IN THIS ISSUE:Feature Article:
Recent Developments:
- Declaration of Trust Treated as Will Codicil
- NJ Enacts Home Sale Tax Break
- Final Regulations Liberalize Rules on Disclaimers of Real Estate
- New Jersey Roth IRA Bill Advances
- Bill Would Permit IRA charitable rollover
- New Jersey Clarifies Sales Tax Treatment of Internet Services
Using A Trust to Protect IRA Beneficiaries
RAs are in the news these days. Roth IRAs. Education IRAs. Old fashioned "traditional" IRAs. You can't pick up a newspaper or magazine, surf the Net, or turn on a TV or radio without hearing about the benefits of these tax-advantaged accounts. With the repeal of the excise tax on excess retirement accumulations and the profusion of new forms of retirement accounts, folks are placing an increasing share of their wealth in IRAs and other qualified retirement plans. The recent performance of the stock market has contributed to the trend by swelling the value of retirement savings.
There is danger in all of this. The fate of your IRA after your death is determined by the beneficiary designation on file with the IRA sponsor. An ill-considered beneficiary designation can negate or disrupt other carefully constructed portions of your estate plan. With increasing frequency, savvy advisors are recommending that IRA balances be paid to a trust, rather than directly to individuals. This article explains why.
Background
Most tax planning for IRAs aims to leave funds in the account as long as possible, to delay the payment of income tax. This strategy applies to Roth IRAs as well as traditional ones, because tax-free growth, the goal of the Roth, ends when the assets are withdrawn. A previous Foresight article ("Planning Distributions from Your IRA", 4th Qtr 1996) looks at the labyrinth of minimum distribution rules, and suggests how payments can be stretched into the next generation. At that time, the usefulness of trusts as IRA beneficiaries was limited. Naming the most common types of trusts as beneficiaries would accelerate taxation, relinquishing the benefits of deferral. But that has changed.
In December, the IRS amended its 10 year-old proposed regulations to permit the designation of a revocable trust as an IRA beneficiary. This long-overdue development makes it easier to mesh the IRA with the balance of the estate plan. It appears that this favorable treatment also applies to a testamentary trust (a trust created under a will), but the language of the regulations is not entirely clear on that point.
Designation of your estate as the IRA beneficiary remains a bad idea. When an estate is named as beneficiary, all assets must be distributed from the account within a short time after the date of death.
Designating a Beneficiary:
Beware Those Standard Forms!Tell your IRA sponsor you want to update your beneficiary selection and it will send you its standard beneficiary designation form. It's easy enough to complete the form and send it back in the mail. However, indiscriminate use of this form can be harmful.
For example, assume your chosen beneficiaries are your children in equal shares. What happens if one child dies before you do? For the non-IRA assets, a well drafted will or trust addresses this issue, and provides an alternative disposition. The most common plan is to have the assets of the predeceased child pass to his or her children in equal shares.
However, when dealing with an IRA, that option is typically not available if you use the standard beneficiary form provided by the IRA sponsor. Most forms provided by banks and brokerage firms permit you to name your children as multiple beneficiaries. But the fine print says that if one child predeceases you, that child's share automatically passes to the other children. This excludes the children of the deceased child, even if they are given a share of the non-IRA assets, and even though they may be the ones who are most in need of financial benefits from your estate. Many people sign and file these standard beneficiary designation forms, unaware that doing so modifies or disrupts their estate plan.
An typical standard beneficiary designation form is available online at the Fidelity Investments Web site. (requires free Adobe Acrobat reader). Some companies, such as Strong Funds, permit the beneficiary designation to be in letter form.
If you designate a trust as beneficiary of the account, as suggested in this issue's feature article, the trust can address the contingencies that may arise, and ensure that the IRA disposition is coordinated with the rest of your planning. Even if you don't use a trust, you need not limit yourself to the language of the IRA sponsor's form. Ask your attorney to draft a custom beneficiary designation to replace or supplement the standard form.
Why use a trust?
Designating a trust as IRA beneficiary offers several advantages.
Timing and control
Perhaps you have reservations about giving your beneficiaries immediate, unrestricted access to the assets in your IRA. A trust allows you to place controls on the payment of funds to them. The trustee can be instructed to use the funds only for limited purposes, or to release them at certain times. You may also permit the trustee to allocate funds among multiple beneficiaries, so as to match distributions with varying needs.
Even if your primary beneficiaries are capable of responsibly managing the IRA assets, it is possible that one of them will die before you do. A trust permits you to anticipate and deal with that contingency. (See the sidebar: "Designating a Beneficiary:
Beware Those Standard Forms!", at right). If the alternative beneficiaries are minors (your grandchildren, for example) the trustee can be instructed to hold and manage the assets for their benefit.
Creditor protection
A trust can help to protect your hard-earned IRA dollars from claims of your beneficiaries' creditors. Assets owned by your child outright may be at risk if he or she is sued or becomes involved in a messy divorce. A trust can be structured to protect assets from those hazards.
Management of tax decisions
The decisions made and actions taken shortly after your death can make or break the success of your distribution planning. For example, if a beneficiary (other than your spouse) withdraws assets from the IRA in the mistaken belief that they can be rolled over to a new IRA in the beneficiary's name, the chance of all future income tax deferral is lost.
With a trust as IRA beneficiary, your trustee controls decisions on withdrawal of funds from the account. You can name as trustee someone who has the willingness and skill to manage the critical tax-sensitive decisions. This may be a family member or a professional fiduciary. Your trust document can even include guidance to the trustee on your tax-planning goals for the IRA.
Generation-skipping
Want to leave your IRA to your grandchildren, rather than your child or children? There are some good reasons to do so. This type of generation-skip prevents the IRA proceeds from being subject to estate tax in your children's estates. If your kids are likely to have substantial estates, the savings can be significant. Perhaps more important, naming grandchildren rather than children as ultimate beneficiaries extends the time period over which distributions can be made. A 12 year-old grandchild has a life expectancy of 69.8 years. After your death, the payout of the account balance can be stretched over that duration, resulting in phenomenal income tax deferral. Of course, a trust is an essential element of this type of planning.
If you feel uncomfortable completely excluding your children from the IRA proceeds, you can name them as beneficiaries of the trust as well, but the income tax deferral will suffer because of their shorter life expectancy. Distributions to a trust that benefits a 45 year-old child as well as his or her children must be made over the child's 38 year life expectancy. One strategy is to split up the IRAs into separate accounts. The account or accounts for grandchildren can enjoy the benefits of long-term tax deferral, unimpeded by your children's shorter life expectancies.
If your IRA is of the Roth variety, the tax savings are even greater, because a Roth IRA offers growth that is tax-free, not just tax-deferred.
Final thoughts
IRA and qualified plan assets represent an increasingly significant share of accumulated wealth. Planning for these assets should be tightly coordinated with the balance of the estate plan. Trusts can be useful in making the most of these retirement funds.
Further reading
RECENT DEVELOPMENTS
Declaration of Trust Treated as Will Codicil
In re Declaration of Trust by Rose Catanio, N.J. Superior Court App. Div., 12/29/97Rose Catanio owned a home in Toms River, New Jersey. On June 30, 1995, Rose called her friends William and Teresa Lyle and invited them to come to her house. She asked them to witness her signing of a "Declaration of Trust" that she had prepared using a printed form. The Declaration described Rose's residence and declared that she would hold the home in trust for the benefit of her sister, Pauline De Maio (no relation to the author). It named Pauline as successor trustee and directed that ownership of the home be transferred to Pauline after Rose's death. Rose died two weeks after signing the document.
Rose's Will, signed 9 years earlier, made no mention of the home. It left her entire estate to five beneficiaries.
After Rose's death, the other beneficiaries claimed that the Will, not the trust, controlled the disposition of the real estate. The Declaration of Trust, they argued, was ineffective because ownership of the home was never deeded to the trust. The trial court agreed with them.
Reversing the trial court's decision, the Appellate Division held that Pauline was entitled to the home. According to the court, the Declaration of Trust showed Rose's intent to modify her Will. Since it bore the signatures of two witnesses, it was in effect a codicil to the Will, even though Rose had not called it a codicil.
Comment: None of the parties had argued that the Declaration of Trust should be treated as a codicil to the Will. That suggestion was first made by the judges of the Appellate Division during argument of the appeal.
NJ Enacts Home Sale Tax Break
P.L. 1998, C. 3The Taxpayer Relief Act of 1997 expanded the federal income tax exemption for sale of a principal residence. Up to $500,000 of capital gain per married couple is now tax-free. The New Jersey income tax law has now been amended to conform to the federal law. Like the federal law, the change applies to sales on or after May 7, 1997.
Final Regulations Liberalize Rules on Disclaimers of Real Estate
T.D. 8744 , 62 F.R. 68183-68187 (December 29, 1997)Most married couples in New Jersey who own real estate hold it in a form called "tenancy by the entirety." Under this form of ownership, each spouse owns a one-half interest as well as the right to succeed to full ownership on the death of the other spouse. However, neither spouse can transfer his or her interest without the consent of the other. As discussed in a prior issue, it sometimes makes sense for the surviving spouse to disclaim, or refuse, the survivorship rights that arise on the death of the first spouse to die. Tax regulations issued in December make it easier to do so.
Disclaimer regulations proposed by the IRS in 1996 treated tenancy by the entirety property consistent with recent court rulings. Because property held as tenants by the entirety in New Jersey cannot be unilaterally severed by either spouse during lifetime, the proposed regulations provided that the survivorship interest that results from the death of one of the spouses could not be disclaimed by the other spouse unless the property was acquired within nine months before the death of the first spouse. In other words, the nine-month time period for a disclaimer was held to run from the acquisition of the property in tenancy by entirety form, rather than from the death of the first spouse. This, for all practical purposes, prevented a disclaimer of the survivorship interest .
The final disclaimer regulations issued by the IRS in December provide that property held as tenants by the entirety is treated the same as property held as joint tenants. Thus, the nine month time period for a disclaimer begins at the death of the first spouse.
Comment: This change will open up new possibilities in estate planning for married couples. It will no longer be necessary that the family home or other real estate be held by the husband and wife as tenants in common or as joint tenants with right of survivorship in order to permit a disclaimer by the surviving spouse. There may be good reasons to use one of those forms of ownership. However, under the final regulations, it is possible to evaluate all of the available forms of ownership, including tenancy by the entirety, without losing the option of a disclaimer by the surviving spouse.
New Jersey Roth IRA Bill Advances
Senate Bill 840, Assembly Bill 1660Contributions to IRAs are not deductible for New Jersey income tax purposes. When distributions are made, they are taxable only to the extent of income and capital gains earned by the IRA. These rules also apply to Roth IRAs, newly created under the federal Taxpayer Relief Act of 1997.
The New Jersey Senate has unanimously approved a proposal to conform New Jersey's income tax treatment of Roth IRAs to federal law. Under the bill, qualified distributions from Roth IRAs would be tax-free. As under federal law, a qualified distribution is one made after the beneficiary is disabled, dies, or reaches age 59 1/2, or a distribution for qualified home purchase expenses. In addition, to be qualified, the distribution must come at least five tax years after the first contribution to a Roth IRA. Rollovers from a traditional IRA to a Roth IRA will be taxed, under the bill, to the extent of earnings on the account prior to the rollover. Like federal law, for rollovers made in 1998, the income is spread over four years.
The Assembly Appropriations Committee favorably reported the bill on May 4, 1998. It is expected that the bill will be finalized later this year.
Bill Would Permit IRA charitable rollover
(HR 2821, S 1734)Donating your IRA to charity during your lifetime can be a costly proposition. First you must withdraw the funds from the IRA in a taxable distribution. Because of limitations on charitable deductions, the deduction you receive when you donate the funds to charity doesn't always offset the taxable income resulting from the distribution.
Sen. Kay Bailey Hutchison of Texas has proposed legislation to ease the cost of donating IRA funds to charity. The Bill, S. 1734, would amend section 408 of the federal tax code to permit a tax-free donation of an IRA to a charitable organization. The proposed legislation would apply only after the account owner has reached age 59 1/2. A similar bill, H.R. 2821, was introduced in the House of Representatives in November. Both bills contains special rules for contribution of an IRA to a charitable remainder trust, gift annuity or pooled income fund.
New Jersey Clarifies Sales Tax Treatment of Internet Services
State Tax News, Spring 1998The New Jersey Division of Taxation has issued a private ruling addressing the applicability of sales and use tax to services provided by an Internet service provider (ISP). According to the Division, some of the typical products of an ISP fall within exempt categories under the sales tax law, while others are taxable.
Exempt - Internet access charges, whether calculated on a lump-sum basis for unlimited access, or by the hour. According to the Division, this service falls within the exemption for the sale or use of information. - Web site storage. - Internet consulting services, if separately stated. These fall into the exemption for professional services, according to the Division. - Domain name registration Taxable - Transmission-related services, such as dedicated phone numbers and telephone connect time, for New Jersey customers only.
- Web site design for promotional purposes. According to the Division, this falls under the category of "advertising services", which is taxable.
FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It is not intended as and does not constitute legal advice, nor does it create an attorney-client relationship. The information contained in this publication should not be acted upon without first obtaining the advice of a professional advisor.
De Maio & De Maio is a law firm located in central New Jersey. We provide legal services in the areas of estate planning and administration, tax planning, business formation and transfer, trust administration, and related fields.
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