1

Estate Planning with Retirement Assets Jay P. Tarshis ARNSTEIN & LEHR LLP

120 SOUTH RIVERSIDE PLAZA | SUITE 1200 CHICAGO, IL 60606

P 312.876.7891 | F 312.876.0288 jptarshis@arnstein.com

1. General Considerations.

For many individuals, retirement benefits represent a significant portion of their wealth. Planning for retirement benefits as part of an estate plan is complicated by a mix of tax and non-tax considerations.

An additional layer of complexity is often involved when a trust is the designated beneficiary of the benefits. As the estate tax exemption has increased, more individuals may need to allocate retirement benefits to a credit shelter trust to fully fund their applicable exclusion amount (estate tax exemption). Other common situations where a trust may be named as a beneficiary include:

• Allocating benefits to a QTIP trust for a surviving spouse • Allocating benefits to a trust (or trusts) for descendants • Allocating benefits to a charitable trust

In determining the appropriate beneficiary of retirement benefits, it is important to

understand:

• Income Tax and ERISA rules governing the distribution of the benefits, including the minimum required distribution (“MRD”) rules and spousal consent requirements

• Operational rules governing the particular qualified retirement plan (”QRP”) or IRA

• Estate tax consequences of paying benefits to the beneficiary.

Retirement benefits are not “one size fits all.” Different rules (tax and ERISA) govern QRP vs. IRA’s. Also, rules may differ for different types of QRP’s and IRA’s (Roth vs. regular). Moreover, retirement benefits come in many different “flavors”:

• Employer sponsored QRP’s, such as a traditional pension plan, 401(k) plan or defined contribution (money purchase) pension plan

• 403(b) plan

2

• 457 plan

• Regular and Roth IRA’s

• Non-qualified retirement benefits

A QRP may limit the time and manner in which benefits will be distributed, either during lifetime or after death. Some limits, such as spousal survivor/consent rules, are mandatory. Other limits may be plan-specific. For example, some QRP’s allow a participant to withdraw benefits while employed; other QRP’s require a termination of employment to allow a benefit distribution. It is therefore important to “know your plan.”

In contrast, generally, an IRA owner may decide how/when benefits will be withdrawn from an IRA (subject to applicable penalty taxes for early or late withdrawals).

Retirement benefits are potentially subject to both estate and income taxes. The “game plan” for many individuals will be to take advantage of the tax-free growth available from a QRP or IRA (and, in effect, reduce the economic impact of the “double tax”) by deferring benefit distributions, both during lifetime and after death, as long as possible. This type of planning requires a knowledge of the relevant estate and income tax considerations, as well as many of the non-tax rules governing the distribution of the benefits.

2. Spousal Consent.

QRP’s are subject to spousal consent requirements for married participants. These rules limit the manner in which benefits may be distributed during lifetime and post-death, and often complicate estate planning for retirement benefits. Navigating the spousal consent requirements will be necessary if benefits of a married participant in a QRP will be paid or allocated to a non-spouse beneficiary, including a trust.

No spousal consent rules apply to IRA’s in Illinois (or other non-community property states).

Generally, spousal consent rules for retirement (lifetime) distributions are as follows:

• For all defined benefit (DB) pension plans (and some defined contribution (DC) plans)—“normal” retirement benefit must be paid in the form of a joint and survivor annuity with spouse, unless spousal consent is obtained for a different form of benefit. IRC §§401(a)(11) and §417; ERISA §205, 29 U.S.C. 31055. This rule is sometimes called the “survivor annuity rule” (since benefits are paid in a manner which provides an annuity to the surviving spouse).

• For most DC plans – benefits may be paid in a lump sum (non-annuity) to the participant if the “spousal death benefit” requirement is satisfied by the QRP. The “spousal death benefit” requirement is satisfied if (1) the benefit payable at the participant’s death must be paid directly to the surviving spouse (unless

3

the surviving spouse consents to a different beneficiary), (2) the participant does not elect to receive his or her benefits in the form of a life annuity, and (3) no part of the benefits is attributable to benefits from another QRP protected by the survivor annuity rule or spousal death benefit requirements. IRC §401(a)(11)(B)(iii); Treas. Reg. §1.401(a)-20, Q&A 3(a), Q&A 5.

The spousal consent rules for death benefits are as follows:

• For all DB plans (and some DC plans) - death benefit for a married participant must be paid in the form of a spousal survivor (life) annuity, unless spousal consent is obtained. This means that after the participant’s death, his or her spouse continues to receive a life annuity. IRC §401(a)(11)(A).

• For most DC plans – surviving spouse must be the sole direct beneficiary of the participant’s death benefit, unless spousal consent is obtained. IRC §401(a)(11)(B)(iii).

Note: In most cases, a participant in a QRP will want his/her death benefit paid in a form other than an annuity to a surviving spouse. This allows greater planning flexibility by (1) facilitating spousal rollover of death benefits (if benefits are paid in a lump sum), (2) allowing a non-spouse beneficiary to receive MRD’s over his/her life expectancy, (3) shifting investment and actuarial risk/reward from plan (or annuity provider) to owner, and (4) assuring any residual benefits are paid to a beneficiary designated by the participant (or the participant’s beneficiary).

For most QRP plans, a spouse of a married participant must consent to any non-spouse beneficiary of the participant’s death benefit. Spousal consent applies to any trust established for a surviving spouse (or any other beneficiary).

Spousal consent must:

• Be in writing;

• Designate a specific non-spouse beneficiary (including any class of beneficiaries and contingent beneficiaries) that cannot be changed without spousal consent (unless spousal consent expressly permits a change without further spousal consent);

• Acknowledge effect of spouse’s waiver; and

• Be witnessed by a plan representative or notary public. IRC §417(a)(2)(A); Treas. Reg. §1.401(a)-20, Q&A 32.

In the case of a trust named as beneficiary, a spouse is not required to consent to the beneficiaries of the trust or any later change to the trust beneficiaries. Treas. Reg. §1.401(a)-20, Q&A 31(a).

4

It is important to understand the spousal consent rules of the particular QRP. Spousal consent to a non-spouse beneficiary may be either general or specific. A general consent may allow later beneficiary changes without additional spousal consent. Consent may be irrevocable or not – if not, a spouse may later revoke his/her consent. These issues will be governed by the particular plan involved. Treas. Reg. §1.401(a)-20, Q&A 31(c).

Spousal consent is not required if:

• No spouse

• Spouse cannot be located

• Spouse is incompetent

• Spouses are legally separated (living apart is not enough)

• Spouse has been legally “abandoned.” IRC §417(a)(2)(B); Treas. Reg. §1.401(a)-20, Q&A 27.

However, there are no exceptions for an incarcerated spouse, a military spouse or an uncooperative spouse.

Watch out: spousal consent cannot be satisfied by a premarital agreement. In other words, under ERISA a waiver of spousal benefits in a premarital agreement is, in itself, meaningless. Spousal consent is only valid after marriage. (Marital agreements almost always predate the marriage.) Spousal consent rules have been strictly enforced. See, Pedro Enterprises v. Perdue, 998 F.2d 491 (7th Cir. 1993); National Automobile Dealers & Associates Retirement Trust v. Arbeitman, 89 F.3d 496 (8th Cir. 1996); Hayward v. Newton, 282 F.3d 285, (4th Cir. 2002). Spousal consent is not binding on a “later” spouse. Treas. Reg. §1.401(a)-20, Q&A 29. In contrast, some courts have applied equitable principles to enforce a spousal waiver of benefits in divorce settlement agreements, despite absence of a formal QDRO. These “equitable” decisions generally do not extend to the enforcement of premarital agreements (absent spousal consent).

What to do if spousal consent cannot be obtained? In some cases, it may be possible for a participant to receive a lump sum distribution of benefits (either in-service or post-termination) and rollover benefits to an IRA. This works for most DC plans, including 401(k) plans, if the QRP provides a lump sum distribution as the “normal” form of retirement benefit. The IRA may be a “safe haven,” since the spousal consent requirements generally do not apply to IRA’s.

3. Minimum Required Distributions.

The MRD rules govern (1) when benefit distributions must commence (both during lifetime and after death) and (2) the time period over which distributions must be made. In

5

sum, these rules govern “how quickly” and “how much” benefits must be distributed from a QRP or IRA.

MRD’s must commence by April 1 of the calendar year after reaching age 70-1/2. However, an employee who is not a “5% owner” can defer distribution from a QRP (but not an IRA) until April 1 of the year after the employee actually retires. IRC §401(a)(9)(C)(ii).

Lifetime MRD’s will be made based on the value of the benefits (i.e., account value) as of the prior December 31 multiplied by “applicable divisor.” Treas. Reg. §1.401(a)(9)-5. At age 70, MRD’s are calculated based on IRS projected life expectancy of 27.4 years. Treas. Reg. §1.401(a)(9)-9.

An individual with a spouse more than 10 years younger may use a joint life expectancy based on IRS Joint and Last Survivor Table. This will allow a longer distribution period.

An individual can receive MRD’s from several IRA’s by “picking and choosing” how much will be withdrawn from each IRA each year. This technique does not apply to a QRP. MRD requirements apply separately to each QRP.

MRD requirements must be satisfied in year of the owner’s death. In effect, the MRD “accrues” on January 1 of each year. For year of death (when death occurs after age 70-1/2), MRD (or balance of MRD if a partial distribution has been made) will be made to the owner’s designated beneficiary (or default beneficiary, if none). Unless the decedent’s estate is his/her beneficiary, the MRD should not be paid to the decedent’s estate.

The MRD’s which apply when death is before “required beginning date” (generally, age 70-1/2):

A. If there is no “designated beneficiary,” then “5-year rule” applies.

B. If there is a “designated beneficiary,” then either “5-year rule” applies or distributions may be made over life expectancy of designated beneficiary starting in year following owner’s death.

C. If spouse is beneficiary, then spouse may elect rollover treatment and “start fresh.” Alternatively, spouse may elect to start MRD’s from deceased owner’s IRA/QRP by the later of (a) December 31 of year after owner’s death or (b) December 31 of year in which deceased spouse would have reached age 70-1/2. Unlike a non-spouse beneficiary, a spouse’s life expectancy may be recalculated each year. Treas. Reg. §1.401(a)(9)-3.

A “designated beneficiary” is an individual identified as a beneficiary in IRA or QRP as of September 30 following the year of owner’s death. A “designated beneficiary” must be an individual: an estate, charity or cat will not qualify. Treas. Reg. §1.401(a)(9)-4, Q&A 1, Q&A 3. One “bad” beneficiary taints all beneficiaries—resulting in the absence of a “designated

6

beneficiary.” Treas. Reg. §1.401(a)(9)-4, Q&A 3. A trust is subject to a special “look through” rule (described below). Be sure to prohibit use of retirement benefits to pay estate obligations, such as estate taxes and expenses, to prevent the owner’s estate from being treated as a beneficiary. Remember: without a “designated beneficiary,” post-death benefits (if owner dies before age 70-1/2) are subject to the 5-year rule.

The “5-year rule” requires all benefits to be distributed no later than the end of year which includes the 5th anniversary of the owner’s death. IRC §401(a)(9)(B)(ii).

The MRD’s which apply when death is after required beginning date:

• MRD’s must be made over the longer of (a) owner’s remaining life expectancy, or (b) designated beneficiary’s life expectancy.

• If there is no designated beneficiary, MRD’s must be made over deceased owner’s remaining life expectancy (based on Single Life Table) determined in year of death.

• If designated beneficiary dies before all benefits are distributed, then MRD’s must continue (presumably to successor beneficiary) “at least as rapidly” as while designated beneficiary was alive. Treas. Reg. §1.401(a)(9)-5.

Trust may qualify as a “designated beneficiary” if “trust requirements” and “documentation requirements” are satisfied. The “trust requirements” are:

• Only individuals are beneficiaries of trust; • Trust must be valid under applicable state law; • Trust must be irrevocable no later than owner’s death; • Beneficiaries must be identifiable under trust. Treas. Reg. §1.401(a)(9)-4, Q&A 5

The “documentation requirements” are:

• the administrator of the QRP or the IRA custodian must be provided with a “final” list of all beneficiaries of the trust (including contingent and remaindermen beneficiaries, with a description of the conditions of their entitlement) as of September 30 of the calendar year following the calendar year of the owner’s death, and certify that, to the best of the trustee’s knowledge, the list of beneficiaries is correct and the trust requirements (described above) are satisfied, and agree to provide a corrected certification in the future if any of the described information changes; or

• agree to provide a copy of the trust to the plan administrator upon demand or,

instead, provide the administrator with a copy of the actual trust document of the trust that is named as a beneficiary of the benefits. Treas. Reg. §1.401(a)(9)-4, Q & A 6.

7

There is typically no issue as to whether a trust designated as beneficiary of a QRP or IRA is a “valid trust” under state law. Either a revocable trust (which is irrevocable at death) or a testamentary trust will qualify. Treas. Reg. §1.401(a)(9)-5, Q&A 7. Also, a trust treated as an estate by reason of an election under IRC §645 will qualify. 67 Fed. Reg. 18988, 18992 (April 17, 2002).

A “look through” rule applies to trusts for MRD purposes. The life expectancies of the trust beneficiaries are used to determine the distribution period under the MRD rules. If there are multiple beneficiaries, the individual who is the trust beneficiary with shortest life expectancy (i.e., oldest individual) is used for MRD calculations. Treas. Reg. §1.401(a)(9)-5, Q&A 7(a)(1).

In applying the “look through” rule, the following steps are followed:

• first, identify trust beneficiaries who are potential beneficiaries of benefits. If any beneficiary is not an “individual,” either “clean up” the tainted beneficiary by the September 30 measuring date or comply with the 5-year rule.

• second, identify the beneficiary with the shortest life expectancy. Beware: as a

general rule, contingent beneficiaries must be considered. See PLR 200228025 (April 18, 2002); Treas. Reg. §1.401(a)(9)-5, Q&A 7, Example 1. Permissible appointees under a power of appointment must also be considered. See PLR’s 200235038 – 202235041 (June 4, 2002). This makes it problematic to name many trusts as a beneficiary, since “disaster provisions” often include either “old” beneficiaries (i.e., heirs) or charities.

Also, consider use of boiler plate “fail safe” language, such as follows:

“Notwithstanding anything to the contrary herein provided, the Trustee may (1) accelerate the distribution to any “Disqualified Beneficiary” (defined below) hereunder to a date prior to September 30 following the year of the settlor’s death (the “Measuring Date”), or (2) commute the interest of any Disqualified Beneficiary in any trust hereunder and, in so doing, distribute such commuted value prior to the Measuring Date. The term “disqualified Beneficiary” shall mean any beneficiary who is (1) not an “individual” within the meaning of Code §401(a)(9) and the Regulations thereunder, or (2) an individual who is older than the oldest remainder beneficiary under Section ____ hereof who is living as of the Measuring Date.”

A different rule applies to “conduit trusts.” Only the lifetime of the “conduit” beneficiary is used to determine MRD’s. Treas. Reg. §1.401(a)(9)-5, Q&A 7(c)(3), Example 2. A conduit trust is merely a pass-through vehicle. All benefits are distributed “through” the trust directly to the beneficiary. Therefore, a conduit trust has few advantages as an asset accumulation vehicle (since all MRD’s must be distributed to the beneficiary). However, with a conduit trust, if the surviving spouse is beneficiary (1) he or she can defer MRD until the IRA owner would have reached age 70-1/2, Treas. Reg. §1.401(a)(9)-3, Q&A 3(b), and (2) the

8

spouse can recalculate his or her life expectancy each year (rather than use the “less one” method), Treas. Reg. §1.401(a)(9)-5, Q&A 5(c)(2).

If “separate shares” are created for each trust beneficiary, then each beneficiary’s life expectancy can be used for each separate share for MRD purposes. See PLR 200052042. However, payment of benefits to “umbrella trust”—which, in turn, is divided into sub-trusts for children or other beneficiaries—will not allow use of different ages of each beneficiary.

Roth IRA’s are subject to different MRD rules:

• No MRD’s required during owner’s lifetime

• After owner’s death, normal MRD rules apply (5-year rule or MRD’s over life expectancy of designated beneficiary). Treas. Reg. §1.408A-6

4. What to do with Retirement Benefits.

Some of the obvious options for selecting a beneficiary of retirement benefits are as follows:

• Pay benefits directly to surviving spouse

• Pay benefits to a QTIP trust for surviving spouse

• Pay benefits to “umbrella” revocable trust

• Pay benefits directly to credit shelter trust (or indirectly to credit shelter trust via spousal disclaimer)

• Pay benefits directly to children or other “younger” beneficiaries

• Pay benefits to charity

9

Spouse as Direct Beneficiary:

Advantages: Disadvantages:

• Allows spousal rollover and “fresh start” with MRD, thereby deferring both estate tax and income tax

• Surviving spouse can defer MRD until deceased spouse would have reached age 70-1/2 (if surviving spouse is older than deceased spouse)

• Simplicity

• Outright distribution can be combined with “spousal disclaimer” as a way to fund credit shelter trust

• Surviving spouse controls the benefits, so not ideal for multiple marriage client or spendthrift spouse

• Surviving spouse’s taxable estate may be “too big;” benefits not available to fund estate tax exemption

• Beware of “premature distribution” if surviving spouse needs to access benefits which are rolled over prior to age 59-1/2

10

QTIP Trust as Beneficiary:

Advantages; Disadvantages:

• Allows owner/deceased spouse to control ultimate distribution of benefits

• Allows benefits to qualify for estate tax marital deduction

• Allows MRD over life expectancy of surviving spouse

• “All income” requirement per Rev. Rul. 2006-26 treats QRP/IRA as separate assets of QTIP trust. To satisfy marital deduction requirements, all income of QRP/IRA must be distributed to QTIP, even if greater than MRD (so income tax deferral on benefits is lost if income exceeds MRD). In turn, QTIP must distribute all income of QRP/IRA to spouse.

• Be sure trustee of QTIP has absolute right to withdraw all income from QRP/IRA—otherwise, “all income” standard may not be satisfied.

• Beware of states which have adopted Section 409 of UPIA (AZ, CA and MI). State law in these states distort definition of “income” from QRP/IRA and violate “all income” requirement. Section 409 of UPIA allocates 1) 10% of MRD to income, and 2) all other benefit distributions to principal. In effect, this deprives the surviving spouse of the income from the QRP or IRA.

• MRD in excess of “income” of QRP/IRA gets “trapped” in QTIP, unless QTIP distributes principal to spouse. This portion of MRD may be subject to income tax at higher trust rates (vs. spouse’s lower individual rate).

11

Revocable Trust as Beneficiary:

Advantages: Disadvantages:

• Allows use of benefits to fund credit shelter trust (if needed)

• Beneficiary designation should “work” regardless of whether “other” spouse survives

• Can allow “indirect” spousal rollover of benefits if trust provides for outright marital gift (no marital trust) and directs trustee to use benefits to fund marital share

• Must use a fractional marital formula (with hassle of fractionalizing all assets to fund residuary testamentary gifts)

• Must assure revocable trust is a valid “designated beneficiary.” Under “look through” rule, be sure (1) benefits can not be used to pay estate expenses and taxes, (2) no trust beneficiary who is “too old,” and (3) no non-individual trust beneficiary.

• If descendants are expected beneficiaries of benefits, prevents use of “separate shares” to determine MRD for children/descendants.

Credit Shelter Trust as Beneficiary:

Advantages: Disadvantages:

• Funding of estate tax exemption at first death may reduce aggregate estate taxes.

• MRD based on oldest beneficiary of credit shelter trust (typically the surviving spouse.)

• Can use post-mortem spousal disclaimer to fund credit shelter trust on an “as needed” basis.

• Requires MRD to credit shelter trust beginning in year following death—this may accelerate distributions (vs. spousal rollover).

• Benefits are not ideal asset to fund credit shelter trust, since QRP/IRA benefits come with an income tax liability. If paid by credit shelter trust, the income taxes on MRD will waste trust assets and reduce potential estate tax savings. If MRD’s are distributed from credit shelter trust to surviving spouse, spouse’s estate will be increased by “net” MRD’s.

12

Payment of Benefits Directly to Children or other Descendants

Advantages: Disadvantages:

• Simplicity.

• Do not have to satisfy “look through” rule for trusts.

• Can use life expectancy of individual beneficiary to determine MRD.

• Each beneficiary can treat his/her portion of IRA as a “decedent’s IRA.” This allows each beneficiary to control investments, pick managers and exercise discretion over withdrawals (subject to MRD rules).

• Generally, individual beneficiary may be in a lower income tax bracket than trust.

• Beneficiary may elect to withdraw entire benefit immediately.

• No trustee management/oversight over assets.

• Beneficiary of benefits may, in turn, designate their own beneficiary of remaining benefits at death—owner loses control over ultimate distribution of benefits.

• Creditor protection for beneficiary of an “inherited” IRA is uncertain. Recent cases have mixed results on issue of whether an inherited IRA can be protected under bankruptcy exemption for regular IRA’s.

Charity as Beneficiary:

Advantages: Disadvantages:

• No income or estate tax on benefits—the “tax problem” is eliminated. If client is charitably inclined using benefits may be “cheap” way to fund gifts.

• If paid to a private foundation, benefits will not be considered “net investment income” subject to 2% excise tax.

• If non-charitable beneficiaries are also named from a single IRA, then charitable beneficiaries must be paid out before September 30 “measuring date”—otherwise, there will be no “designated beneficiary” of IRA

• Do not use QRP/IRA to fund pecuniary charitable gifts “through” trust—since trust will pay income tax on IRD used to fund charitable bequest

• Unless charitable gift is a dollar amount specified in IRA beneficiary designation, the amount passing to charity will be unknown, since value of IRA will fluctuate.