Retirement plans are unique and require special planning. Unlike most other assets, you cannot place ownership of your retirement plans into your revocable living trust during your lifetime. Instead, even with a trust-based estate plan, the distributions of your retirement plans are controlled by the beneficiary designation documents held by the account custodian.
Because you may not place retirement plans into your revocable living trust during your lifetime, historically retirement plans that represented a significant portion of a client’s estate posed a unique planning challenge.
Prior to the Fiscal Cliff Legislation (formally known as the American Taxpayer Relief Act of 2013), the only way to guarantee the use of both spouses’ estate tax exemptions (the amount that may be shielded from the estate tax) was to draft an “A/B Trust” which subdivides into two sub-trusts upon the death of the first spouse. The “A Trust” represents the surviving spouse’s share of the estate while the “B Trust” represents the deceased spouse’s share of the estate. The “B Trust” uses the deceased spouse’s estate tax exemption.
A problem would arise if the decedent had significant wealth in retirement plans because such non-trust assets would not automatically flow to the “B Trust.” The result would be that although the deceased spouse could have shielded a significant amount of his/her assets from the estate tax by allocating those assets to the “B Trust,” the retirement plans would fall outside of the “B Trust,” creating unnecessary estate tax. This problem is known as “underfunding the ‘B Trust.’”
One common way to address this problem was to name the “B Trust” as the beneficiary of the retirement plan on the beneficiary designation documents. Although you may not place ownership of a retirement plan in your revocable living trust during life, under certain circumstances, you may name a trust as a beneficiary of a retirement plan upon death by listing the trust as the beneficiary on the beneficiary designation documents held by the account custodian. The idea behind naming the “B Trust” as the beneficiary of the retirement plan is to ensure that the retirement plan assets would be shielded from the estate tax. There are two main problems with this solution.
First, unless there are concerns about giving the surviving spouse unfettered control of the retirement plan, often it makes sense to name the spouse as the primary beneficiary of a retirement plan as the surviving spouse has unique options with regard to inheriting a retirement plan that other beneficiaries do not have.
Second, naming the “B Trust” as the designated beneficiary of a retirement plan assumes that the retirement plan owner would be the first spouse to die because the “B Trust” is for the first-to-die spouse while the “A Trust” is for the second-to-die spouse. If the retirement plan owner was not the first spouse to die and he or she did not update the beneficiary designation, there would be a significant problem with the retirement plan designating the wrong sub-trust as the beneficiary of the plan upon the surviving spouse’s death.
An alternate solution that addresses the two problems listed above is to draft a customized beneficiary form that spells out various contingencies in detail. The customized beneficiary form would typically leave the retirement plan to the surviving spouse if the retirement plan owner was the first to die. The customized form would also state that if the surviving spouse chose to “disclaim” (i.e., say “no thank you to”) any portion of the retirement plan, the form would direct that the asset flow to the “B Trust.” Finally, if there was no surviving spouse, the customized form would direct the retirement asset to the remainder beneficiaries (i.e., children or sub-trusts created for the children). This allows the most flexibility and covers as many contingencies as possible, but the customized beneficiary form is cumbersome and not all retirement plan custodians would accept such a customized form.
In light of the fact that the Fiscal Cliff Legislation makes the estate tax exemption permanent at $5 million adjusted for inflation ($5,250,000 in 2013), most estates are not subject to the estate tax and worries about underfunding the “B Trust” are greatly reduced. Furthermore, the Fiscal Cliff Legislation makes permanent the concept of “portability” which allows the surviving spouse to claim the deceased spouse’s unused estate tax exemption regardless of whether they executed an “A/B Trust.” The result is that even if a decedent’s estate exceeded the estate tax exemption, the surviving spouse could still shield the non-trust retirement plans from the estate tax by claiming portability, making an elaborate plan to direct the retirement plan assets into the “B Trust” completely unnecessary.
If you have a retirement plan that represents a significant portion of your estate, you might want to examine your beneficiary designation to see if the “B Trust” is named as a beneficiary or if you have a customized beneficiary form. If so, you might want to consider simplifying your beneficiary designations in light of the Fiscal Cliff Legislation. Keep in mind that the estate planning rules regarding retirement plans are extremely complex and you should seek the counsel of a qualified attorney who can help guide you through your options.