Estate Planning with Retirement Accounts

A "retirement account" refers to any account subject to the minimum distribution rules under section 401(a)(9) of the Internal Revenue Code (IRC), including an IRA, 401(k), or 403(b) account. 

A beneficiary of an inherited retirement must pay income taxes on the funds as they are withdrawn.  Taxes are paid at the beneficiary's income tax rate. A retirement account must be fully distributed to a beneficiary within a limited period of time.

The beneficiary of a retirement account must withdraw the funds, and pay the corresponding income tax, based on the status of the beneficiary when the account owner died: 

• A spouse must withdraw the funds based on his or her life expectancy, and the withdrawals must begin the when the account owner would have attained age 72, or a spouse may rollover funds to his or her own account;

• An adult beneficiary must withdraw the funds within 10 years of the date of death of the account owner;

• A minor beneficiary must withdraw the funds within 10 years after they reach the age of 18; and, 

• If the account owner did not name a beneficiary, or the beneficiary is any non-person (such as a charity), then the funds must be withdrawn within 5 years of the death of the account owner.

Other time periods apply to a beneficiary who is not more than 10 years younger than the account owner, a disabled beneficiary, or a chronically ill beneficiary.  In each case, the account may be distributed over the life expectancy of the beneficiary, starting within 1 year after the death of the account owner.  

A retirement account should be held in trust for beneficiaries when the account owner wants the funds to be managed by a trustee upon his or her death.  The most common situation to use a trust is when the account owner's beneficiares are minors or disabled persons.  Otherwise, it is usually preferable to name individual beneficiaries for the retirement account. 

Taxes must be paid on a retirement account held in trust when funds are withdrawn from the account by the trustee.  The time frame within which such withdrawals must be made depends on whether the trust is classified as a "conduit trust" or an "accumulation trust" under current treasury regulations -- 

Conduit Trust

A "conduit trust" is a trust in which the trustee is required to immediately distribute all of the funds to the trust beneficaries upon withdrawal from a retirement account.  In other words, the trust simply acts as a "conduit" for distributions from the account to the trust beneficiaries.  The trustee of a conduit trust must withdraw funds from the retirement account (and pay taxes) based on the shortest distribution period applicable to any primary beneficiary of the trust.

Accumulation Trust

An "accumulation trust" is a trust in which the trustee is not required to distribute the funds to the trust beneficiaries upon withdrawal from a retirement account.  In other words, the trustee is permitted to "accumulate" funds for the trust beneficiaries, including contingent beneficiaries.  The trustee of an accumulation trust must withdraw funds from the retirement account (and pay taxes) based on the shortest distribution period applicable to any beneficiary of the trust, including contingent beneficiaries.  

Why It Matters

The reason that the classification of a trust matters is that it will dictate the time period within which all trust beneficiaries are required to pay taxes on their share of a retirement account held in trust.  The time period within which a retirement account must be withdrawn by the trustee of an accumulation trust is usually shorter than a conduit trust because contingent beneficiaries of an accumulation trust are taken into account to determine who has the shortest distribution period.  Since contingent beneficiaries are usually older than primary beneficiaries, it is more likely that the distribution period for an accumulation trust will be shorter than a conduit trust.  Therefore, taxes are usually paid sooner on a retirement account held in an accumulation trust when compared to a conduit trust. 

Example

Assume that Jane creates a trust for her daughter Zoe, and names the trust as the sole beneficiary of her retirement account.  The alternate beneficiary of the trust is Jane's mother Kathy.  Jane dies when Zoe is 7 years old. 

If Jane's trust is a "conduit trust" (i.e. distributions from the retirement account are paid to Zoe upon receipt by the trustee), then the distribution period will be based solely on Zoe's age.  Therefore, the account must be fully withdrawn, taxes paid, and distributed to Zoe within 10 years after Zoe turns 18 (about 21 years from Jane's date of death). 

On the other hand, if Jane's trust is an "accumulation trust" (i.e. the trustee may hold distributions from the retirement account for the beneficiaries), then the distribution period will be the shortest period for any trust beneficiary, which includes Kathy.  Therefore, the account must be withdrawn, and taxes paid, within 10 years of Jane's date of death.  However, since Jane's trust is an accumulation trust, the trustee may hold the funds for Zoe's benefit for so long as permitted by the trust.  

There are three types of trusts that may be used to manage a retirement account: 

• Conduit trust for all beneficiaries
• Accumulation trust for all beneficiaries
• Separate trust for each beneficiary

Please see the previous section for a discussion regarding conduit trusts and accumulation trusts. Recent changes to federal tax law make it less certain whether a conduit or accumulation trust is preferable in any particular situation.   As a result of these changes, we also offer estate plans with a separate trust for each beneficiary.  

The purpose of using a separate trust for each beneficiary is to extend the time frame within which taxes must be paid by each beneficiary while still alowing the trustee to manage the retirement account according to their individual needs.  In other words, the objective is to obtain the benefits of both a conduit trust (longer distribution period) and an accumulation trust (longer management period) at the same time.  

We would be glad to discuss your options with respect to managing retirement accounts.