for his IRA. Under the account documents for this particular IRA, the default beneficiary is Yuri's estate. He also left no will, so under the applicable intestacy laws, the estate passes half to Yuri's wife "Lara" and half to their daughter, "Tonya." The estate has no other assets. Lara, as administrator of the estate, has instructed the IRA provider to transfer Yuri's IRA in equal shares, via direct IRA-to-IRA transfer, half to Lara's own IRA and half to an "inherited IRA" payable to Tonya as beneficiary. The IRA provider refuses to do this unless an "inherited IRA" is opened in the name of the estate first. We are at an impasse. If the IRA provider insists on this condition, then the IRA will be subject to the "5-year rule." We want to instead have Lara do a spousal rollover of her half, and Tonya wants a life expectancy payout for her half. We also don't want to have to report the account as an estate asset for probate purposes. How can we resolve this dilemma?

Answer: On this one, the IRA provider is doing it right.

To back up a little bit, there is nothing wrong (in my opinion) with your goal of transferring the IRA out of the estate, intact, to the estate's two beneficiaries. Some IRA providers permit estates to do this, requiring only that the executor or administrator of the estate take control of the account and then give proper instructions for the transfer. Some IRA providers permit the transfer but have more substantial requirements--for example, the IRA provider might require an IRS ruling, legal opinion, and/or hold harmless agreements from the beneficiaries. And some IRA providers do not permit such transfers under any circumstances.

But whether or not the IRA provider permits the estate fiduciary to transfer the account out to the estate's beneficiaries, the IRA provider cannot deal with the fiduciary at all until the fiduciary has provided proper documentation to establish the fiduciary's right to give instructions with respect to this asset. Typically this means the fiduciary must (1) provide documentation of its right to deal with the account, such as a certificate of appointment from the Probate Court, and (2) sign the IRA provider's paperwork agreeing that the estate (as IRA beneficiary) is bound by the IRA provider's terms and conditions. Only once the IRA provider has this documentation can the provider begin taking orders from the estate fiduciary with respect to the deceased participant's IRA.

If the estate is going to transfer the asset out to the beneficiaries immediately, the IRA provider may or may not require the opening of an actual formal "inherited IRA account" in the name of the estate, before allowing that account to be closed as the IRA is transferred to the beneficiaries. If this step is required, the new "inherited IRA" account will be titled "Yuri IRA, payable to the estate of Yuri as beneficiary" or "Lara, administrator of the estate of Yuri, as beneficiary of Yuri." Some IRA providers might be willing to dispense with formally opening an account in the name of the estate as beneficiary, once the executor has provided evidence of its authority, written acceptance of the IRA provider's terms, and instructions for the transfer.

The transfer instructions would say in essence, "I, Lara, as administrator of the estate of your deceased IRA customer Yuri (see my certificate of appointment attached) hereby instruct you to divide the above account [i.e., Yuri's IRA] into two separate equal inherited IRAs, one titled 'Yuri, deceased, IRA, payable to Lara as successor beneficiary' and the other titled 'Yuri, deceased, IRA, payable to Tonya as beneficiary.'"

So the "good news" is that (one way or another) Lara can do these transfers. If the IRA provider she is dealing with won't allow the transfers, the account can be moved (still as an inherited IRA in the name of the estate as beneficiary) to a more cooperative IRA provider.

The bad news is that, unfortunately, Lara is misinformed about the effects of doing this transfer. Transferring the account to Lara and Tonya individually will not magically transform them into "designated beneficiaries" for minimum distribution purposes.

The "stretch" or "life-expectancy-of-the-beneficiary" payout is available only to a "designated beneficiary." A "designated beneficiary" means an individual or a qualifying "see-through trust." When Yuri died, there was no designated beneficiary on his IRA account. His estate was the default beneficiary, and (under the IRS' regulations) an estate cannot be a "designated beneficiary." Therefore the stretch or life expectancy payout method is not available for this IRA. Transferring the account out of the estate has absolutely no effect on the "applicable distribution period" for the account. It does not cause the transferees to become "designated beneficiaries" with respect to the account.

Yuri died before his required beginning date, with no designated beneficiary, meaning that the applicable distribution period for his IRA is the "5-year rule." All funds must be distributed out of his IRA no later than Dec. 31, 2015. As a result of the transfer, Tonya is now the successor beneficiary of "her half" of Yuri's IRA, but she is not entitled to use the life expectancy payout method.

The only bright spot here is that, although the IRS regulations never permit a life expectancy payout for benefits payable to or through an estate, the IRS applies more lenient standards when the issue is the spousal rollover rather than the life expectancy payout. Because Lara, the surviving spouse, was entitled to half the IRA through the estate as her intestate share, the IRS might well allow her to "roll over" her half into her own IRA, thus salvaging substantial income tax deferral.

I understand that families and their advisors can be very upset when they receive this answer, because it may mean they have to incur probate costs they hoped to avoid and the daughter does not get the life expectancy payout she hoped for. These bad results are caused by Yuri's failure to do proper estate planning, not by some evil intent on the part of the IRA provider.

Resources: The following sections of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011) provide complete discussion and citations to authority for the points discussed in this answer.

The views expressed are the authors.