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The Trust As Designated Beneficiary, Conduit Trust and Accumulation Trust

Qualification requirements divulged.

May 15, 2008
by Joseph Welch, JD

In the March issue of this CPA Wealth Management Insider, we talked about the incredible growth power of the multigenerational qualified retirement plan (“Stretch QRP”), the non-spousal beneficiary’s ability to choose “rollover” and the mathematics that drive the stretch. Last month, I divulged the mathematics that drive the multigenerational qualified retirement plan (“Stretch QRP”), as well as the problem of “Stretch Blowout,” the tendency of beneficiaries to withdraw QRP funds before they achieve full tax­‑deferred growth.

This month, we’ll take a closer look at multigenerational trust planning with retirement plans. I’ll tell you more about the requirements for qualifying a trust as a “Designated Beneficiary,” the “Conduit Trust” (which assures Required Minimum Distribution calculations over the beneficiary’s life expectancy) and the greater asset protection benefits provided by the “Accumulation Trust.”

The Trust Must Qualify As a “Designated Beneficiary”

Unfortunately, the IRS Rules have made it difficult for a conventional living trust to maximize the stretch-out of taxable distributions. First, the trust must qualify as a “Designated Beneficiary.” This means that:

  1. The trust must be valid under state law;
  2. The trust must be irrevocable at the death of the Plan Owner;
  3. Documentation must be timely given to the Plan custodian; and
  4. The beneficiaries must be identifiable from the trust instrument.

Failure to meet any of the above requirements may mandate distribution of the entire account balance within five years of the year of the Plan Owner’s death (the dreaded “Five-Year Rule”) and result in immediate loss of approximately 40 percent of the account to income tax.

The requirements for Designated Beneficiary status, upon which depends the “stretchability” of the Plan based on the beneficiary’s life expectancy, presents a number of problems:

  1. If the trust divides into “subtrusts” for various beneficiaries (e.g. the Plan Owner's children) can each beneficiary use their life expectancy to determine their own Required Minimum Distributions (RMDs)?
  1. Can the primary beneficiary of each “subtrust” use their life expectancy to determine the RMDs?
  1. Can you redirect QRP benefits after the death of the Plan Owner by a power of appointment, a disclaimer or a decision by a Trust Protector, without running afoul of the “irrevocability” requirement of Designated Beneficiary qualification?

The Conduit Trust

In order to solve these problems, a “safe harbor” technique (called a “Conduit Trust”) has been developed in living trust planning. This requires payment of all RMDs to the primary beneficiary each year, using the Single Life Table.

Using the Conduit Trust technique assures planners that the life expectancies of other (possibly older) trust beneficiaries, including successors and potential beneficiaries, (such as the Plan Owner’s parents or estate) can be ignored in satisfying the Designated Beneficiary requirement and in the calculating RMDs.

Obviously, a Conduit Trust, which mandates that the beneficiary’s distributions are paid out each year, does not provide a high level of asset protection or spendthrift protection for QRP assets, since payments are required even if the beneficiary is involved in a divorce, lawsuit or bankruptcy  or if the beneficiary is a minor, a "Special Needs" person, or an individual with a proven tendency to dissipate assets. If RMDs are paid to a beneficiary who is involved in bankruptcy, divorce, a lawsuit or other judgment against them, the RMD amount can be seized by others.

Since the complexities of trust planning with the “Stretch QRP” often lead to use of the Conduit Trust, the beneficiary’s personal protections are weakened. In addition, many Plan Owners fail to limit the Conduit Trust payout provision to RMDs only. Consequently, with a typical Conduit Trust, whether or not the "Stretch QRP" will really stretch throughout the lifetime of the next generation depends on the child's willpower and his or her ability to say “no” to withdrawing more than the RMD each year. The typical Conduit Trust estate plan can enable a stretch (assuming the retirement Plan itself allows it or the beneficiary properly implements a rollover through a Trustee‑to‑Trustee transfer) but does not ensure the stretch, since the child can always pull out more than the RMD (and most children do).

Furthermore, whether the trust even qualifies as a Conduit Trust may be subject to dispute. For instance, what if taxes, Trustee’s fees and other trust expenses are deducted from the trust prior to distributions (so that something less than the RMD is paid to the beneficiary); will the trust still qualify as a Conduit Trust? Will payment of trust expenses require the use of the life expectancy of an older, “potential” beneficiary or even require distribution of the entire account balance within five years from the year of the Plan Owner's death? What if the trust limits the potential successor beneficiaries so that none will be older than the primary beneficiary? Because of these uncertainties, many Plan Owners are required to make hard choices between tax deferral and asset protection for their beneficiaries.

The Accumulation Trust

In the April issue of AICPA Wealth Management Insider, I examined the phenomenon of “Stretch Blowout,” the tendency of most beneficiaries to take more than their Required Minimum Distribution (RMD). Very few beneficiaries have the sense, willpower or understanding of the tremendous growth potential of the tax deferral feature to limit their withdrawals to the RMD.

In addition, emerging case law suggests that these “inherited” qualified retirement plan (QRP) accounts are not entitled to the creditor exemptions afforded to the same Plans while the Owner remains alive. Consequently, trust protections are necessary and desirable. However, the Conduit Trust, which assures that the life expectancy of the primary beneficiary may be used to determine RMDs, thus exposing the RMD to the possibility of seizure by a creditor of the beneficiary. However, it is possible to place QRP funds in trust at the Plan Owner’s death and still provide beneficiaries with personal protections chosen by the Plan Owner (divorce protection, lawsuit protection, bankruptcy protection, spendthrift protection, “Special Needs” protection, etc.) with another type of technique called an “Accumulation Trust.” The Accumulation Trust provides enhanced asset protection for qualified funds by giving the Trustee discretion to make or withhold distributions, depending on the beneficiary’s current situation. Distributions can be withheld while the client is involved in a divorce or a bankruptcy or is being sued or becomes disabled. However, Accumulation Trusts can NOT automatically use the primary beneficiary’s life expectancy. The life expectancies of all beneficiaries must be taken into account in establishing the RMD and the oldest beneficiary’s life expectancy will determine the maximum term of distribution and tax deferral. This may include contingent beneficiaries as well as potential appointees under lifetime and testamentary powers of appointment!

In Conclusion

The asset protection benefits of Accumulation Trusts for QRP assets are rarely made available to Plan Owners in a living trust. This is because the requirements and uncertainties involved in the design of the Accumulation Trust features make it difficult to predict whether or not you can still use the primary beneficiary’s life expectancy for RMDs.

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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. You can reach him at 866-566-0088.

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..