Bosley, Janine H. e Hutzelman, Martha L.. Retirement plan distribution considerations in estate planning. Washington: Tax Management Memorandum, 5 de julho de 1999.
Retirement plan distribution considerations in estate planning
Tax Management Memorandum; Washington; Jul 5, 1999; Janine H Bosley; Martha L Hutzelman;
Abstract:
Initially, the distribution elections should be made with the idea of preserving the core principal of the retirement plan while at the same time providing the retirement plan participant with a comfortable retirement income. Such elections, if properly coordinated with estate planning techniques, can enhance the value of the estate by reducing the estate's potential income tax burden. Three types of retirement plan distribution options that have a direct impact on the amount and timing of the distribution of the individual's plan benefits at the time of the individual's death are: 1. choice of beneficiary, 2. choice of timing and form of distribution, and 3. choice of method of life expectancy calculation. The options available for each of these choices under the terms of the retirement plan should be reviewed, and a retirement benefit management plan should be devised for the individual that will identify distribution selections to be made that will be consistent with the individual's overall estate plan.
Copyright Tax Management Inc. Jul 5, 1999
Major References: I.R.C. (sec)401(a)(9); Prop. Regs. (sec)1.401(a)(9)-1
INTRODUCTION
Retirement plan benefits are now often an individual's single greatest asset. For this reason, retirement and estate planning considerations frequently merge, particularly as participants in retirement plans approach retirement age. An individual may initially seek legal advice regarding the handling of retirement benefits in his or her overall estate plan. Before estate planning issues are addressed, however, it is important that the individual understand that his or her own retirement planning needs will be satisfied. That is, estate planning is secondary to retirement planning. After it is confirmed that the individual has sufficient assets for his or her own retirement, a plan can be developed regarding the management of the individual's retirement benefits to be included in the individual's estate. One significant. part of this management plan is to identify retirement plan-distribution selections that will enable the retirement plan participant to best attain his or her estate planning goals, as well as reduce or defer income tax liability on the plan distributions. When devising the individual's retirement benefit management plan, it is important that the tax practitioner remind the individual that estate planning strategies do not remain static and, as a result, the individual's retirement plan distribution selections should be reevaluated upon the occurrence of any significant life event in the individual's family, such as death, divorce, remarriage, or birth. This memorandum reviews three types of retirement plan distribution options: (1) choice of beneficiary ( ie., spouse, children, grandchildren, or a trust); (2) choice of timing and form of distribution (i.e., lump sum, installment, single or joint life annuity, etc.), and (3) choice of method of life expectancy calculation. These options have a direct impact on the amount and timing of the distribution of the retirement plan participant's plan benefits at the time of the participant's death. Consequently, these distribution options should be ad dressed in the individual's retirement benefit manage ment plan. 1
BACKGROUND
Available Timing and Form of Plan Distributions
The retirement plan distribution options available to a plan participant are limited to a certain extent by the type of retirement plan in use. For example, the available forms of retirement plan benefits and timing of plan distributions are limited for qualified plans by a number of specific statutory requirements relating to eligibility to participate, vesting, benefit computation, and funding, among others.2 Therefore, the terms of the retirement plan must be reviewed to determine the timing and form of plan distributions that are available to plan participants and beneficiaries. A brief description of various types of retirement plans is set out below.
Qualified and Tax-Favored Retirement Plans
Tax-qualified 3 retirement plans are retirement arrangements established by an employer for the exclusive benefit of its employees and their beneficiaries. Tax-qualified retirement plans are intended to satisfy the requirements of (sec)401(a). The employer's contributions to the plan must generally be held in trust and are not taxable to participants until distributed from the trust. The available forms of retirement plan benefits and timing of plan distribution are limited by a number of specific statutory and regulatory requirements relating to eligibility to participate, vesting, benefit computation, and funding, among others. The retirement plan must comply with these requirements both in form and operation. Amounts distributed from tax-qualified retirement plans are entitled to special tax treatment.4
Tax-favored retirement plans, for purposes of this discussion, refer to individual retirement accounts and annuities that satisfy the requirements of 408 and 408A. Assets of these tax-favored retirement plans are held in a trust or custodial account established by the individual holder of the account assets.
There are two basic categories of tax-qualified retirement plans: defined contribution plans and defined benefit plans. Defined contribution plans provide an individual account (or number of accounts) for each participant. A participant's benefit under the plan is based on the amounts that have been contributed to the participant's account (or accounts), plus any income, expenses, gains and losses, and forfeitures from other participants that have been allocated to this account (or accounts). In a defined contribution plan, the participant bears the risk of loss from investment performance.5 Defined benefit plans are defined under the Internal Revenue Code of 1986, as amended ("Code"), as tax-qualified plans that are not defined contribution plans.6 A participant's benefits under a defined benefit plan are generally determined under a formula that takes into account factors such as plan year compensation or a stated dollar amount, and years of service with the employer. A participant's benefit is generally expressed as a monthly pension payable upon the participant's retirement at a specified normal retirement date. The amount of the benefit payable before a participant's normal retirement date is generally reduced on an actuarial or proportionate basis. In a defined benefit plan, the employer bears the risk of loss from investment performance.
Common types of tax-qualified and tax-favored retirement plans are described below:
(1) Profit-Sharing Plan: A profit-sharing plan is a defined contribution plan that allocates an annual employer contribution among eligible participants' accounts based on a stated formula that is generally a function of each participant's plan year compensation.
(2) (sec)401(k) Plan: A (sec)401(k) plan is a defined contribution plan that permits participants to elect to make pre-tax contributions to the plan out of their compensation. These plans generally provide for employer matching contributions equal to a percentage of the employee's pre-tax contribution. There are a number of special rules that limit an employee's ability to obtain a distribution of his or her contributions under a (sec)401(k) plan.
(3) Money Purchase Pension Plan: A money purchase pension plan is a defined contribution plan with a benefit formula that requires a fixed employer contribution based on participant compensation.
(4) Employee Stock Ownership Plan ("ESOP"): An employee stock ownership plan is a defined contribution plan in which participants' account balances are primarily invested in stock of the employer.
(5) Target Benefit Plan: A target benefit plan is a hybrid of a money purchase pension plan and a defined benefit plan. It has a defined benefit "target" or "assumed" formula, but the plan is otherwise drafted to resemble a money purchase pension plan. Thus, the participant's benefit under the plan is limited to the amount credited to his or her account under the plan, which may be more or less than the target benefit.
(6) Individual Retirement Accounts and Annuities: An individual retirement account (referred to generally as a "regular IRA") is a tax-favored trust or custodial account established by an individual with a bank or similarly qualified entity which acts as a trustee or custodian of investments contributed by the individual or purchased with funds contributed by the individual. An individual retirement annuity is an annuity contract issued by an insurance company into which an individual pays premiums instead of contributions. The maximum deductible contribution an individual may make to all IRAs in any one year is $2,000 or 100% of compensation ($4,000 for married couples). Prior to 1998, the spouse of an active participant in an employer-sponsored retirement plan was limited in the amount he or she could contribute to the spouse's own IRA. Beginning in 1998, the spouse of an active participant in an employer-sponsored retirement plan may make a deductible annual contribution of $2,000 to the spouse's own IRA, if the couple has a combined adjusted gross income of less than $150,000.7 The IRA contribution deduction is phased out for the spouse if the couple's adjusted gross income is between $150,000 and $160,000. This broader accessibility to IRAs may open up new estate planning considerations for "stay at home" spouses and others who have not previously been able to make significant retirement plan contributions.
(7) Roth IRA: Under prior law, only one type of individual retirement account ("regular IRA") was available to taxpayers. The Taxpayer Relief Act of 1997 ("TRA '97") created the "Roth IRA," a taxfavored vehicle which expands IRA options for taxpayers, effective January 1, 1998.8 Taxpayers (even those who have reached age 701/2) may make annual nondeductible contributions of up to $2,000 of compensation to a Roth IRA. However, the total annual contributions made to all of an individual's IRAs cannot exceed $2,000 (or the lesser of 100% of combined annual compensation or $4,000 for married couples). Contributions to a Roth IRA are phased out for individuals with an adjusted gross income between $95,000 and $110,000 and joint filers with an adjusted gross income between $150,000 and $160,000. Distributions from a regular IRA may be rolled over to a Roth IRA, if the taxpayer does not have an adjusted gross income in excess of $100,000 and the taxpayer is not married filing separately. Amounts in a regular IRA that are rolled over or converted to a Roth IRA are included in the taxpayer's gross income in the year of the conversion. Qualified distributions from a Roth IRA are tax free and penalty free if the distribution is made at least five years after the contribution and the distribution is made on or after the participant's attainment of age 591/2 death, or disability, or if the distribution is used for qualified first-time homebuyer expenses.
Section 401(a)(9) Required Minimum Distributions
The retirement plan distribution options that a plan participant selects will affect how and when plan assets are distributed from the retirement plan both before and after the participant's death, pursuant to the requirements of (sec)401(a)(9) and its related regulations. Section 401(a)(9) provides qualification rules governing when benefit payments must begin under a qualified plan and regular (i.e., not Roth) IRAs and the rate at which benefits must be paid out.9 In addition to potential plan disqualification, a 50% excise tax applies if retirement distributions fall below the levels required by schedules contained in Treasury regulations.10
Section 401(a)(9) provides that a plan participant's entire retirement plan interest must be distributed or begin to be distributed no later than the "required beginning date." The "required beginning date" is generally April 1 of the calendar year following the later of the calendar year in which the participant attains age 70 1/2 or retires.11 For IRAs and plan benefits paid to participants who own more than a 5% interest in the employer, the "required beginning date" is April 1 of the calendar year following the calendar year in which the participant attains age 70 1/2.12 If not paid in a single sum on or before the required beginning date, the participant's plan benefits must be paid: (1) over the employee's life; (2) over the lives of the employee and a designated beneficiary; (3) for a period not exceeding the employee's life expectancy; or (4) for a period not exceeding the joint and survivor life expectancies of the employee and a designated beneficiary.
The participant may affirmatively name a designated beneficiary or the beneficiary may be specified by the retirement plan. If distributions commence before the participant's death, the existence and identity of any designated beneficiary is generally determined as of the participant's required beginning date. If distributions commence after the participant's death, the existence and identity of any designated beneficiary is determined at the death of the participant or holder.
CHOICE OF BENEFICIARY
In general, a participant's beneficiary designation under the retirement plan will affect the period over which payments must be made under the minimum distribution rules of (sec)401(a)(9). If the participant fails to name a beneficiary, or if the beneficiary is deceased, the terms of the retirement plan will sometimes designate the default beneficiary (such as the participant's spouse, children, or estate). If there is no designated beneficiary, all of the plan assets allocated to the participant must be distributed within five Years of the participant's death ("the five-year rule").'> If a beneficiary receives a participant's interest through the operation of state law (i.e., through the operation of state intestacy statutes) rather than pursuant to the terms of the plan, only the participant's life expectancy can be used for determining the period over which the plan benefits must be paid.l4
Only individuals and the beneficiaries of certain trusts will qualify as "designated beneficiaries" for purposes of (sec)401(a)(9). An estate or a charitable organization may not be a designated beneficiary for purposes of avoiding the five-year rule. 15 If multiple beneficiaries are designated, the shortest life expectancy of the designated beneficiaries will be used in determining the distribution period under (sec)401(a)(9).16
A plan participant may change his or her beneficiary designation at any time, even after the required beginning date of distributions. If the beneficiary designated after the required beginning date is older than the designated beneficiary at the required beginning date, the payout period for the required minimum distributions will be reduced at the time of the new beneficiary designation. The selection of a younger designated beneficiary after the required beginning date will not lengthen the payout period for required minimum distributions.l7
The plan participant has the option to select a spouse, non-spouse individual, or certain type of trust as the designated beneficiary of his or her retirement plan benefits. Each of these types of beneficiaries has unique rights and requirements that must be satisfied in order for the beneficiary to be treated as a designated beneficiary for purposes of (sec)401(a)(9). When making a beneficiary designation, the plan participant should, evaluate whether the following rights and requirements that apply to the type of beneficiary he or she is considering are consistent with the participant's overall retirement and estate plan.
Spouse as Designated Beneficiary
As a designated beneficiary, a spouse has rights unavailable to other designated beneficiaries. The spouse has the right to rollover the retirement plan distribution into either his or her own IRA or the decedent participant's IRA, thus deferring the payment of income tax on the amount of the plan distribution. The spouse can wait until the later of April 1 of the year following the year the spouse reaches age 70 1/2 or the date on which the decedent participant would have reached age 70 1/2 to begin receiving distributions. By having the option to roll the funds over to his or her own IRA, the spouse has the right to designate his or her own beneficiary of the plan assets and to pass them to the beneficiary on a tax-deferred basis. Prior to 1997, the spouse had the right to defer the 15% excise tax on excess retirement accumulations.18
The surviving spouse of a participant with vested benefits under a tax-qualified retirement plan (except for certain profit-sharing plans) is entitled to a qualified joint and survivor annuity ("QJSA") if the participant dies after the annuity starting date (i.e., the first day for which an amount is payable as an annuity or any other form under the plan).'9 A QJSA is an annuity for the life of the participant with a survivor annuity for the life of the spouse if the spouse survives the participant.20 The survivor annuity must not be less than 50% and not more than 100% of the amount which is payable during the joint lives of the participant and spouse.
The QJSA rules are enforced by special spousal consent requirements. A waiver of the QJSA may be made in favor of a lump sum distribution (if allowed under the terms of the retirement plan) or a single life annuity. Such election, however, must be made during the 90-day period before the benefit commences and only after notice is given to the spouse. If the spouse consents, notice of the waiver must be made at least seven days before benefits commence.