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Living Trusts and the Emergence of the Qualified Retirement Plan Inheritance Trust

QRP inheritance trusts can have many advantages over traditional living trusts. Here's why.

July 24, 2008
by Joseph Welch, JD

The "Stretch" Inside the Living Trust

In my last article, I revealed the "Conduit Trust" and the "Accumulation Trust" as attempts to ensure the "stretch" ability of the qualified retirement plan ("QRP") assets. Although Conduit Trusts can assure the use of the beneficiary's life expectancy (as calculated on the Single Life Table) to calculate required minimum distributions ("RMDs"), they provide very little asset protection, since they require the RMD to be paid out to the beneficiary each year.

On the other hand, the Accumulation Trust can provide exceptional asset protection, but cannot guarantee that the beneficiary's life expectancy can be used in calculating the annual RMD. Use of the Accumulation Trust requires that the oldest beneficiary's life expectancy will determine the maximum term of distribution and tax deferral, which could even be a surviving spouse!

Because of the asset protection drawbacks of the Conduit Trust and the dangers and uncertainties of the Accumulation Trust, it is difficult to synchronize living trust planning with QRP trust planning. There are many risks involved with naming an ordinary living trust as beneficiary of the QRP:

  1. The oldest life expectancy may be used to determine the maximum "stretch" ability of the QRP (which may even be the surviving spouse!), thus denying most of the benefits of the "Stretch" to the next or a subsequent generation; or
  2. Assets in the trust may be completely disqualified from the "Stretch," because of other (usually desirable) features in the design of the living trust, including powers of appointment or the very small possibility that, if the client should die with no living descendants, the benefits could be paid to an older family member or to the estate of the beneficiary.

In a well-drafted living trust, other trust provisions may "bleed in" and force a five-year payout, instead of, e.g. a 45-year "Stretch." These include provisions regarding the payment of estate debts, expenses and taxes and the determination and payment of income to beneficiaries, various types of powers of appointment and "Special Needs" provisions.

The QRP Inheritance Trust

GOOD NEWS: The IRS has now issued a Private Letter Ruling giving guidance on our ability to use a separate "stand-alone" QRP Inheritance Trust to accomplish maximum lifetime planning flexibility, spendthrift and asset protection, postmortem flexibility and asset growth for the benefit of subsequent generations. (Note: While IRS Private Letter Rulings do not have the force of law, they do provide valuable insight into the thinking of the IRS.)

A separate, revocable trust is prepared solely to hold the inherited QRP account. The trust is designed as a Conduit Trust. A "switch" is built into the trust to convert the trust from a Conduit Trust to an Accumulation Trust if a beneficiary later needs more protection even after the death of the Plan Owner, yet the trust continues to satisfy the "irrevocable" requirement necessary to qualify as a Designated Beneficiary. The new QRP trust, approved in PLR 200537044, allows a "Trust Protector" (a neutral person appointed by the Grantor) to convert any trust from a Conduit Trust to an Accumulation Trust within nine (9) months after the death of the account Owner, which power would likely be exercised only if the Trust Protector believes that a beneficiary's inheritance is likely to be threatened by an attempt on the assets.

Although the QRP Inheritance Trust is designed to function initially as a Conduit Trust, the trust can also be designed to prevent "Stretch Blowout" by ensuring that the stretch will occur. For instance, it can provide that the beneficiaries are allowed to take out RMDs only. An exception can be provided for cases of emergency or need or education or any other item which the Plan Owner deems sufficiently important to warrant reduction of the full benefits of the "Stretch."

In a typical eight percent example using a QRP Inheritance Trust, a QRP account totaling $250,000 for a 65-year-old Owner, upon which he defers RMDs until age 70½, will continue to increase in value until he dies at age 80. The trust is revocable and amendable until the Owner's death, allowing the Owner to choose to withdraw and spend any of the account assets and to change his mind regarding their ultimate disposition. If the account then passes to his 45-year-old child who restricts withdrawals to the annual RMD, the child will, by age 80, have taken withdrawals totaling approximately $2.9 million AND will still have over $700,000 remaining in the account to use or pass on to the child's beneficiary. In this garden-variety example, the $250,000 account will provide benefits in excess of $3.5M to the Owner's beneficiaries and family. If, however, the 45-year-old child simply withdrew the funds, loss of the longer tax-deferred ("Stretch") growth opportunity would total approximately $1.5M!

Who Can Benefit?

Who should consider a QRP Inheritance Trust? Obviously, account size is a factor. A person who has a $100,000 QRP with one beneficiary has as much to gain for that beneficiary as a person with a $500,000 account and five beneficiaries. Basically, any person can benefit from the QRP Inheritance Trust who has a substantial QRP and either now has or may have:

  1. A minor child or grandchild who is either already a beneficiary or who may become a beneficiary in the event of the death of another; or
  2. A desire to protect beneficiaries from divorces and lawsuits; or
  3. A desire to ensure that the account will continue to grow tax-deferred during the beneficiaries' lifetime; or
  4. A desire to protect the client's beneficiaries from the very human tendency to take all or a large portion of the money out of the account prematurely; or
  5. A "Special Needs" beneficiary.

The new QRP Inheritance Trust should be considered a valuable addition to the estate plan of any client who has substantial qualified funds.

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Joseph D. Welch, J.D. is the managing partner of Cary, Welch and Hickman, L.L.P. and the founder and manager of The Estate Planning Center, L.L.C. His practice is limited to estate planning, trust administration, asset protection and business succession planning. He is a frequent author and lecturer on estate planning topics. www.JosephDWelch.com

Disclaimer:

IMPORTANT: This brief summary of planning ideas is for discussion purposes only. It does not contain legal, tax, investment or insurance advice and cannot be relied upon for implementation and/or protection from penalties. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

Unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein..