What happens if you have a will or revocable trust agreement which leaves some or all of your assets at death to a beneficiary who predeceases you? To whom do assets pass at your death, which are earmarked for the deceased beneficiary?
The answer is more complicated than you might imagine, and it can be dependent on a number of factors.
Beneficiary designations in a well-drafted will or revocable trust agreement will anticipate unexpected events, such as the death of a beneficiary prior to the death of the testator or the Grantor of a revocable trust agreement. For example, wills commonly provide that a deceased beneficiary’s share will either lapse at death or will be distributed to other beneficiaries.
North Carolina has an anti-lapse statute, NC Gen. Stat. Section 31-42, which determines what happens to certain property under a will if the intended beneficiary predeceases the testator, and no successor beneficiaries are named for a specific devise.
That statute provides that a beneficiary under a will is deemed to have predeceased the testator unless the beneficiary survives for at least 120 hours after the testator’s death (a deadline set by the NC Uniform Simultaneous Death Act), in which case the predeceased beneficiary’s share will pass as follows:
If the deceased beneficiary is a close relative, i. e, a grandparent of the testator or a descendant of a grandparent, that the descendants of the deceased beneficiary will take the deceased beneficiary’s share, to be divided into further shares as set forth under the North Carolina intestacy laws (the laws which apply when there is no will).
If the beneficiary is not a close relative as described above, the share of the deceased beneficiary will pass as part of the testator’s residuary estate under the will. Most wills drafted by attorneys leave any assets which were not left by specific devise, under a catch-all provision, called the “residuary estate.”
If there is no residuary estate provision in the will, then the deceased beneficiary’s share will pass under the North Carolina intestacy laws, which are often a decedent’s spouse and children first, if any, but they could be more distant kin of the testator if he or she is not married and/or doesn’t have children or grandchildren.
Please note that the anti-lapse statute by its terms is applicable only to wills. Presumably that statute would not apply to revocable trust agreements or to other forms of property ownership or to beneficiary designations.
Examples of other forms of ownership which provide for survivorship include ownership as joint tenants with right of survivorship, accounts with transfer-on-death (TOD) or payable-on-death (POD) provisions, life insurance policies or retirement accounts, payable on death to named beneficiaries, etc. These forms of ownership should provide for successor beneficiaries.
Please be advised that the default provisions of some accounts may be determined by the internal documents of the financial firm, which forms control the disposition of those assets and which are not necessarily identical to the North Carolina intestate succession laws. Often the default beneficiary would be the deceased owner’s estate, in which case the account would ultimately pass under the deceased owner’s will, if any, or under the North Carolina intestacy laws, along with other probate assets, if the decedent had no will.
Perhaps the most important purpose of estate planning is to designate the persons who will receive the decedent’s assets after death.
Consequently, we recommend that you gather your asset ownership and beneficiary designation documents when doing your estate planning, to make sure that they dispose of your assets exactly as you want, and that they make proper provision for the possibility that beneficiaries may predecease you. Your estate planning attorney can name alternate beneficiaries for each devise under your will and for your residuary estate, and can verify the survivorship or beneficiary provisions of assets not passing under your will.
The federal gift tax and estate tax exclusion was doubled from $5 million, indexed for inflation, to $10 million, indexed for inflation, by the Tax Cuts and Jobs Act of 2017, which is currently scheduled to expire in 2026. Including the index for inflation, the total exclusion for 2021 is $11.7 million per person, or $23.4 million per married couple.
Because of the high exclusion under the Tax Cuts and Jobs Act, very few people are currently required to pay federal estate tax.
The Tax Cuts and Jobs Act of 2017 was passed during the Trump administration, and the Biden administration has proposed significant cuts to the exclusion, which many anticipate as going back to the pre-Trump level of $5 million, indexed for inflation, which would be $5.85 million in 2021, if applicable this year, or $11.7 million for a married couple.
Generally, a decedent’s taxable estate is computed by combining the assets constituting his or her taxable estate at death, with the total of his or her lifetime taxable gifts. The decedent’s gross taxable estate is then calculated on that amount, reduced by a credit equal to the date-of-death estate tax exclusion amount. If any federal gift tax has actually been paid by the decedent on any taxable lifetime gifts, then an additional credit is allowed for gift taxes paid.
If a decedent made $1 million in taxable gifts (not including annual exclusion gifts) and thereby used $1 million of his or her lifetime gift tax exclusion to avoid paying gift tax on those gifts, the full $1 million would be added into the decedent’s taxable estate on Form 706, Federal Estate Tax Return, but the decedent’s estate would be entitled to the full amount of the estate tax exclusion on the date of death, unreduced by the gift tax exclusion which had been used during the decedent’s lifetime.
If that decedent’s assets were worth $6.5 million on the date of death, and if he or she had made $1 million in lifetime taxable gifts, then his or her taxable estate would total $7.5 million, and the estate would be entitled to the full estate tax exclusion applicable on the date of death. Under the $11.7 million exclusion in effect in 2021, there would be no estate tax payable at the decedent’s death.
If, however, the estate tax exclusion amount is lowered to pre-Tax Cut and Jobs Act levels by the time of a decedent’s death, and if the adjustment for inflation is $1.1 million at that time, the date-of-death exclusion amount would be $6.1 million ($5 million base amount plus $1.1 million adjustment for inflation). If we further assume that the taxable estate totaled $7.5 million under the facts described in the above paragraph, then there would be federal estate tax on the difference between the gross taxable estate of $7.5 million and the date-of-death exclusion of $6.1 million – a difference of $1.4 million, since the lifetime taxable gifts would total less than the date-of-death exclusion.
In contrast, let us suppose that the decedent had made taxable lifetime gifts utilizing his or her full $11.7 million gift tax exclusion prior to his or her death in 2021, instead of the $1 million gifts assumed in our example above, and further suppose that the estate tax exclusion is later lowered to $6.1 million on the date of death. Would the $5.6 million difference between the gift tax exclusion of $11.7 million reported on the decedent’s gift tax returns and the date-of-death estate tax exclusion of $6.1 million, be included in the decedent’s taxable estate?
In November 2019, the IRS published final “Anti-Clawback” Regulations, Regs. Sec. 20.2010-1(c), under which the $5.6 million difference between gift tax exclusion at the time of the gifts and the date-of-death estate tax exclusion would not be “clawed back” into the decedent’s taxable estate. Instead of adding all lifetime taxable gifts to the decedent’s taxable estate on Form 706, the Federal Estate Tax Return, the difference between the higher gift tax exclusion at the time of the gift and the lower estate tax exclusion on the date of the decedent’s death would not be included in the decedent’s taxable estate. Under the above example, $5.6 million of the lifetime gifts (the difference between the $11.7 million gift tax exclusion and the $6.1 million date-of-death exclusion) would not be added into the decedent’s taxable estate. There would be no gift or estate tax on those gifts totaling $5.6 million which had been made under the gift tax exclusion in excess of the date-of-death estate tax exclusion.
The Anti-Clawback Regulations are applicable if the Tax Credit and Jobs Act of 2017 expires in 2026 or if the exclusion is reduced by legislation prior to that deadline.
The Anti-Clawback Regulations are applicable only when the value of total lifetime taxable gifts exceeds the date-of-death exclusion. Taxable gifts totaling less than the date-of-death exclusion amount are added back, in computing the decedent’s taxable estate, but gifts in excess of that amount, up to the gift tax exclusion at the time of the gift, are not included in the decedent’s taxable estate.
Even if the Anti-Clawback Regulations are not applicable, there can be some tax advantages to making lifetime taxable gifts totaling less than the date-of-death estate tax exclusion. For example (1) income earned on gifted assets is taxable to the donee, instead of the donor, and that income is not included on the donor’s federal estate tax return; and (2) post-gift capital appreciation on the gifted property, if any, also is not included on the donor’s estate tax return. However, there would be no advantage under the Anti-Clawback Regulations.
Not many taxpayers can afford to make lifetime gifts which are large enough to take advantage of the Anti-Clawback Regulations, but those few taxpayers who can and do make such gifts could reap large transfer tax benefits for their family.
One possibility is that a person who has a very short life expectancy might make large lifetime gifts to take advantage of the Anti-Clawback Regulations, which they might otherwise not consider because of fear of outliving their assets. With only weeks or months to live, this might not be such a concern. If that person is unable to act for himself or herself at that time, and if that person has a durable power of attorney which expressly permits his or her Agent under the power of attorney to make gifts, then the Agent should consider making those large gifts on behalf of that person.
If you’ve heard of a “three year rule” under which “deathbed” gifts, made within three years prior to a decedent’s death, were disregarded for estate tax purposes, that is not a problem! That rule was the law at one time, but the law has been changed. At the time of the three-year rule, federal gift taxes and federal estate taxes were separate tax systems. Estate taxes were payable only on assets either owned at death or subject to certain powers retained by a decedent. To keep taxpayers from avoiding estate taxes by making gifts shortly before death, Code Section 2035 at that time treated all transfers made within three years of death as “gifts in contemplation of death,” and disallowed those gifts in the calculating a decedent’s taxable estate.
Congress later adopted an integrated gift/estate tax system, whereby all taxable lifetime gifts are added to a decedent’s taxable estate for estate tax purposes, whether or not made within three years prior to death. Consequently, the Anti-Clawback Regulations make no distinction between deathbed gifts or gifts made years earlier, and large deathbed gifts could reap the benefits of the Anti-Clawback Regulations, even if the estate tax exclusion is lowered after the date of the gift and before the death of a decedent.
Another tip: If a husband and wife want to make large lifetime gifts to their children and/or grandchildren – to take advantage of the Anti-Clawback Regulations – but they are not able to make large enough gifts to utilize both spouses’ full exclusions – they should not make joint gifts, which would be deemed to be one-half each. It would be more tax-efficient for the gifts to be from one spouse only, to enable the gifts by that spouse to utilize his or her gift and estate tax exclusion as much as possible, without splitting the gifts with the other spouse.
For married taxpayers with total assets of several million dollars or more, it is important to consider whether the estate tax exclusion of the first spouse to die should be utilized to minimize federal estate taxes upon the death of the surviving spouse.
Anything which a decedent leaves outright to his or her surviving spouse will qualify for the deceased spouse’s estate tax marital deduction and will pass to the spouse, tax-free. However, that property will become part of the surviving spouse’s taxable estate and will therefore be subject to potential transfer tax (gift tax/estate tax) for the surviving spouse, unless a portability election is made on a federal estate tax return for the deceased spouse.
A portability election is made in Part 6 of the deceased spouse’s federal estate tax return, unless the surviving spouse intentionally opts out of portability under Section A of Part 6.
Until 2011 the only way to take advantage of the estate tax exclusion of the first spouse to die was to leave assets in a manner which would not qualify for the deceased spouse’s marital deduction and thereby would use the deceased spouse’s estate tax exclusion, instead of his or her marital deduction, to avoid or reduce estate tax at the first death. That is, using the exclusion at the first spouse’s death was a “use it or lose it” proposition. If the first spouse to die did not provide for a portion of his or her estate to be set aside in a manner which did not qualify for the marital deduction, then his or her estate tax exclusion would be lost forever and could not later be used to reduce federal estate taxes at the death of the surviving spouse.
Let us assume that a deceased spouse in 2010 had a taxable estate of $6 million, and that the estate tax exclusion was $3.5 million at that time. Estate taxes at the first death could have been completely avoided if the deceased spouse left at least $2.5 million to the surviving spouse in a manner which qualified for the estate tax marital deduction, in which case up to $3.5 million in value could be set aside at the first death which would not be subject to estate tax at the surviving spouse’s death. Thus, only $2.5 million would become part of the taxable estate of the surviving spouse.
Often the first priority of a deceased spouse is to provide for the surviving spouse, in which case the $3.5 million share (under the above fact situation) which was intended not to qualify for the estate tax marital deduction was often left in trust for the surviving spouse’s lifetime benefit, but the terms of the trust would keep the assets from being included in the taxable estate of the surviving spouse. The undistributed trust assets would remain outside the surviving spouse’s taxable estate and would pass to the secondary beneficiaries after the surviving spouse’s death, free of estate tax.
Prior to 2011, when the law was changed, a common method used to minimize estate taxes at the surviving spouse’s death, was a “shelter credit” trust created by the deceased spouse, sometimes called a “family” trust (which is a friendlier-sounding name). A trust funded at the first spouse’s death, could make income and/or discretionary principal distributions to or for the benefit of the surviving spouse for life, but upon the death of the surviving spouse, the trust assets would pass on to the remainder beneficiaries, often the deceased spouse’s children and grandchildren, free of federal estate tax.
Starting in 2011, however, a different set of rules became applicable. After that date it became possible for the deceased spouse’s unused exclusion at the time of his or her death to be preserved, even if assets were left outright to the surviving spouse. If the deceased spouse’s exclusion was preserved, the exclusion could be used for gifts subsequently made by the surviving spouse, or on the surviving spouse’s estate tax return.
If you have estate planning documents which were executed before 2011 which include a shelter credit trust (a “family trust”) for the surviving spouse, you are advised to review these documents with your estate planning attorney, to see that such a trust is still appropriate for you, especially with the higher threshold for estate taxes likely to be available at your death.
The federal and gift tax exclusion has been increased substantially since 2011 on two occasions, first to $5 million indexed for inflation, then to $10 million indexed for inflation. The latter was under The Tax Cuts and Jobs Act of 2017, which is scheduled to expire in 2026, but which could be reduced at an earlier date by act of Congress.
If a deceased spouse does not utilize the opportunity in his or her estate planning documents to preserve some or all of his or her estate tax exclusion, the surviving spouse now has the option of filing a federal estate tax return and electing the portability option to preserve the Deceased Spousal Unused Exclusion (DSUE) on that return, which allows the surviving spouse to apply the deceased spouse’s DSUE against any gift and estate tax liability of the surviving spouse, including future lifetime gifts and transfers upon the death of the surviving spouse.
In order to take advantage of the portability of the deceased spouse’s DSUE, the personal representative of the deceased spouse’s estate must file a federal estate tax return (Form 706) in a timely manner, on which the DSUE is computed, and must elect to claim a DSUE portability election. That election may be made in Part 6 of the federal estate tax return. Once made, that election is irrevocable.
Estate tax returns are due nine months after the date of death, but a six-month extension is available, if requested on or before the original due date of the return.
Sometimes a personal representative fails to file a federal estate tax return claiming the portability election in a timely manner. If so, Rev. Proc. 2017-34 provides a fairly simple procedure for relief in certain circumstances. If the personal representative, after the return’s due date, wants to file an estate tax return to claim portability, he or she may be allowed to do so under that Revenue Procedure, but only if all the following requirements are met: (1) The decedent must have died after 12/31/2010, and must have been a U.S. citizen who was survived by his or her spouse; (2) The personal representative must not have been required to file a federal estate tax return (other than to claim portability); (3) An estate tax return must not have been filed before the filing date for the return; and (4) The personal representative must include the following statement at the top of Form 706: FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER SECTION 2010(a)(5)(A).
This method of filing for relief is available only if filed within two years from the date of death, and only if all the requirements listed above have been met. If those requirements have not been met, the personal representative may request a private letter ruling from the IRS, which is more cumbersome and expensive procedure, but which may provide relief.
Please note that the DSUE does not apply to generation-skipping-tax. The deceased spouse’s GST exemption is lost if not used by the deceased spouse.
Also please note that, although the exemption for gift and estate tax for the surviving spouse is indexed for inflation, the DSUE amount for the deceased spouse’s exclusion is frozen as of the deceased spouse’s date of death, and is not indexed for inflation which occurs after the deceased spouse’s death.
If the surviving spouse makes taxable lifetime gifts after the death of the first spouse to die, and if a portability election has been made after the first spouse’s death, the DSUE of the deceased spouse is first applied to those gifts, before the surviving spouse’s gift tax exclusion is used.
On page 1 of Form 709, U.S. Gift Tax Return, Item #19 asks whether the surviving spouse has applied for a DSUE exemption from a predeceased spouse to a gift or gifts reported on the surviving spouse’s gift tax returns; if so, the surviving spouse is instructed to complete Schedule C on the Form 709.
If a surviving spouse has more than one deceased spouse who made DSUE elections, the exemption of the last predeceased spouse at the time of the gift shall be applied first, if available. That is, the DSUE of more than one predeceased spouse, if applicable, may be applied in succession, starting with the most recently-deceased spouse.
There is a limit on the total DSUE amount which can be applied for a surviving spouse, however. The total DSUE amount claimed by a surviving spouse or by his or her estate cannot exceed the overall exclusion set out for gifts or estates for a single individual.
There are a number of factors which should be considered when determining whether or not to use portability at the first spouse’s death, both in pre-death planning and after the death of the first spouse to die, including: (a) the size of the combined estates of both spouses; (b) the age of the surviving spouse; (c) the surviving spouse’s ability to manage assets, and his or her spending habits and needs; (d) protecting the eventual inheritances of the children and grandchildren; (e) other likely inheritances by the surviving spouse; and (f) the possibility of remarriage by the surviving spouse.
If considering whether to make a portability election after the first spouse’s death, the safest approach – based on the theory that one never knows what will happen – would be to have the surviving spouse make a portability election, no matter what the circumstances, but the cost of preparing an estate tax return and making the election is often impractical, given the financial situation of the surviving spouse. Each case and each family financial situation is different, so we recommend that you review your circumstances with an experienced estate planning attorney, both while both spouses are living and again after the death of the predeceased spouse, to decide what’s best for you.
What do you do if someone wrote a will, but the will cannot be found after the testator’s death?
Will that person’s estate pass to his or her heirs according to the North Carolina intestacy laws, which are applicable when a person dies without a will?
No. It is possible in North Carolina to probate either a lost will or a will which has been inadvertently destroyed without the testator having the intent to revoke the will.
In North Carolina the Clerk of Superior Court has jurisdiction to probate a lost or destroyed Will. The North Carolina General Statutes do not provide a special procedure to be followed, but the right to probate a lost will is established by case law. See In re Hedgepeth, 150 N.C 245 (1909), concerning the probate of a Will in common form, i.e. the informal procedure under which most wills are probated. Also see In re Will of Herring 19 N.C. App. 357 (1975) where a lost will was probated in solemn form, which is a formal and binding procedure.
There are no printed forms furnished by the clerk’s office for the probate of a lost or destroyed will, so we recommend that an application for probate be drafted by an attorney.
There is no case law or statutory law concerning who may apply for probate of a lost or destroyed Will, but the persons who may apply for the probate of an existing will include the executor named in the will or, if the named executor fails to apply for probate within 60 days after the date of death, any person interested in the estate – whether under the will or under the intestate succession laws – may apply.
The person propounding the lost or destroyed will for probate must provide evidence of the following:
The death and domicile of the testator. This is usually done by a sworn statement that the testator has died, accompanied by a certified copy of the death certificate and a sworn statement that the testator was a resident of the county at death.
Evidence that the will was properly executed. A photocopy of the will would provide evidence, if available, but if not available, this can be proven by affidavits from subscribing witnesses, if living and available. The Clerk of Court determines whether the evidence is sufficient.
The contents of the will. Usually a copy of the will, if available, is admitted into evidence, but if a copy is not available, the contents may be proven by the testimony of witnesses (not necessarily by subscribing witnesses on a witnessed will).
A statement that the will was lost or was destroyed without the testator’s intent to revoke the will. The application may describe the circumstances that resulted in the loss or destruction of the will, such as a fire or a move by the testator to another house, or perhaps to a home for the elderly.
The evidence must be sufficient to overcome a presumption that the will was revoked. Sometimes a will may be given to someone else for safekeeping, but that person later loses the will.
Evidence that there was a diligent search performed for the original Will, in places where it would be likely to be found. We recommend that the propounder describe the places searched and the description of the search.
If the testator had a safe deposit box at his or her bank – that would be an important place to look. If the name of the attorney or law firm that drafted the will is known, their office should be checked. Also, wills are occasionally filed for safekeeping with the office of the Clerk of Superior Court of the county where the testator resided at the time the will was written. Searches should include the testator’s valuable papers, copies of tax returns, or sometimes special places, such as a family Bible.
With a probate in common form, the evidence will often be filed with the application, and the Clerk will rule on the evidence informally. Normally, if the propounder submits sufficient evidence, the Clerk will admit the will to probate. However, some Clerks will require a hearing.
A caveat or will contest may be filed for a lost or destroyed will, following statutory procedures. A caveat proceeding is heard in Superior Court and not before the Clerk. If a will has already been admitted to probate in common form, the matter will be transferred to Superior Court to determine whether the will was properly the testator’s will – even is the caveat is not filed until after the probate in common form.
A probate in solemn form is a procedure in which the clerk issues summonses to all persons interested in the estate and holds a hearing. A probate in solemn form will be binding and will not be appealable if no will caveat is filed before or during the hearing. That is, if someone wants to challenge the validity of a will submitted for probate in solemn form, they must either file a caveat before the probate hearing or raise the issue at the hearing, because the probate will otherwise be final and binding. If the caveat is filed in a timely manner, however, the matter will be transferred to Superior Court to determine whether the Will is valid, without a ruling by the Clerk.
Consequently North Carolina law provides that a Will may be probated which has been lost or inadvertently destroyed.
Qualified Disclaimers can be useful tools to alter the way property passes at death, and are often used as a method to reduce transfer taxes, such federal estate tax or gift tax.
Simply stated, a qualified disclaimer is a refusal to accept a gift, bequest, devise or beneficiary designation, done in a manner which meets certain statutory requirements.
Disclaimers may be made of lifetime gifts, but that is extremely rare, and this article will focus on transfers after a transferor’s death.
A qualified disclaimer after a transferor’s death must be in writing, it must clearly identify the property which is being disclaimed, and it must be signed by the person making the disclaimer, or his or her legal representative. The written disclaimer must be delivered to the transferor’s legal representative, such as the executor of an estate, and in North Carolina to the probate court, within nine months after the transferor’s death, with the exception of a disclaimer by a minor disclaimant, which may be made within nine months after the minor disclaimant’s twenty-first birthday.
Property cannot be disclaimed after it has first been accepted by an individual. For example, if an individual accepts stock dividends, he or she cannot later disclaim the shares of stock which paid those dividends.
The disclaimed property passes as though the disclaimant had predeceased the transferor. If there is a will, it passes to the successor devisees or beneficiaries under the will, after it has been disclaimed by the primary devisee or beneficiary. If there is no will, the property must pass to the secondary heirs under state law, who would have inherited the disclaimed property if the disclaimant had predeceased the decendent.
The person making the disclaimer cannot direct that a disclaimed devise or inheritance be passed to someone else, other than the person or persons who would have received the property if the disclaimant had predeceased the transferor. For example, a will leaves property to the transferor’s brother if he survives the transferor, and if he does not survive the transferor, the will leaves the property to the transferor’s sister. The disclaimant cannot disclaim the property and direct that is passes to his or her children, instead of to the sister.
The disclaimed property passes to the successors without any tax consequences to the person making the disclaimer, provided that the disclaimer is “qualified.” That is, the qualified disclaimer is not subject to gift tax, which would have been applicable if the person making the disclaimer had accepted the property and subsequently made a gift of that property to the transferees.
Generally, a disclaimant cannot disclaim property to a trust that names the disclaimant as a beneficiary of the trust or gives the disclaimant the power to direct the further disposition of the disclaimed property. For example, if the disclaimant is also the trustee of the trust to which the disclaimed property passes because of a disclaimer, and, as Trustee, has the discretionary power to direct its further disposition then the disclaimer would not be qualified unless the disclaimant also disclaimed his discretionary power.
There is an exception for a spouse, who can be a beneficiary of a trust, but the spouse cannot have the power to further direct the disposition of the trust property after the disclaimer, unless the spouse also disclaims his or her right to direct such disposition.
It is possible to disclaim partial interests in property, but not interests which cannot be severed into separate shares at the time of the disclaimer. For example, a person may disclaim 1,000 out of a total 2,000 shares of stock in an estate, but he or she cannot accept the dividends for life and disclaim the “remainder interest” in those shares after his or her death. In that case, a “vertical” disclaimer of half the shares will work, but a “horizontal” disclaimer would not work.
If the disclaimant is the trustee of the trust into which property is disclaimed, but as trustee is given the authority to make distributions among several beneficiaries, then the disclaimant must also disclaim his or her fiduciary power to direct the disposition among those beneficiaries.
Generally, a person cannot disclaim property in order to become qualified for Federal Title XIX assistance, such as Medicaid. The person must disclose all of his or her property to qualify or to remain qualified, including any property the person has disclaimed or wishes to disclaim.
Disclaimers are very technical in nature and you should not try to disclaim property without the assistance of a qualified attorney.
Charitable Remainder Trusts can be useful tools to avoid or to postpone capital gains tax on the sale of appreciated assets, for someone who wants to make a charitable gift after the termination of the trust. A person (the trust “grantor”) creates a trust which pays a stream of distributions each year to one or more beneficiaries (the “income beneficiary”) for life or for a term of years, after which the trust terminates and the remaining trust assets are distributed to a tax-exempt organization or organizations (the “remainder beneficiary”). Since the remainder beneficiary is a charitable organization, any capital gains which are retained in the trust are not subject to capital gains tax.
There are two types of charitable remainder trusts, called Charitable Remainder Annuity Trusts or CRATs and Charitable Remainder Unitrusts or CRUTs. A CRAT pays fixed distributions to the income beneficiary based on the original value of the trust assets, whereas a CRUT adjusts the distributions each year to reflect any increases or decreases in the value of the trust assets.
Example: $1,000,000 in assets are transferred to a charitable remainder annuity trust, or CRAT. The Grantor is to receive 5% of that value, or $50,000, per year, until the trust terminates. The income beneficiary frequently is a married couple and the trust term may be for their joint lifetimes and for the lifetime of the survivor. If the trust is funded with appreciated assets, no capital gains tax will be payable upon the sale of those assets. If the assets are worth $1,000,000 at the time of the gift and if they are sold for that amount, assuming that they were originally acquired for $100,000, the trust would not pay income tax on the $900,000 capital gain when the assets are sold. In addition to avoiding capital gains tax at that time, the grantor gets a charitable deduction on his or her income tax return for the value of the charitable remainder interest, calculated by Treasury actuarial tables applicable when the contribution to the trust is made. When the trust terminates – often after the death of the second spouse to die, the remaining trust assets are paid to a tax-exempt organization or organizations (the “charitable remainder beneficiary”) as set forth in the trust agreement.
A charitable remainder “unitrust” or CRUT is similar to an annuity trust, except that the distributions are adjusted annually, to reflect any increase or decrease in the value of the trust assets. If a 5% Unitrust was originally funded with $1,000,000 in assets, but grows in value to $1,100,000, the unitrust distributions for the following year would be 5% of the new value, or $55,000. This is different from a CRAT or annuity trust, for which the distributions would remain the same, even if the value of the trust assets increases or decreases.
Please note that the distributions from a CRT to the income beneficiary are taxable, to the extent that (a) the trust has taxable income, including capital gains, and/or (b) the trust had , in previous years, taxable income which has not been distributed to the income beneficiary. The trust cannot avoid income tax by investing in tax-free bonds until all taxable income has first been distributed, which makes this strategy impractical.
The general rule is that a CRAT or CRUT is required to distribute at least 5% annually, but there are exceptions for certain types of unitrusts. For example a “net income” CRUT (sometimes called a NICRUT) is not required to distribute more than its net income, and a “net income” CRUT with makeup provisions” (sometimes called a NIMCRUT) may make up income arrearages from past years (i.e., from years in which the trust was allowed to distribute less than the unitrust percentage), until the excess distributions have caught up with those arrearages. Thus a 5% NIMCRUT which earns only 1% in a given year would distribute only 1% currently and would accrue a 4% arrearage, which may be distributed only from excess income in subsequent years, i.e., income in excess of the 5% unitrust percentage. If 7% income is earned in a subsequent calendar year, the 2% overage for that year in excess of 5% may be distributed to the income beneficiary as a make-up distribution.
There are certain types of investments which enable the trustee to have some control over the realization of taxable income of a trust, in which case the trustee may minimize taxable income in one year and maximize taxable income in another year.
Occasionally someone creates a CRT which he or she later desires to exit. Circumstances can change over time, and sometimes there is an unanticipated major life event, which causes a change of mind. The trust itself is irrevocable, but there are alternatives which permit an income beneficiary of a CRT to obtain a more suitable result.
Let us suppose that the spouse of the trust grantor unexpectedly dies and later the grantor remarries and wants to make the new spouse an income beneficiary. Since the original trust was irrevocable, it cannot be changed to substitute the new spouse as a replacement beneficiary. In that case the grantor may want to exit the original trust in a manner permitted by law and to enter into a new trust agreement under which the new spouse is an income beneficiary.
There are several alternative methods for exiting an existing charitable remainder trust:
Temination of a CRT. One option is for the trustee simply to terminate the trust, in which case the trust assets must be divided between the charitable beneficiary and the income beneficiary strictly according to Treasury actuarial tables, following procedures established by the IRS. Care must be taken to avoid “self-dealing” under Code Section 4941, which could subject the trust to severe penalties.
Sale of income interest. Another option would be for the income beneficiary to sell the income interestin the trust to a third-party buyer. An important benefit from this alternative is that it frequently results in getting more money to the income beneficiary than would be received in a straightforward trust termination. Please note that the income interest in a CRT is considered a capital asset for income tax purposes, and if the sale of that capital asset results in a higher price than the actuarial value of that asset under the Treasury actuarial tables, there would be a taxable capital gain for the income beneficiary.
The original CRT would continue to exist under this alternative, under the same terms and conditions, but with a different income beneficiary – but please be aware that if the original term of the trust was measured by the life of the original income beneficiary, there would be no change in the term of the trust and the original income beneficiary’s life would continue to be the measure for the remaining term of the trust.
The proceeds received by the income beneficiary from the sale of the income interest could be contributed to a new charitable remainder trust if the Grantor so desired, with income tax benefits applicable to a new CRT, but the new trust would be scaled down in size as compared to the original trust unless additional assets were added to the new trust. The new trust could have different beneficiaries than the original trust, such as a spouse by a second marriage or other family members.
CRT Rollover. A third option could be a charitable remainder trust “rollover,” where the income beneficiary rolls over his or her income interest to a new CRT. Initially, the new CRT would have no assets other than the right to receive unitrust distributions from the old trust, which would continue to exist. However, an important benefit of this alternative is that the income interest from the old trust can be sold by the new CRT to a third-party buyer, and if the sale price is higher than its actuarial value under the Treasury tables, there will be no capital gains tax on the sale of that income interest, as long as the gain is retained by the trust. The proceeds of sale could be invested by the new CRT differently than the assets of the old trust, which investment strategy may be more appropriate for the new trust. The income beneficiary from the old trust would be the grantor of the new CRT and would get income tax benefits applicable upon the creation of a new CRT. New beneficiaries could be named for the new trust.
The original CRT would continue to exist and the charitable beneficiary would still receive the remainder distribution on termination of the trust under the original terms of the trust. Please note that if remaining term of the old trust was based on the measuring life of the original income beneficiary, that same person’s life would continue to be the measuring term for the old trust, even if that person is no longer receiving the unitrust distributions from the old CRT.
Distribution to charitable beneficiary. Lastly, an income beneficiary who no longer needs or wants the income distributions from the CRT may want to terminate his or her trust by giving the income interest to a charitable remainder beneficiary. If that is done, then the charitable remainder beneficiary would own both the income interest and the remainder interest, and the trust could be terminated. A beneficiary who gives his or her income interest to a charitable organization will get a charitable deduction for giving that income interest to charity, based on the value of the income interest under the Treasury actuarial tables at the time the trust is terminated.
Charitable remainder trusts often last for one or more decades. Although the original reasons for creating the trust were presumably valid at the time the trust was created, circumstances can change over time. Whatever the reason for the exiting a CRT, the procedure is complicated and in some states may even require court action. You need to consult with an experienced professional to discuss your situation and to determine the best option available for you.
Prior to the adoption of The SECURE Act of 2019, the required minimum required distributions (RMDs) for retirement accounts were based strictly on the actuarial life expectancy of the beneficiary. If the beneficiary of the retirement account was a trust, the distributions from the retirement account to the trust were based on the age of the trust’s “identifiable primary beneficiary.” If there were several identifiable beneficiaries, the RMD was based on the life expectancy of the oldest identifiable beneficiary.
The SECURE Act of 2019 changed the required minimum distributions (RMD) for retirement account beneficiaries (including identifiable beneficiaries of trusts) other than spouses, including adult children or grandchildren. The RMD has been changed from their actuarial life expectancy to 10 years (maximum), subject to exceptions. An exception is still available for beneficiaries who are “disabled” as defined by Internal Revenue Code Section 72(m)(7) or “chronically-ill” as described by Code Section 7702B(c)(2), with limited exceptions. The RMD for trusts on behalf of those beneficiaries is still based on the actuarial life expectancy of the identifiable primary beneficiary, and is not subject to the 10-year maximum payout applicable to most beneficiaries.
The Secure Act of 2019 virtually eliminated the “Stretch IRA” strategy to reduce IRA distributions by naming very young beneficiaries, but some of those benefits still exist for disabled or chronically-ill beneficiaries.
Distributions from a retirement account result in taxable income to the beneficiary or beneficiaries who receive the distributions. When a distribution is payable to a trust, the trust receives the taxable income, but the income tax liability for the distribution is passed on to the beneficiaries to whom the trust further distributes the income. Trusts are taxable entities and they file fiduciary income tax returns each year and pay income tax on any undistributed income. However, if distributions to beneficiaries are made during the year (or early in the following year, if the trust so elects on its timely-filed fiduciary income tax return), the trust can claim a “distribution deduction” on its fiduciary income tax return. That is, the trust can deduct from its taxable income the amount distributed to trust beneficiaries, and the trust issues a Schedule K-1 to the trust beneficiaries, reporting the distribution as taxable income to them. The tax laws discourage trust income from being accumulated in a trust by taxing undistributed trust income at much higher rates than the rates applicable to individuals.
The terms of some trusts require that the trusts distribute all their income to trust beneficiaries each year. These trusts are often called “simple trusts,” but insofar as retirement benefits are concerned, this type of trust can be categorized as a “Conduit Trust.”
A Conduit Trust is sometimes called a “see-through” trust, since the retirement distributions are taxable to the trust beneficiaries who end up receiving the distributions, and are not taxable to the trust.
Most of the time, overall income taxes are` reduced if a trust distributes retirement account income to the beneficiaries of a trust – because of the high tax rates applicable to trusts. However, minimizing taxes may not be the only consideration.
If the beneficiary of the IRA is a trust for a special needs beneficiary who is an “identifiable primary beneficiary,” any distributions of retirement account income from the trust to the trust beneficiary might result in too much income for the beneficiary, thereby disqualifying the beneficiary from means-tested governmental benefits, such as Medicaid.
An Accumulation Trust is an alternative to a Conduit Trust. The Accumulation Trust can be named as a beneficiary of retirement account benefits for an identifiable primary beneficiary, instead of a Conduit Trust. If the retirement income is not required to be distributed to the identifiable primary beneficiary and it may instead be retained by the trust, then the retirement account income would not cause the beneficiary to lose means-tested benefits, such as Medicaid. See Reg. Section 1.401(a)(9)-5, Q & A-7(c)(3), Example 1.
Consequently, an Accumulation Trust may be appropriate where the identifiable primary beneficiary of a trust is a special needs individual. The Accumulation Trust allows the trustee to receive the RMD from the retirement account, but does not require the trustee to distribute the RMD to the special needs beneficiary each year, thereby preserving the eligibility of the special needs beneficiary for needs-based government benefits. Instead of distributing the benefits to the beneficiary every year, which is a requirement of a Conduit Trust, the trustee of an Accumulation Trust can retain retirement benefits within the trust for future distributions to the special needs beneficiary or to the remainder beneficiaries of the special needs trust.
An Accumulation Trust which accumulates retirement distributions within the trust and does not distribute those benefits to the beneficiary must pay income tax on the accumulated income at trust tax rates, which are much higher than individual rates. However, even highly-taxed retirement account income which is accumulated within a special needs trust might be preferable to having the trust beneficiary declared ineligible for means-tested benefits, such as Medicare.
That is, if a Special Needs Trust is required to distribute to beneficiaries the required minimum distribution (RMD) from retirement accounts, the distributions would reduce the trust’s taxable income on the trust’s fiduciary income tax return, but would increase the beneficiary’s income. If the trust is an Accumulation Trust and is not required to distribute the income to the special needs beneficiary, the undistributed income is taxable to the trust itself, and it is not deemed to be taxable income of the trust beneficiary; since the income is retained by the trust, it is not considered to be the beneficiary’s income and does not disqualify the beneficiary from means-tested government benefits.
To be a valid Accumulation Trust, (a) the trust must be a valid trust under state law, (b) the trust must be irrevocable, (c) the beneficiaries must be identifiable and (d) certain documentation must be provided to the plan administrator.
As a result, even though the RMD may be taxable to the Accumulation Trust in high income tax brackets, The SECURE Act of 2019 may permit smaller RMDs from a retirement account to a trust for a disabled or chronically-ill beneficiary, in which case the amount required to be distributed to the trust will often be a smaller amount than would be applicable if the beneficiary were not disabled or chronically ill. That is, the tax detriment caused by the high fiduciary income tax rates, may be partially offset by a lower RMD from the retirement account to the trust.
If you currently have named a trust for the benefit of a disabled or chronically-ill trust beneficiary as beneficiary of your retirement account, you should review the terms of the trust with a qualified attorney, to make sure that the trust is not a Conduit Trust, which could render the trust beneficiary ineligible for means-tested government benefits, such as Medicaid.
If you have a retirement account or accounts from which you want to accumulate retirement income in trust for the possible needs of a disabled or chronically-ill beneficiary, you should consider having the retirement account payable to an Accumulation Trust for that beneficiary, instead of a Conduit Trust, which must be paid out at least annually to the beneficiary.
With less than 1% of taxpayers now being subject to federal estate tax under the new tax laws, the emphasis for tax planning for most of us has shifted from estate tax planning to income tax planning. Many people have retirement accounts of sufficient size to warrant more attention to income tax planning for those assets.
A participant’s retirement account is funded with tax-deductible contributions during his or her high earning years, presumably when he or she is in a higher income tax bracket than after retirement. By making contributions during a participant’s high-earning years, the participant not only delays the payment of taxes on the contributions, but also is likely to have lower tax rates when distributions are later made.
The participant gets tax deductions for contributions to the account, and the account builds value tax-free until distributed. Maximum funding of a retirement account during one’s working years is usually a very effective tax planning technique.
DISTRIBUTION RULES DURING OWNER’S LIFETIME
With a traditional IRA, the owner has to begin taking required minimum distributions (RMD) for the calendar year in which he or she reaches age 72, by April 1 of the following calendar year.
Prior to the adoption of the “Setting Every Community Up for Retirement Enhancement” (SECURE) Act in December 2019, the required beginning date for IRAs was April 1 of the year after which the IRA owner attained age 70½. The old rule is applicable through 2019, but not to 2020 or later years. Under the old rule, if the IRA owner’s birthday was on or before June 30, the required beginning date would be April 1 of the following calendar year, but if his or her birthday was on or after July 1, the required beginning date was one year later, also on April 1. The new rule under the SECURE Act makes April 1 of the following year after you attain age 72 as the required beginning date, no matter whether your actual birth date is in the first six months or the last six months of the year.
There is a “uniform lifetime table” whereby the RMD or required minimum distribution is determined, based on the life expectancy of the account owner and the life expectancy of a second person who is 10 years younger, but if a taxpayer is married to a spouse who is more than 10 years younger, the account owner may use a “joint and survivor table,” based on the taxpayer’s age and the actual age of the younger spouse. The Life Expectancy Factor under the uniform lifetime table for an IRA owned by for a person who is age 70, is 27.4 years; for age 80 is 18.7 years; for age 90 is 11.4 years; and for age 100 is 6.3 years. The reason those life expectancies seem so long is because they are based on the life expectancies of the second to die of two lives, using 2-life tables, based on the age of the account owner and the age of a person who is ten years younger.
Please be aware that the uniform lifetime table applies to every IRA owner (not including owners of “inherited” IRA accounts), except someone with a spouse who is more than 10 years younger. It applies to someone with an older spouse, to someone with no spouse, and to a participant who has not named a beneficiary at all for his or her retirement account. It also applies to someone who has designated his or her children, grandchildren, or others – except for a spouse who is more than 10 years younger – as beneficiaries of his or her account.
Distributions from an IRA or qualified plan before the taxpayer reaches age 59½ are ordinarily subject to a 10% early withdrawal penalty, but there are exceptions to the general rule: If the IRA owner qualifies as a first-time homebuyer, for example, he or she can withdraw up to $10,000, penalty-free, to use as a down payment or to help build a home. With the cost of higher education spiraling, people are also allowed to turn to their IRAs to help pay certain college expenses, penalty-free, from their IRAs – for tuition, books and other qualifying expenses – as long as the student (you, your spouse, your child, or your grandchild) is enrolled more than half-time at an eligible educational institution. Distributions for those purposes are not subject to the 10% early withdrawal penalty, but they are subject to regular income tax.
Early withdrawals also may be allowed penalty-free through a “Substantially Equal Periodic Payment” (SEPP) plan, with specified annual distributions for a period of five years or until the account-owner reaches age 59½, whichever comes later. Again, income tax must still be paid on the SEPP withdrawals, but no penalties. A SEPP plan is best suited to those who need a steady stream of income prior to age 59½, perhaps to compensate someone whose career has ended earlier than anticipated.
SEPP plans can be boons to those who need access to retirement funds earlier than age 59½, but starting a SEPP early – or even withdrawals for educational expenses or for a down payment on a new home – will have implications for your security later, in retirement. If you spend the money now, it will not be available when you are older. Before you embark on a SEPP plan, you should get the advice of your financial planner.
DIRECT TRANSFER FROM IRA TO CHARITY
If you are fortunate enough that you do not need your IRA distribution for living expenses, and if you are charitably inclined, you can avoid income tax by making a direct distribution from your IRA, up to $100,000/year, to a charitable organization. This is called a “Qualified Charitable Distribution” or QCD. If you file a joint income tax return and if your spouse also has an IRA, your spouse can also make a QCD of up to $100,000 from his or her IRA, which will not be taxable on your joint tax return. The gift will also reduce the value of your IRA account, thereby reducing your required minimum distributions (RMDs) in the future.
QCDs may be made only from IRAs – not from 401(k)s or other similar retirement accounts – but you can roll over funds from a 401(k) account to an IRA, then make the gift from the IRA to the charity. This takes extra time, and you must meet the deadline (usually December 31) for completing the charitable gift.
The charity to which you make the gift must be a 501(c)(3) organization, eligible to receive QCDs, but may not be (a) a private foundation, (b) a “supporting organization,” which is an exempt organization which carries out its exempt purposes by supporting other exempt organizations, or (c) a Donor-Advised Fund of “sponsoring organization,” which is a public charity which accepts and manages such funds, and from which distributions may be made to other charitable organizations, as recommended by individuals or families.
Please note that the QCD is not included in your taxable income, so you cannot claim an itemized charitable deduction for your gift on your income tax return. Otherwise, you would be getting a double benefit, i.e., (1) the distribution to charity would not be taxable income on your tax return, and (2) if it had been deductible, you would also get an itemized charitable deduction on your tax return. That would be too good to be true and is not allowed. However, you can still claim a standard deduction on your personal return – not an itemized charitable deduction – in addition to excluding the income.
Another benefit is that, since the qualified charitable distribution is not counted as part of your income, it will not be subject to the limitation to charitable deductions on your income tax return – that is, charitable deductions cannot exceed 60% of your adjusted taxable income. Consequently, it is less painful tax-wise to make large charitable contributions in this manner, for those with ample other means of support.
THREE WAYS TO MINIMIZE TAXES ON REQUIRED MINIMUM DISTRIBUTIONS
One simple step, if the account owner is still working after age 72, would be for him or her to continue making contributions after that age to his or her IRA or 401(k) or similar account, which would provide an income tax deduction to offset income from the required minimum distribution. For example, if a 75-year-old person has an RMD of $5,000 from his or her IRA, and if he or she contributes $7,000 to his or her 401(k) from his or her earnings, the deduction would more than offset the taxable income from the RMD. The age limit for IRA contributions – formerly 70½ – has been removed by the SECURE Act.
There is another exception for calculating the required minimum distribution for a taxpayer older than 72 who works for a non-profit entity or who works for a for-profit company in which he or she owns less than 5% of the company, if the employer has a 401(k) program which accepts rollovers from IRAs. In that case a taxpayer may be able to roll over his or her IRA into the company’s plan, and thereafter not be required to take required minimum distributions applicable to IRAs from that account until actual retirement from that employer. If you are still employed, you will need to inquire with your employer, to see if you can roll over your IRA to the company’s 401(k) plan and if so, whether you can defer distributions until you retire.
Another (more complicated) alternative, allowed by the IRS since 2014, would be to purchase a Qualified Longevity Annuity Contract (QLAC) inside your IRA. Many consider an annuity to be a poor investment for an IRA, since both annuities and IRAs are “tax shelters” – and to hold a tax shelter within a tax shelter is a redundancy and wastes the tax benefit of one of the shelters. You get the benefit of only one tax shelter when an IRA owns an annuity.
But the purchase of a QLAC within an IRA offers a different kind of tax advantage: the purchase of a QLAC is a retirement strategy in which an IRA owner can defer a portion of his or her required minimum distributions (RMDs) until a certain age (maximum limit is age 85). A QLAC is an annuity bought with a chunk of money from an IRA now, for payouts starting years later, but no later than at age 85. Money tied up in the QLAC is not counted in calculating your RMD, so the QLAC reduces your required minimum distribution (RMD). Also, it allows the value of the annuity to grow tax-free until you reach the annuity starting age, typically at age 85. Qualified longevity annuity contracts (QLACs) can be bought inside an IRA with (a) up to 25% of the IRA’s value or (b) the amount of $135,000 (in 2020) – whichever is smaller. The annuity would be paid to the annuitant or annuitants for life after the starting age, which provides a guaranteed stream of income which the annuitant or annuitants will not outlive.
The tax benefit of purchasing a QLAC is to reduce income taxes by removing money from the calculation of the required minimum distributions (RMDs) from your IRA after attaining age 72. QLACs are legal creatures created by the IRS to address the fears of many individuals as they grow older, of outliving their money. A QLAC is an investment vehicle to guarantee that some of the funds in a retirement account may be turned into a lifetime stream of income without violating the required minimum distribution rules. The annuity will be paid, no matter how long the individual lives – that is, the recipient cannot outlive the annuity payments.
Annuities provide guaranteed payments to the annuitants during their lifetimes, but at the death of the annuitant (or surviving annuitant, as the case may be) the payments stop. Consequently, an annuity itself is not a good vehicle for passing wealth to persons other than the annuitants. If an annuitant dies (or both annuitants die, if applicable) unexpectedly early, the annuity would prove to have been a poor investment, but if the annuitants outlive their actuarial life expectancies, the annuity may prove to have been a very good investment. Even though nothing would pass to the family at the death of the last surviving annuitant, the annuity payments would presumably allow the annuitant or annuitants to preserve other assets, which would pass to the annuitants’ survivors.
To prevent a total loss of premiums paid for an annuity if the annuitant or annuitants die early, the annuity (including a QLAC), may be custom-designed in some respects to meet your needs. For example, (a) a QLAC could be a joint annuity with the primary annuitant’s spouse, whereby the annuity payments continue for the lifetime of the spouse, if he or she survives, (b) the annuity may guarantee that any unused premium at the annuitant’s death will be refunded, and/or (c) the annuity payments may be adjusted for inflation. Under (b) above, if the annuitant originally paid $100,000 for an annuity, and if the annuitant died before the annuity had paid out $100,000 in total annuity payments, then the remainder of the $100,000 would be refunded.
There are negatives to owning a QLAC in your retirement account. For example, (1) if you need money sooner than originally expected, you could not get payments from the annuity in advance, and (2) your annuity would be only as secure as the company which issued the annuity – so your money would be at risk if the company became insolvent. You need to consult with your financial advisor before embarking on such a strategy.
PROS AND CONS TO ROLLING OVER IRA TO 401(k) – AND VICE-VERSA
An IRA-to-401(k) rollover offers benefits, such as (a) earlier access to the money at age 55 without penalty (as compared to age 59½ for an IRA), and without a Substantially Equal Periodic Payment Plan (SEPP) , (b) postponing required minimum distributions if still working for the employer with the 401(k) plan, and (c) in some instances, easier conversions to Roth IRAs. Also, in some states (other than North Carolina), 401(k) accounts have protections against creditors that IRAs don’t provide; in North Carolina, IRAs are protected against creditors. Also, loans are allowable from 401(k)s, whereas loans from IRAs are not allowed. Generally, you do not want to borrow against your 401(k) account, but, if you have a temporary need which can be repaid in the future, you may, as a last resort, be able to borrow from your 401(k) and to repay the loan with interest.
There are a lot of circumstances where a traditional IRA has a leg up on a 401(k) account, which is why so many people roll their 401(k) accounts into IRAs. Advantages can be wider investment selection, often lower investment costs, and looser rules for hardship withdrawals, without penalty – for reasons such as higher education expenses and first-time home purchase (limit $10,000).
DISTRIBUTIONS AFTER DEATH OF IRA OWNER/PARTICIPANT
It is very important for you to complete the beneficiary designation forms for your retirement account. Sometimes participants fail to fill in the necessary paperwork, or when they do fill in those documents, it is without professional advice. If no beneficiary is named, the default beneficiary is often the participant’s estate. Although naming an estate or trust as a beneficiary may seem logical, you’ve got to be careful. Doing so may subject an estate or trust to unexpected rules and implications, and sometimes imposes them with tax results which might seem unfair or even nonsensical.
Some rules which apply to beneficiaries of IRAs are:
If a spouse is the beneficiary of the owner’s IRA at the owner’s death, the spouse can “roll over” the balance in the account into his or her IRA, or into a “rollover IRA” opened by the surviving spouse, on which the spouse will be subject to similar distribution rules as an original IRA owner. That is, the RMD will be based on the joint life expectancies of the surviving spouse and an individual who is 10 years younger. If the spouse is under age 72, distributions from the rollover IRA will not be required until the spouse reaches age 72. However, the surviving spouse may take discretionary withdrawals before age 72 and can receive distributions in excess of required minimum distribution (RMD) after reaching age 72.
If a beneficiary is someone other than a spouse, the account may not be “rolled over” into the beneficiary’s IRA or a rollover IRA, but the IRA may be transferred to an “inherited IRA” account, which is not the same as a spousal “rollover” account. A beneficiary other than a spouse must take RMDs from the inherited IRA account starting the following calendar year, no matter what the age of the beneficiary. That is, the beneficiary of an inherited IRA cannot wait until he or she reaches age 72 before taking distributions. Since annual distributions are mandatory, there is no 10% penalty for distributions from inherited IRAs made to beneficiaries under the age of 59½. Under the old rules applicable prior to the enactment of the SECURE Act effective December 20, 2019 – an inherited IRA was subject to a one-life mortality table instead of a two-life table, and life expectancy was not recalculated as the beneficiary grew older. Under the SECURE Act applicable to accounts of participants who died on or after January 1, 2020, an inherited IRA must generally be distributed to the beneficiary over a period of no more than 10 years.
On a different related topic, the IRS has not issued guidelines – but there have been several private letter rulings (requiring some expense to taxpayers) – to allow spousal rollovers of qualified plans and IRA benefits when an estate or trust is the beneficiary of the account, (a) when the spouse is sole beneficiary of the estate or trust, and (b) has a general power of appointment over the trust. This can apply where there is no named beneficiary and the “default” beneficiary is the participant’s estate.
In a 2018 private letter ruling, a decedent failed to designate any post-death beneficiary and the plan was payable by default to the decedent’s estate. The decedent had no will, and under state law the estate was split among the surviving spouse and the children. The children were adults with no children of their own and all executed valid disclaimers, leaving the spouse as sole beneficiary of the estate. The IRS approved a spousal rollover in that case.
“STRETCH” IRA STRATEGY
“Stretch IRAs” have been popular for many years as a strategy for slowing down the mandatory payout of IRAs, by designating much younger beneficiaries at the owner’s death – such as grandchildren – to take advantage of their longer life expectancies (and consequently, lower required minimum distributions) than older beneficiaries. Until adoption of the SECURE Act discussed in the following paragraph, an IRA left to a beneficiary other than a spouse was payable over the life expectancy of the beneficiary. That is, if the beneficiary had an actuarial life expectancy of 30 years , the required minimum distribution (RMD) for Year 1 would be 1/30th of the account’s value, for Year 2 would be 1/29th of the account’s value, etc. If the beneficiary died before the account was closed out, his or her successor would continue, on the original beneficiary’s schedule until the account was depleted.
That tactic has been brought to a screeching halt – the SECURE Act, signed into law on December 20, 2019, and generally effective on January 1, 2020, has changed that all, by generally requiring that inherited IRAs by beneficiaries other than spouses must be paid out in no more than 10 years. That is, inherited IRAs left to much-younger beneficiaries will generally need to be paid out in 10 years, instead of over the actuarial life expectancy of the beneficiary. There are exceptions applicable to certain “eligible designated beneficiaries.” If your current estate plan includes a “stretch” IRA, you should go back and re-visit your plan, to see whether it still fits your needs, given the new 10-year payout rule.
An “eligible designated beneficiary” who is not subject to the 10-year payout requirement includes an individual who is (i) the employee, or IRA owner, (ii) a spouse of the participant, (iii) a minor child of the participant, (iv) a person who is disabled or “chronically ill,” as defined in Internal Revenue Code Section 401(a)(9)(E)(ii)(IV), or (v) any individual who is not more than 10 years younger than the participant. But upon the death of the “eligible designated beneficiary,” the 10-year rule kicks in, instead of continuing to be distributed over the remaining life expectancy of the original “eligible designated beneficiary.” When a minor beneficiary attains the age of majority applicable in his or her state (usually age 18 or 21), the 10-year rule kicks in, but a child may be treated as though he or she had not reached the age of majority, if he or she (a) has not completed a specified course of education as described under Internal Revenue Code Section 401(a)(9)-6 and is under 26 years of age, or (b) if applicable, so long as the child continues to be disabled after reaching the age of majority, see Reg. § 1.401(a)(9)-6, A-15.
The new legislation will not affect the terms of payout for original designated beneficiaries of participants who died before January 1, 2020, and it will be applicable only to accounts of participants who die on or after January 1, 2020, subject to the proviso that, instead of continuing to follow an original designated beneficiary’s minimum distribution schedule if the original designated beneficiary dies on or after January 1, 2020, the distribution schedule for any successor beneficiaries will be re-set to a 10-year payout schedule.
A POSSIBLE ALTERNATIVE WHICH SPREADS OUT RETIREMENT DISTRIBUTIONS
An alternative strategy which is still available would be to leave an IRA upon death to a charitable remainder trust (CRT), which would pay a flat percentage each year to the beneficiary or beneficiaries, either for their lifetimes or for a term not to exceed 20 years, whichever the Trust Grantor selects, following rules applicable to IRAs. A CRT is a tax shelter itself, and no income tax would be payable when the IRA was paid to the CRT, but distributions from the CRT to individual beneficiaries of the trust would be taxable to those individual beneficiaries when distributed. In the meantime, the investments inside the CRT could accrue tax-free, perhaps allowing the value of the CRT to grow. At the death of the last surviving beneficiary, the trust would terminate, and the account would be paid to a charitable beneficiary or beneficiaries, as set forth in the trust agreement for the CRT.
Because laws are changed from time to time, and because it is possible for a retirement account owner to become incapacitated, it is a good strategy for the owner to have a durable power of attorney which would be effective in the event of incapacity, specifically empowering the Agent under the durable power of attorney, on behalf of the owner, to change the beneficiaries of retirement accounts and even to create entities such as charitable remainder trusts.
SECURE ACT OF 2019
The SECURE Act was enacted in December, 2019, to expand the opportunities for individuals to increase their savings and to make administrative simplifications to the retirement system. In addition to some of the changes discussed above (moving the required beginning date to age 72 instead of age 70½, permitting deductible IRA contributions after the required beginning date for withdrawals, generally eliminating “stretch” IRAs, etc.), the SECURE Act makes it easier for small businesses to offer multiple employer plans by allowing otherwise-completely unrelated employers to join the same plan, and It also makes it easier for long-time part-time employees to participate in elective deferrals, and it allows penalty-free distributions from qualified plans and IRAs for births and adoptions. Also, penalty-free distributions are allowed from defined-benefit plans or IRAs for the birth or adoption of a child. These withdrawals may be repaid to such a retirement account.
The old rules were not repealed, but the provisions of the SECURE Act were superimposed on the old rules. Consequently, the ins-and-outs of the SECURE Act are very complicated, and there is a separate blog on our law firm’s website which discusses that Act in more detail.
Donor-Advised funds are a tax-advantaged way to make gifts to charities over time. A donor-advised fund is basically an account with a public charity which has a donor-advised program and which qualifies as a “sponsoring organization.” Gifts are made to the fund, which is held in the name of the donor or in the name or names of the donor’s family members. Gifts from donors to the fund qualify as charitable deductions for income tax purposes, and distributions are made from the fund to charitable organizations over time. Distributions from the fund do not count as additional charitable deductions for the donor, since the donor has already gotten a charitable deduction when the original gift was made to the fund.
Donor-advised funds are usually opened during the lifetimes of the donors, and distributions are made to charitable organizations which the donors select. Since the sponsoring organization is responsible for seeing that the tax laws have been complied with, the donors make “recommendations,” and not binding directives, as to the distributions to tax-exempt organizations. Normally those requests are honored unless the requested done does not qualify as a tax-exempt organization. Donor-advised funds may also be created, or increased at death under a will or trust agreement of the donor, often with family members of the donor to make distribution recommendations to the charitable organization after the deaths of the donors.
Donor-advised funds may be used to support a number of public charities. They are sometimes used as alternatives to private foundations.
Private foundations are separate legal entities created by a donor or donors. They require ongoing maintenance and expense. Also, the donors receive smaller tax benefits than they would receive with a similar gift to a donor-advised fund at a public charity. Legally, a private foundation allows the donor or donors to retain more control over the investments, grants, and control of the entity.
Donors often prefer a donor-advised fund instead of a private foundation for convenience, reduced costs, greater tax benefits and ease of gifting, with no worries about minimum distributions or the tax issue of excise tax on net investment income, which would be applicable to a private foundation.
The donors may make a large charitable gift to the donor-advised fund, and have the gift used to make periodic distributions over time, with the donors not having to worry about compliance costs and requirements.
“Bunching” of Charitable Deductions
Under the new tax laws with higher standard deductions, donors who traditionally have made charitable gifts of several thousand dollars a year in deductible contributions now often receive reduced or no tax benefits from making their customary annual distributions.
For example, consider married donors with $120,000 annual income, who traditionally give about $5,000 per year to charitable organizations. On their tax returns, they cannot claim medical deductions of less than 10% in 2019 (formerly 7.5% in 2017 and 2018), so often the
taxpayers would not itemize medical deductions. They cannot deduct more than $10,000 per year in state and local taxes, and there is no longer a deduction for miscellaneous itemized deductions. Unless they have high home mortgage interest, if they donate $5,000 to charitable organizations in 2019, their total deductions may be less than their standard deduction of $24,400 (in 2019), in which case they would receive no income tax benefit for charitable gifts totaling $5,000.
In the alternative, let’s consider “bunching” their contributions by the use of a donor-advised fund. For example, they could give $50,000 to a donor-advised fund in 2019. If their itemized deductions otherwise would be $10,000 in state and local taxes and $5,000 in home mortgage interest, the gift to the donor-advised fund itemized tax deductions would now total $65,000 ($50,000 gift to the donor-advised fund, plus $10,000 in state and local taxes and $5,000 in mortgage interest), as compared to a standard deduction of $24,400. Their income taxes for 2019 would be reduced by over $10,000, assuming they were in a 28% marginal tax bracket.
The donor-advised fund would receive $50,000 in gifts, but it would be possible to distribute from the fund only the donors’ customary $5,000 to charitable organizations, as requested by the donors. The charities would receive their customary gifts in 2019 and the donor-advised fund would retain the remaining $45,000. In future years similar gifts could be made from the donor-advised fund each year, as directed by the donors or their family.
The donors could resume claiming a standard deduction on their subsequent income tax returns, until the fund was depleted. If the donors died or became incapacitated, their families could continue to make charitable contributions from the fund.
The above example illustrates moderate gifting and the effect of “bunching,” but donor-advised funds are often utilized for very large gifts, often at the death of a donor, sometimes in lieu of a private foundation.
Families With Existing Private Foundations
If the donors already have a private foundation which they find expensive and burdensome to maintain, the private foundation could distribute its assets to a donor-advised fund with a sponsoring organization. The sponsoring organization would then be responsible for compliance with federal laws, instead of the donors or their family’s being responsible.
Another possible benefit would be to bring one’s children into the gifting process during the donors’ lifetimes. After the donors’ deaths, the children would continue to make recommendations for charitable gifts from the donor-advised fund.
Most sponsoring organizations allow grantors or designated family members as advisors for charitable gifts for at least one generation, and some allow two generations.
Most community foundations have donor-advised fund programs and sometimes other organizations such as colleges and universities maintain similar funds, where a certain percentage of contributions must go to the sponsoring organization itself, such as 50%, and the remainder can go to other charitable organizations.
A donor who wishes to establish an ongoing philanthropic program – for themselves and/or their families – should consider establishing a donor-advised foundation as part of their ongoing gifting, and possibly establishing the habit of ongoing gifting to charities for their families.
In Winston-Salem, the Winston-Salem Foundation, Suite 200, 751 West Fourth Street, Winston-Salem, NC 27102, (336) 725-2381, can be contacted about the establishment of a donor-advised fund. See https://www.wsfoundation.org/contact.
Several larger cities and counties in North Carolina have large community foundations, similar to The Winston-Salem Foundation. The North Carolina Community Foundation is a single statewide community foundation with a network of affiliate foundations across the state, which serve many rural and less-populated counties, and which can serve as a sponsoring organization for donor-advised funds in their communities. A list of affiliated community foundations funds can be found at nccommunityfoundation.org/communities.
It is very easy to set up a donor-advised fund with a sponsoring organization. Just contact the organization and see whether it is a sponsoring organization for donor-advised funds. If so, they will meet with you and draft a letter whereby the organization agrees to be the sponsoring organization for your donor-advised fund, which describes the purposes for your fund, etc. They will make it easy for you.
Estate planning is more than simply deciding who gets your assets after your death. It includes a wide range of matters, such as (1) planning for yourself and for your family in the event you become incapacitated; (2) the appointment of guardians for your minor children, if any, in the event of the deaths of both parents; (3) the protection of assets for minors, or for beneficiaries who cannot manage money, are incapacitated, or otherwise need asset protection; (4) planning for family members who are nonresidents or noncitizens of the United States; and (5) planning for a myriad of other personal issues for your family, including tax planning.
Please note that the reasons listed above for estate planning are not necessarily limited to wealthy individuals. It can be very important to a person of modest means to see that his or her assets are used to benefit the proper beneficiaries in a wise and appropriate manner.
We hope the following discussions will be helpful:
Wills are a common estate planning tool and are the most basic device for planning the distribution of an estate upon death. Wills that are 100% handwritten by the Testator and which are either kept with the decedent’s valuable papers or are given to someone else for safekeeping, are called “holographic” wills and do not have to be witnessed, provided that two witnesses attest to Probate Court as to the Testator’s handwriting, when the holographic will is presented to the court for probate after the decedent’s death. North Carolina wills that are not entirely in the Testator’s handwriting must have two witnesses, and preferably both witnesses and the Testator will sign in the presence of a Notary Public. If there was no notary public for the signatures of the testator and the witnesses, the Clerk of Superior Court may still probate the will, after the witnesses’ signatures have been duly proven to the Court.
Unless the Will is filed with the Court and is found by the court to be valid, a purported Will has no legal significance, so any paper which purports to be a will should be filed with the Court and you should request the Court to “probate” the Will (i.e., to certify the document to be valid). By the way, a Will can be probated (i.e., certified) without having a full court administration.
Probate (Court Administration):
One meaning of “probate” is the process whereby a decedent’s will is presented to the Probate Court (i.e., The Office of the Clerk of Superior Court) and the Court determines whether or not the will is valid. In an effort to avoid confusion, we will refer to that process as “probate (certification).”
If the will is found to be valid, an Executor or other personal representative will be appointed to take control of the decedent’s assets, and to notify creditors by direct notice and/or publication of a newspaper notice to creditors. That person will be responsible for tax filings, if applicable, and for paying debts and administration expenses. This process is also called “Probate” of the Estate, and to avoid confusion we will sometimes refer to this process as “probate (administration).” The executor pays valid claims and the remaining assets are distributed to the beneficiaries pursuant to the terms of the will. After these things have been done properly, the Probate Court will close the estate file.
Probate Avoidance (or Avoiding Court-Supervised Administration of an Estate):
Since probate (administration) documents are matters of public record, the family can maintain some privacy, while saving some court charges, by avoiding probate (administration). Probate (administration) can be avoided in several ways, such as by joint ownership of assets with survivorship or by naming beneficiaries in ownership documents, which will pass outside probate. Revocable trusts also hold assets in the name of the trustee, and the trust’s assets do not pass through court probate (administration).
Consequently, many individuals seek to avoid probate (administration), or at least to minimize the process, by a combination of joint accounts with survivorship, by naming beneficiaries for transfer on death of bank and brokerage accounts, and by naming beneficiaries for other assets, including life insurance and retirement accounts. Real estate can pass by survivorship to a joint tenant with survivorship rights, or to a surviving spouse under a “tenancy by the entirety” (a form of joint ownership applicable only to husbands and wives).
Irrevocable Trusts may be used as estate planning tools, sometimes to hold life insurance policies and often for the distribution of assets for the benefit of family members who are minors or developmentally-disabled beneficiaries, and sometimes to prevent wasteful spending by a spendthrift child, or to protect assets for a family member who is in a shaky marriage or who is in a high-risk job or profession. Also, certain types of trusts can provide for management of assets and the disposition of assets to protect family wealth for several generations and are typically called generation-skipping trusts (GST) or “Dynasty” Trusts.
This article cross-references you to other related topics, such as the following:
Who gets your assets if you die without a will? This is not as simple as one might think. North Carolina has laws which deal with the disposition of the estates of decedents who die without wills, called the North Carolina Intestate Succession Act, some provisions of which might surprise you and likely would not be what you would want. Also, please be aware that some assets pass by beneficiary designation or by survivorship to individuals and do not pass under the Intestate Succession Act.
Do you need a Durable Power of Attorney, a legal document which authorizes someone to act for you and to sign legal papers on your behalf if you are incapacitated?
Do you need a Health Care Power of Attorney and Advance Directive, to authorize someone to make health care decisions for you, which may include decisions whether or not to resort to extraordinary means to prolong your life if you are terminally and incurably ill, and to allow you to die a natural death in those circumstances?
Should you have a Revocable Living Trust to avoid the need for court probate at your death, i.e. court supervision, to insure that any assets belonging to you at the time of your death are used to pay your debts, funeral and administration expenses, etc., or can you rely on family members or other trusted individuals to administer your assets without court supervision? A revocable trust is not a matter of public record and affords your loved ones with some privacy concerning the assets which you own on the date of death and to whom those assets have been left.
Would it be appropriate to create Irrevocable Trusts for the benefit of others, either during your lifetime or after your death?
If you are a business owner or partner in a business or LLC, should you consider having a Business Succession Plan for the transfer of your business interest upon your retirement, death or disability?
Would your family benefit from tax planning? With the federal estate tax exemption equivalent at $11.4 million in 2019 and increasing each year, the need for estate tax planning is not very important to many of us. But there are other tax issues, such as income tax considerations, which could benefit a family of moderate wealth, such as step-up in the cost basis of assets upon death.
This article cannot include all the estate planning possibilities and alternatives, but it is intended to give an overview of the issues involved.