This month, I’ll explain how benefits from a tax-deferred account can pass to a surviving spouse while preserving potential benefits for others, such as children by a prior marriage. For many, the bulk of retirement savings is held in tax-deferred accounts. For simplicity, I’ll refer to all such accounts as IRAs, which are governed by IRS rules mandating distribution during the retiree’s lifetime.
Married IRA holders have essentially two beneficiary choices. The first is to leave the IRA outright to their surviving spouse, who can take over the IRA as his or her own, allowing the spouse to be treated as the original IRA owner. This results in the greatest flexibility and longest period during which IRA balances can be deferred from recognition for tax purposes.
The second option is to leave the IRA to a non-spouse, a category including both individuals and entities such as estates and trusts. Non-spouse beneficiaries come in two flavors—those who are deemed a “designated beneficiary” and those who aren’t. Basically, a designated beneficiary means a living, breathing human being. Estates and most trusts don’t qualify.
Designated beneficiaries are treated much more favorably than non-designated beneficiaries, because they’re allowed to stretch their withdrawals out over their actuarial lifetimes. Non-designated beneficiaries must complete withdrawals within five years of the IRA holder’s death. Since most custodians require such withdrawals to be made in one lump sum, this basically means all the tax has to be paid at one time—and at whatever maximum state and federal income tax rates apply.
Fortunately, a properly drafted trust can be treated as a designated beneficiary. This, at least, gives the IRA holder (with a spendthrift or incapacitated spouse) some ability to control the timing, extent and use of IRA withdrawals. In this age of estate tax uncertainty, it’s also important that a designated beneficiary trust for a spouse be treated as “qualified terminal interest property,” better known as a QTIP Trust, which lets the entire IRA qualify for the unlimited marital deduction for estate tax purposes.
To qualify as a QTIP, all trust income must be distributed to the surviving spouse. This is usually done with a “conduit trust,” which treats all IRA distributions as income for marital deduction purposes, meaning the trust merely serves as a conduit between the IRA and the surviving spouse. Using a conduit trust means the entire IRA must be paid out during the surviving spouse’s actuarial life expectancy.
Is it possible to create a QTIP trust to preserve IRA assets for the benefit of not only the surviving spouse but for children or grandchildren? Yes: it’s called a non-conduit unitrust.
A unitrust is a special type of trust, from which income distributions are based on a percentage of the assets, measured periodically, rather than on the actual dividends and interest received from trust investments. For example, a unitrust document might specify that the income beneficiary is to receive 5 percent of the trust annually, as determined by the value of trust assets each December 31. Some planners favor unitrusts as a way to avoid disagreements between the income and remainder beneficiaries.
A special IRS rule lets a unitrust qualify for QTIP treatment as long as at least 3 percent of trust assets are distributed annually to the surviving spouse. Our IRA holder names his non-conduit unitrust as primary IRA beneficiary, directing the trustee to pay at least 3 percent of trust assets (which include both the value of the IRA and of the assets retained by the trust after paying taxes and distributions) to the spouse.
A disadvantage of the non-conduit unitrust is that income retained in it is taxed more heavily than income paid out to the surviving spouse. However, for the IRA holder who wants to provide for a spendthrift spouse or benefits to children or grandchildren, there’s no other alternative.
Let’s look at how the conduit and non-conduit trusts operate, using the following assumptions:
IRA balance: $1 million
Age of surviving spouse: 75
Investment returns: 6 percent
Unitrust rate: 4 percent
Our conduit trust generates total IRA distributions of $1,581,000, all of which are paid out to the surviving spouse over the first 13.4 years. After that time, both the IRA and the conduit trust are depleted. Whether there are any benefits for the children or grandchildren is completely dependent on what the surviving spouse has done with the distributions.
The non-conduit unitrust receives the same $1,581,000 from the IRA during the first 13.4 years. During that period, the Trust distributes $519,000 to the spouse, pays $418,000 in federal income tax, $132,000 in state income tax and, including trust investment returns, has $621,000 on hand for the future. Assuming the trust generates returns greater than the unitrust rate (4 percent in our example), the trust will continue to grow regardless how long the surviving spouse lives past his or her actuarial life expectancy at the IRA holder’s death. And meaningful benefits for the next generation of beneficiaries will be assured.
Using a non-conduit unitrust requires careful planning. Cash benefits flowing to the surviving spouse will be smaller than those from either a direct transfer of the IRA or the conduit trust. In our 4 percent unitrust example, distributions to the spouse begin at $40,000 per year and shrink to about $28,000, after which they begin to grow again at a rate equal to the difference between trust investment returns and the unitrust rate. Higher unitrust rates will produce higher benefits for the surviving spouse but lower benefits for the ultimate beneficiaries. It’s truly a question of balance in a world where Uncle Sam is going to get his due, and you can’t have everything you want.
