Estate Planning and Qualified Retirement Plans

Estate planning is a critical component of financial wellness, especially for retirees and young professionals looking to secure their financial future. Within the realm of estate planning, understanding how to manage qualified retirement plans—such as 401(k)s and IRAs—is paramount. These savings vehicles not only help you amass wealth for your golden years but also have profound implications for your estate planning strategy.

Defining Qualified Retirement Plans

Qualified retirement plans are tax-advantaged accounts recognized by the IRS. They include plans like 401(k)s, 403(b)s, IRAs (Traditional, Roth, SIMPLE, SEP, and SARSEP), TSPs, and other pension plans. The benefits of these plans are manifold, offering tax deductions on contributions, tax-deferred growth, and, for Roth accounts, tax-free distributions in retirement.

Understanding Treatment at Death of an Owner

To comprehend the complex regulations governing qualified retirement accounts upon the owner’s demise, it is essential to first explore the various categories of potential recipients.

With the enactment of the SECURE Act, there are three recognized beneficiary classes:

1. Eligible Designated Beneficiaries.
2. Designated Beneficiaries.
3. Non-Designated Beneficiaries.

Eligible Designated Beneficiaries fall into the following categories:

1. The deceased owner’s spouse.
2. A child of the deceased owner who has not attained 21 years of age.
3. An individual suffering from chronic illness.
4. A disabled individual.
5. An individual who is not more than ten years younger than the deceased owner.

Each subgroup of eligible designated beneficiaries has distinct guidelines. For instance, a spouse enjoys the most flexibility in deciding how to manage the inherited account. Spouses are the sole beneficiaries permitted to conduct a rollover of the plan, affording them the ability to treat the plan as if it were their original account. Consequently, a spouse executing a rollover is not mandated to take any Required Minimum Distributions (RMDs) until reaching their required beginning date (currently 73 years old) and also benefits from creditor protection, which is unlimited for plans governed by ERISA. Conversely, other eligible designated beneficiaries, though lacking the same creditor protection as the original owner, still have the advantage of potentially “stretching” distributions from the inherited plan over their life expectancy. This practice facilitates tax-deferred growth on the account, albeit temporarily for children below 21 years of age who are not chronically ill or disabled.

Designated Beneficiaries are individuals who do not qualify as an eligible designated beneficiary and can also include a “see through trust.” Under the SECURE Act, designated beneficiaries who elect to convert the inherited account into an inherited IRA are bound by the ten-year rule.

Non-Designated Beneficiaries are nonindividual beneficiaries like charities, business entities, estates, trusts (unless such trust is considered a “see through trust”).  Non-designated beneficiaries continue to be governed by the five-year rule as was the case prior to the SECURE Act’s enactment.

What is a See-Through Trust?

In simple terms, a see-through trust allows a trust designated as a beneficiary of a retirement plan to receive the same benefits as its underlying beneficiary. When correctly structured, a see-through trust enables a Trustee to withdraw funds based on the life expectancy of an eligible designated beneficiary or a 10-year allotment for a designed beneficiary. There are four key criteria for a trust to qualify as a see-through trust:

1. The trust must be valid under state law.
2. The trust must be irrevocable or become irrevocable upon the death of the account owner.
3. All of the trust’s underlying beneficiaries must be identifiable as being eligible to be designated beneficiaries themselves.
4. A copy of the trust must be provided to the custodian by October 31 the following year after the account holder’s death.

If you plan to leave qualified retirement plans to a trust, it is imperative that the trust is drafted appropriately to ensure the favorable treatment as a see through trust and that the inclusion of certain beneficiaries does not jeopardize the favorable tax treatment of any beneficiaries who qualify as an eligible designated beneficiary or a designated beneficiary.

Can Distributions Paid to a Trust Stay Protected in the Trust?

In order for distributions paid to a trust to remain in the trust and receive the asset protection the trust provides or to be maintained in accordance with the trust’s directions, the trust must be structured as an accumulation trust.

An accumulation trust gives the trustee discretion in determining what amounts, if any, from the distributions will be passed on the beneficiary at any given time. It is important to note that any funds that are held in the trust and not distributed to the beneficiary during the tax year will be taxed on the trust’s 1041 and at the trust’s tax rate. Funds distributed to the beneficiary during the tax year will instead be taxed at the beneficiary’s personal tax rate.

Many trusts done before the SECURE Act was passed were drafted as conduit trusts. Conduit trusts require that the trustee must distribute any payments from a qualified retirement plan to the beneficiary and they have no authority to accumulate such assets in the trust. This was a safeguard under the rules to ensure that a see though trust would be able to use the life expectancy of the beneficiary and that such beneficiary’s payout was not affected by the shorter life expectancy of a potential older beneficiary or named charity. Post SECURE Act, this strategy became less important since most beneficiaries are subject to the 10-year rule regardless of age differences and since regulations after SECURE 2.0 have altered how charities named as contingent beneficiaries are treated under accumulation trust rules. More on this below.

Taxation of Inherited IRAs

With the exception of ROTHs, distributions from all qualified retirement accounts are taxed as ordinary income to the recipient. Individual beneficiaries just file the income on their 1040. Trusts, on the other hand, file on a 1041 Fiduciary Income Tax Return. Whether the income is taxed to the trust or to the beneficiary can get complicated quickly, but in general, income distributed to the beneficiary of the trust in the same year that the income is earned will be taxed at the beneficiary’s rate and the trust will receive a deduction for the amount distributed.

Determining whether to distribute income is important because it will have a significant tax impact for most families. While individuals do not reach the top of their tax bracket until they have over $609,350 (or $731,200 if married filing jointly) in ordinary income in 2024, a trust reaches that top 37% bracket at just $15,200 in 2024. Often, this means that you will prefer that these funds are taxed at your beneficiary’s individual rate and not your trust’s rate.

Strategic Tools Clients are Implementing

Below are a few tools our clients have implemented in their estate planning in consultation with us and their trusted financial advisor to help ensure that their estate planning goals are met, beneficiaries are protected, and taxes are minimized.

Roth Conversions

One efficient way to manage taxes with qualified retirement plans involves Roth conversions. Converting funds from a Traditional IRA to a Roth IRA can provide tax-free growth and withdrawals, albeit the conversion itself is treated as taxable income. This strategy is especially beneficial if you anticipate being in a higher tax bracket in the future or seek to minimize taxes for your beneficiaries, who will receive tax-free distributions. When paired with a distribution to an accumulation trust, this sidesteps the compressed distribution timeline of the 10 year rule and removes the heightened tax burden for assets remaining in a trust.

Charitable Giving and RMDs

Naming charities as beneficiaries of retirement accounts presents another tax-savvy strategy. Not only does it fulfill philanthropic goals, but it can also reduce the taxable estate and give funds to great causes and not a dime to Uncle Sam.

If you’re already contributing to charity in your lifetime, consider leveraging Qualified Charitable Distributions (QCDs) with your RMDs. This strategy can amplify both your estate tax and income tax savings. A QCD empowers individuals aged 70 1/2 or above to donate up to $105,000 collectively to one or multiple charities directly from their taxable IRA, rather than taking their required minimum distribution.

Updating Conduit Style Trusts

Many families are choosing to transition their conduit trust provisions to accumulation style trust provisions. This shift offers increased flexibility for the Trustee in managing assets and enhances asset protection for the family members involved in the trust structure. Prior to the SECURE Act, many families had to choose between naming certain remainder beneficiaries in their trust or taking advantage of the accumulation style trust for their chronically ill or disabled beneficiary. Since the introduction of “applicable multi-beneficiary” trust (AMBT) structures under SECURE 2.0, it is no longer an issue to name non eligible designated beneficiaries in the same trust as a chronically ill or disabled beneficiary provided that the strict rules on establishing an AMBT are followed.

Utilizing Beneficiary Deemed Owned Trust Provisions

Beneficiary Deemed Owned Trusts (BDOT) under IRC Section 678 are trusts that give a beneficiary the power, either alone or with others, to control the beneficial enjoyment of trust income or corpus without the approval or consent of any adverse party. If a beneficiary has such powers, they are treated as the owner of the trust for tax purposes, even if they don’t technically own the trust assets. All trust income, deductions, and credits are treated as belonging to the beneficiary for tax purposes. This means that the beneficiary must report all of this on their personal tax returns, affording them the ability to leave assets protected in the trust (under most circumstances) while avoiding the compressed tax bracket for a trust (which tops 37% very quickly).

Simulating “Stretch” with Charitable Remainder Trusts

For individuals with substantial qualified retirement plan assets, considering a Charitable Remainder Trust (CRT) might be advantageous. A CRT allows you to contribute retirement assets into a trust that pays a stream of income to designated beneficiaries for a term (usually the beneficiary’s lifetime or 20 years), with the remainder going to charity. This strategy can satisfy philanthropic goals while providing income to loved ones and potentially offering significant tax benefits. For more information on this strategy, check out our prior blog post: Maximize Your Estate Plan with a Charitable Remainder Trust.

Final Thoughts

Effective estate planning with qualified retirement plans is a nuanced process that requires a deep understanding of current laws, tax implications, and strategic opportunities. Whether you’re a retiree aiming to optimize your legacy’s impact or a young professional planning for the future, incorporating these elements into your estate plan can significantly influence your financial landscape and the financial well-being of your heirs. Consultation with financial and legal professionals is recommended to tailor an estate plan to your unique situation and goals.

Let our experienced team be your guide. At Carrell Blanton Ferris & Associates, our estate planning attorneys have access to top-tier resources built on our 30-year legacy. We are committed to establishing a lasting practice that will support you and your family for generations. Reach out to the office nearest you to discover how you can begin working with our team today.