Plan for AgingTM
February 2010 NEWSLETTER
By Law Offices of Andrea Lowenthal PLLC and Pierro Law Group LLC, Of Counsel
In this issue:
The Estate Tax Exemption: Back to the Future
Asset-Protecting Inherited IRAs
Estate Tax Exemption: Back to the Future
Congress passed legislation that imposes a tax on all estates over $1 Million, with a tax rate up to 55%, for all taxpayers who die after January 1, 2011. However, those who die before January 1, 2011 pay no Federal estate taxes regardless of the size of their estates. Curiously, that law was passed in 2001, when the repeal of the so-called "death tax" was set in motion. Confused? You are not alone! Right up until late December 2009 you would have been hard-pressed to find anyone in the estate planning world who thought the Federal Government would actually allow much needed tax revenues to slip away. This newsletter discussion continues below with a review how we got here, and explores some of the planning implications for our clients through all or part of 2010.
How Did We Get Here?
On June 7, 2001, President George W. Bush signed into law the much-heralded Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), designed to provide significant tax relief, including "permanent" relief from the federal estate tax (with its then $675,000 exemption and maximum 55% tax rate).
EGTRRA steadily lowered the maximum estate tax and generation skipping tax rate to 45%, while increasing the exemption amounts to $3.5 million in 2009 and eliminating federal estate tax and GST altogether in 2010. However, as a result of a Senate rule that limits laws with a negative fiscal impact to 10 years (the so-called Byrd Rule), from inception EGTRRA contained a "sunset" provision. Under this provision, as of January 1, 2011, the law is scheduled to revert back to pre-EGTRRA law as if EGTRRA never existed. In other words, the federal estate tax and GST exemption will become $1 million (it was scheduled to increase under prior law) with a maximum rate of 55%.
What Will Congress Do Now?
No one knows with certainty what Congress will do to remedy this situation but several key Congressmen have stated publicly that they will attempt to pass estate tax legislation early in 2010. One of them, Senator Max Baucus, Chairman of the Senate Finance Committee, has said that swift action is necessary to prevent "massive, massive confusion."
Furthermore, many in Congress have expressed the desire to make such legislation retroactive to January 1, 2010. If Congress purports to make these tax charges retroactive to January 1, there are sure to be numerous lawsuits over the constitutionality of such retroactivity and, in all likelihood, these challenges would not be resolved until after years of litigation culminating in a Supreme Court decision. Where would that leave those who die in the interim?
Modified Carryover Basis for 2010
Under our current estate tax system, subject to some exceptions, assets owned at death receive a basis "step-up" to their fair market value at the time of death. Therefore, if you die owning Walmart stock that you bought for $10,000 many years ago, for example, the beneficiaries could sell the stock at its fair market value of, say, $10 million, and pay little or no income tax. The only tax the beneficiaries would have to pay would be on the difference between the sale price and the fair market value at death. (Of course, the stock would also be subject to estate tax at the your death.)
Under EGTRRA, along with repeal of the estate tax and GST in 2010, a beneficiary receives property with an adjusted basis equal to the lesser of the decedent's basis or the asset's fair market value on the decedent's date of death. Thus, EGTRRA eliminates the automatic "step-up" to the date of death value but retains the "step-down" for depreciating assets.
To offset this loss of the step-up in basis, EGTRRA provides that the executor (or other person responsible for the decedent's property) may allocate a $1.3 million "aggregate basis increase" on an asset-by-asset basis up to the particular asset's fair market value at the date of the decedent's death. Assets left to a spouse may receive an additional $3 million "spousal property basis increase," also asset-by-asset, up to the particular asset's fair market value at the date of the decedent's death.
Planning Tip: Unless one can affirmatively prove the basis of an asset, the IRS presumes that the asset has a basis of the property's approximate fair market value on the date it was acquired by its last owner. Therefore, it is absolutely critical that you keep adequate records for all assets.
Lifetime Powers of Appointment
Under current law, for purposes of the basis step-up, a surviving spouse is considered to "own" property in a marital trust over which that spouse has a lifetime or testamentary power of appointment. However, for purposes of the $3 million spousal property basis increase, only a Qualfied Terminable Interest Property (QTIP) trust is eligible and EGTRRA treats property in a QTIP trust over which the surviving spouse has a lifetime power of appointment as not owned by that spouse. Thus, if the surviving spouse has a lifetime power of appointment over the QTIP trust the executor (or other person responsible for the decedent's property) cannot allocate the spousal basis increase to marital trust property. Alternatively, the executor can allocate the spousal property basis increase to QTIP property over which the surviving spouse has only a testamentary power of appointment.
The Impact on Existing Estate Plans
Residuary Marital Trust Formula Funding Clauses
Under a typical living trust or will, the document creates at least two trusts, a credit shelter (aka bypass or Family) trust and a marital trust. Often, the living trust or will language divides the decedent's property into the two trusts through what is known as a residuary marital trust formula funding clause, as follows: the amount of the decedent's property that will pass to the credit shelter trust equals the "maximum amount that can pass free of federal estate tax;" the balance of the decedent's assets pass to the marital trust.
If this typical estate plan was created when the federal exemption was significantly lower, and in particular if the client dies in 2010, this common estate planning language will cause the unintentional over-funding of the family trust and under-funding of the marital trust. Where the family and marital trusts contain identical beneficiaries and dispositive provisions, this over-funding of the family trust and under-funding of the marital trust will have no significance. However, if the family and marital trusts contain different beneficiaries and/or different dispositive provisions, this may cause unintended and undesirable consequences.
For example, with second or subsequent marriages, and in particular where there are children from a prior marriage, the client often limits the surviving spouse's rights to the income from the marital trust, while the children from the prior marriage are often the beneficiaries of the credit shelter trust. If the client dies in 2010, all of the client's assets will pass to the credit-shelter trust, and the marital trust - i.e., the surviving spouse - will receive nothing! This is certainly not what the client wanted and it will not provide the state's statutory minimum to the surviving spouse. With few or no assets left to the surviving spouse, he or she may resort to a lawsuit against the trust or estate for the statutory minimum, thereby increasing legal fees and wreaking havoc with the estate plan.
Conclusion
Since most estate planners reasonably did not anticipate EGTRRA playing out into 2010, many clients' estate plans may not take into consideration the lack of estate tax and its replacement, modified carryover basis. Estate plans should be reviewed and, if necessary, adjusted to take the 2010 estate tax laws into account.
Asset-Protecting Inherited IRAs
Qualified retirement plans (here referred to as "qualified plans") and IRAs are ever increasing in importance in U.S. household wealth. According to the Investment Company Institute, at the end of the second quarter 2009, Americans held approximately $14.5 Trillion in their IRAs and qualified plans, up from $10.5 Trillion at the end of 2002.
IRAs account for more than 10% and qualified plans for 24% of all household financial assets, up from a combined 14% in 1978. More than 41% of all U.S. households have at least one. This newsletter discussion continues below a review of the alarming concurrence of courts that inherited IRAs are not asset protected, and explores how Retirement Plan Trusts can provide that asset protection, along with the required distribution rules for these trusts.
The Need for Retirement Planning.
IRA Qualified retirement plan accounts are asset-protected under federal law. IRAs are protected to at least some extent under state law. Many wrongly believe that these accounts will remain asset protected after their owners die. Below, we review the asset protection of qualified plans and IRAs, and the required distribution rules for account owners. Premature plan owner deaths and minimum required distribution rules designed to never force a retiree to exhaust their IRAs and qualified plans, will combine to transfer a significant portion of those assets to the owners' beneficiaries. How they reach the beneficiaries is usually not governed by the owner's will or trust but rather by each account's beneficiary designation.
ERISA Protection for Qualified Plans
ERISA (the federal Employee Retirement Income Security Act of 1974) provides protection from creditors for all qualified plan assets while they remain inside the plan. ERISA's asset protection for qualified plan distributions, however, depends upon whether the plan is a pension plan (complete protection) or a welfare benefit plan (no protection). Under ERISA, a "pension" plan is any "plan, fund or program which...provides retirement income to employees." Defined benefit pension, profit sharing, and 401(k) plans are all "Pension" plans under that definition. ERISAs protections are the same in bankruptcy court and outside of bankruptcy.
ERISA's protection also extends to an owner's IRA assets that were rolled over from a qualified plan.
Non-Bankruptcy Protection for IRAs
ERISA does not govern IRAs and Roth IRAs. Any non-bankruptcy protection afforded for them comes under state law, which varies widely from state to state. That protection goes all the way from unlimited protection to protection of a specified amount to protection of a court-determined amount reasonably necessary for the debtor and any dependents. Also some state statutes may not protect Roth IRAs or IRAs converted to Roth IRAs.
Bankruptcy Protection for IRAs
Bankruptcy law only protects up to $1 Million of IRAs that were not created by rollover from a qualified plan.
Planning Tip: Do not combine an IRA rolled over from a qualified plan with one that was not. Doing so can jeopardize your asset protection in bankruptcy.
Planning Tip: ERISA provides unlimited protection for assets inside a qualified plan and for distributions from a pension plan, whereas state law determines the extent of protection for IRAs and Roth IRAs. Thus, in some instances it may be beneficial from an asset protection perspective to roll an IRA into an ERISA-protected plan, when possible.
Asset Protection of Inherited IRAs and an Alarming Trend
Many courts have held that the protections available for IRAs do not extend to inherited IRAs. Courts in Alabama, California, Florida, Illinois, Texas, and Wisconsin have all ruled that inherited IRAs have no asset protection, whether in or out of bankruptcy. It is important to note that Texas and Florida statutes generally provide the highest level of asset protection for IRAs, so the decisions there and the general trend are doubly alarming.
A consistent theme in these decisions is that Congress did not contemplate asset protection for anyone other than the worker (or the worker's spouse after a spousal rollover); its goal was to ensure the availability of assets during the owner/participant's retirement. Given this reasoning, it seems likely that more courts will find that inherited IRAs provide no asset protection.
Planning Tip: You have worked hard to accumulate assets in your IRAs. In the case of Roth IRAs, you may have even paid the income tax on the contributions to the plans. Those who want to provide asset protection to the recipients of their other assets are likely to also want to provide that protection for the recipients of their IRA and qualified plan assets. You should be aware that the asset protection you have will not extend to you beneficiaries.
The Fox Guarding the Hen House
A second major problem in planning for qualified plans and IRAs is the "found money" syndrome.
Those who put the money in IRAs and qualified plans are often loath to take out even the required minimum distributions. Their beneficiaries often do not share that inhibition. Instead, they view their inherited IRA or qualified plan account as found money to be withdrawn and spent. Too often that spending is for the unwise and imprudent satisfaction of material desires and whims.
The good news is that the "found money" syndrome can be prevented.
The Retirement Plan Trust
Can you asset protect your beneficiaries' inherited IRAs and qualified plan accounts and ensure that your beneficiaries receive the maximum stretch out benefit of tax-free compounded growth? The answer is a resounding, "YES!" The Retirement Plan Trust can do just that.
The Retirement Plan Trust is designed to weave carefully through the many pitfalls that exist in the law. To understand what that means, it is helpful to start with an understanding of the rules governing when withdrawals from qualified plans and IRAs must begin, the minimum rate at which withdrawals must take place once they are required to begin, and the rights of various classes of beneficiaries to "roll over" an inheritance from a qualified plan or IRA to another IRA.
Benefits and Detriments of Creating a Retirement Plan Trust to Be the Beneficiary of an IRA or Qualified Plan
The Retirement Plan Trust, like any estate planning technique, is not a panacea. One size definitely does not fit all. To determine whether a Retirement Plan Trust is an appropriate option for a particular client requires a weighing of benefits against disadvantages.
Retirement Plan Trust Benefits
Establishing a Retirement Plan Trust and naming it as the beneficiary of an IRA or qualified plan can provide a number of benefits. These include:
- Spendthrift protection - Protecting the individual trust beneficiary from his or her temptation to waste "found money."
- Predator protection - Even if the individual beneficiary does not have spendthrift tendencies, there are many out there whose interest lies in separating the beneficiary from their money and property.
- Creditor protection - Ours is a litigious society in which we never know who is going to be the target of a lawsuit. A trust makes the beneficiary a less attractive "target."
- Divorce protection - With the national divorce rate above 50%, it is impossible to determine which marriages will stand the test of time. A Retirement Plan Trust keeps the inherited IRA from being divided or even lost in a divorce.
- Government benefits protection - As with divorce, whether a healthy beneficiary will suffer some catastrophe that makes him or her dependent on needs-based government programs is unpredictable. Inheriting an IRA can easily disqualify someone from receiving needs-based government benefits until the IRA is exhausted.
- Providing consistent investment management (often from the participant's investment advisor).
- Estate planning.
- Control over use of the retirement plan/IRA assets (e.g., to fund education, start a business, or buy the beneficiary's first home or, in the case of a mixed family, to prevent diversion away from the owner/participant's descendants).
Planning Tip: The Retirement Plan Trust can begin as a revocable trust and become irrevocable on the owner/participant's death. This provides the flexibility of planning and control that many clients prefer.
Retirement Plan Trust Disadvantages
The disadvantages of using trusts generally are all applicable to Retirement Plan Trusts. These are: the legal costs to create the trust and the trustee fees to administer it; the compressed tax brackets applicable to trusts, and the need to file income tax returns if the trust accumulates income; and greater complexity. However, the Retirement Plan Trust can be designed to mitigate these disadvantages, such as by making it revocable until the owner/participant's death.
Planning Tip: The benefits of using a trust generally outweigh the costs, particularly from an asset protection perspective. This is especially true in the context of inherited IRAs, which otherwise have no asset protection.
Attorney Advertising Notice:
We are not providing you with information because we have targeted you as needing our services for a particular matter, and we are not soliciting you for any particular matter or assignment. We are providing this information to make you aware of the type and quality of legal services we provide. The information in this newsletter should not be relied upon as legal advice specific to you or your circumstances unless and until we provide that advice to you as a client of the firm. If you have any questions, for purposes of attorney advertising rules, please contact The Law Offices of Andrea Lowenthal PLLC at 212 662 5324.
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purposes of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer's particular circumstances.