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George F. Bearup, J.D. Senior Legal Trust Advisor

29-Jan-20

Retirement Benefits Left to a Surviving Spouse

Take-Away: Under the SECURE Act, a surviving spouse is treated as an eligible designated beneficiary who is entitled to continue to use the former stretch distribution rule over the surviving spouse’s life expectancy. When one spouse dies leaving their retirement assets to their surviving spouse, or to a trust for their spouse’s benefit, usually one of four different distribution scenarios will apply.

Spousal Rollovers Still Work Well: To maximize income tax deferral, and for simplicity’s sake, the IRA owner can name their spouse the primary beneficiary of their IRA. The surviving spouse can then transfer the inherited retirement account balances to his/her own ‘rollover’ IRA and he/she will not need to begin to take distributions until April 1 of the year that follows the year in which the surviving spouse attains age 72 years. The ‘rollover’ IRA will be treated exactly as if it was the surviving spouse’s IRA from inception.

  • However: If the surviving spouse needs money and has to access the rollover IRA assets to meet his/her cash-flow needs, and he/she is under the age 59 ½,  he/she will incur a 10% penalty for any distributions prior to attaining age 59 ½. In addition, giving the surviving spouse full control over the transferred retirement assets means that the survivor could redirect those assets on his/her death to someone that the first spouse to die would not have favored, e.g. a second spouse. If cash flow is required by the surviving spouse who is under age 59 ½, he/she could ‘annuitize’ the ‘rollover’ by investing the ‘rollover’ IRA assets in an annuity contract where the insurance company that issues the annuity contract will make a series of substantially equal annual (or more frequent) lifetime payments to the surviving IRA owner; these equal installment payments will be considered as satisfying the RMD rules, while also avoiding the 10% excise tax for early distributions.

Inherited IRAs Still Work Well: The surviving spouse can also decide to remain the retirement account beneficiary who inherits the deceased spouse’s IRA, in lieu of ‘rolling over’ the decedent’s IRA into his/her own IRA. If the survivor decides to keep the IRA in place and simply remain its primary beneficiary, then the life expectancy rule can still be used, and distributions from this inherited IRA will be based on the surviving spouse’s remaining life expectancy. In this situation, where the survivor decides to remain as the IRA beneficiary, then required minimum distributions must begin by the later of December 31 of the year that follows the year of the decedent spouse’s death, or December 31 of the year in which the deceased spouse would have reached age 72, regardless of the surviving spouse’s age. This option to ‘stay-as-the-beneficiary’ might be preferred over the spousal ‘rollover’ if the surviving spouse has not yet reached age 59 ½ and he/she will need to take distributions from the inherited IRA as its beneficiary (rather than ‘rolling’ it over) in order to avoid the 10% excise tax that is imposed an when an IRA owner withdraws assets from his/her non-Roth IRA prior to attaining age 59 ½.

A Spousal Conduit See-Through Trust Might Work Well: A conduit see-through trust is required to pay to the surviving spouse, its designated beneficiary, exactly what is distributed from the IRA to the trust, without delay, and regardless of: (i) the survivor’s financial needs; (ii)  if there are creditors lurking around the surviving spouse; and (iii) the survivor’s unwise spending habits. A conduit trust thus protects the part of the IRA that has not yet been distributed, and it allows the trustee to use the life expectancy of the surviving spouse, recalculated annually, when taking the distributions from the inherited IRA. If the surviving spouse has attained age 72 and is already required to take our RMDs from his/her own IRA, then the tax impact and the timing of RMDs to the survivor are almost as good under the conduit see-through trust as they will be in a ‘rollover’ IRA, but the principal and management of the IRA will be better protected since the trustee will control those investment decisions and presumably will not take lump sum distributions from the IRA. Consequently, there is often a trade-off decision to be made by the IRA owner: either permit their survivor to use a ‘rollover’ IRA, or name a conduit see-through trust for the survivor’s lifetime benefit. Or, the IRA owner could name an accumulation see-through trust for the survivor as the IRA beneficiary if keeping control of the distributions away from their surviving spouse is more important, which is a sacrifice of an increase in income taxes paid (accumulation trust) in exchange for the protection afforded by an accumulation trust (against the survivor’s spending habits, creditors, future spouses, or dementia.)

  • Convert from a conduit to an accumulation marital trust? One private letter ruling  confirmed that it is possible to toggle what would have been a conduit see-through trust to an accumulation see-thorough trust, if the change occurs before the formal ‘designation date,’ which is September 30 of the calendar year that follows the death of the IRA owner. [PLR 2005370344.] Converting a conduit see-through trust for a surviving spouse to an accumulation see-through trust would thus provide creditor protection and asset preservation which might be important if the surviving spouse is young, unsophisticated, or poses creditor, spendthrift or divorce risk factors. Some states also provide creditor protection to inherited IRAs, while other states do not, which is why an accumulation trust for a surviving spouse, one that has a spendthrift provision, might be warranted, or prompt the consideration of a conversion/toggle of a conduit see-through trust to an accumulation see-through trust .
  • Rhetorical Question: Could an accumulation see-through trust created for a surviving spouse be converted (by a trust director?) to a conduit see-through trust for the surviving spouse when his/her creditor concerns, which prompted the initial use of the accumulation trust, disappear? While a toggle sounds like an interesting strategy to keep in mind, it is also important to remember that the IRS has repeatedly said that ‘absent specific authority in the Code or Regulations, the post-death modification of a trust will not be recognized for federal tax purposes.” [PLR 201021038.]

A Spousal Accumulation See-Through Trust Might Work Well: This type of trust can receive distributions from a decedent’s IRA and accumulate those distributions without having to pay the distribution directly to the surviving spouse who is the trust beneficiary. Usually the trustee possesses the discretion to withhold distributions, or to make them as needed for the surviving spouse’s health, support and education, or for the same needs of his/her/their descendants. The key point is that even if the accumulation see-through trust is created for the sole benefit of the surviving spouse, it will not qualify for life expectancy distributions using the survivor’s life expectancy. The life expectancy distribution using the surviving spouse’s life expectancy is denied to an accumulation see-through trust because the IRA distributions (to the trust) can be accumulated and later used for distributions to non-spouse trust beneficiaries. Consequently, the 10-year distribution rule will apply to an accumulation trust that is created for a surviving spouse. Still, the SECURE Act’s 10-year distribution rule permits the IRA to remain intact and not distributed to the accumulation see-through trust until the tenth anniversary of the death of the spouse who initially owned the IRA.

Blowing the see-through Trust Rules: If the see-through trust created for the surviving spouse does not satisfy all of the see-through rules, so that it is neither a conduit nor an accumulation trust, then either of two different distribution rules may apply depending upon the age of the IRA owner.

  • See-through Rule: In order for the trust established for the surviving spouse is to be treated as a see-through trust, four conditions must be met: (i) the trust must be irrevocable on the day the IRA owner dies; (ii) all beneficiaries of the trust must be individuals who are identifiable by September 30 of the calendar year following the IRA owner’s death (e.g. no charities); (iii) information with regard to the trust must be provided to the IRA custodian (or qualified plan administrator) by October 31, of the calendar year that follows the IRA owner’s death; and (iv) none of the trust’s assets can be available or used to pay creditors of the trust or creditors of the estate of the IRA owner after September 30 of the calendar year (note, this is not the year following, it is the year of the IRA owner’s death.) If all these conditions are met, then the trust will be treated as a see-through If any of these four conditions are not met, then the named trust beneficiary is not a see-through trust and the distributions taken by the trustee from the decedent’s IRA will fall under the ‘old’ pre-SECURE Act’s distribution rules.
  • Failing to Qualify as a see-through Trust: Assuming the trust, which is the designated primary beneficiary of the deceased spouse’s IRA, does not meet the four see-through conditions, then either of two different existing distribution rules will apply, depending on the age of the IRA owner at the time of his/her death.
  • (A) 5-Year Rule: If the IRA owner was younger than the required beginning date (now 72 years) then a 5-year distribution rule applies. This rule requires that the inherited IRA, payable to the trust, must be distributed within 5 years of December 31 of the calendar year of the IRA owner’s death, when that owner had not yet reached his/her required beginning date. This is the default rule that will apply if no more favorable method of required minimum distribution rules applies. If the IRA owner dies after his/her required beginning date (age 72) then the at-least-as-rapidly distribution regime, described below, applies.
  • (B) At-Least-As- Rapidly Rule: If the deceased IRA owner was older than his/her required beginning date (now 72) then a distribution called the at-least-as-rapidly regime will apply. This distribution rule is also a default rule, which requires that the life expectancy of the deceased IRA owner must continue to be used. Therefore, if the IRA owner died after his/her required beginning date, then the 5-year distribution rule cannot be used. In short, if the IRA owner dies after his/her required beginning date of age 72, then the trustee of the trust established for the IRA owner’s surviving spouse will have the inherited IRA assets ratably distributed  to the trust over the deceased spouse’s life expectancy so that the benefits come out of the IRA at least as rapidly as provided by the IRA owner’s life expectancy. Thereafter, the trust will either carry out its conduit directive, or accumulate the distributions from the decedent’s IRA. Note that if the IRA owner died in his/her early 70’s, a least-as-rapidly distribution period may actually be more than the 10-year distribution period required by the SECURE Act for an accumulation

Summary: The ‘old’ rules that pertained to naming a spouse as an IRA beneficiary were complicated. Adding to those options will be the SECURE Act’s 10-year distribution rule, an overlay of that new rule onto old distribution rules. The SECURE Act treats a surviving spouse as an excepted eligible designated beneficiary, which while helpful, simply adds more confusion to the existing distribution rules. Distilling these complex distribution rules is not for the faint-hearted, but consider the following:

Spouse-as-Designated Beneficiary:

  • The surviving spouse can use the life expectancy distribution rule since a spouse is an eligible designated beneficiary under the SECURE Act.
  • The surviving spouse can delay taking the first distribution with a ‘rollover’; distributions from his/her rollover IRA can be delayed until after the survivor attains the age of 72.
  • If the surviving spouse decides to instead remain as the beneficiary of his/her deceased spouse’s IRA, i.e. no ‘rollover,’ then distributions from the deceased spouse’s IRA need not begin until the later of: (i) December 31 of the year following the IRA owner’s death; or (ii) December 31 of the year in which the IRA owner would have reached the age of 72, but only if the IRA is made payable directly to the surviving spouse as a beneficiary. Once those distributions begin the surviving spouse as an eligible designated beneficiary can continue to use his/her life expectancy to calculate required minimum distributions from the IRA.

Spousal Trust-as-Designated Beneficiary:

  • A spousal trust that is named as beneficiary of the deceased spouse’s IRA will need to qualify as a conduit see-through trust to enjoy the benefit of  the surviving spouse’s classification as an eligible designated beneficiary. This enables the trustee of a conduit trust to use the surviving spouse’s life expectancy to take distributions from the IRA.
  • The trustee must follow the SECURE Act’s 10-year distribution rule if the trust is an accumulation see-through trust of which the surviving spouse is one of many trust beneficiaries. That is the case even if the surviving spouse is the sole lifetime beneficiary of the accumulation see-through
  • If the spousal trust does not have those see-through trust special provisions, then the 5-year distribution ‘default’ rule will apply to the deceased spouse’s IRA (if death is before age 72), unless the at-least-as-rapidly rule applies , which means the IRA owner had died at or after age 72 years. To comply with the see-through trust rules, a trust must be specially designed to not benefit any charities, and even then, it must meet the other three conditions required of a see-through
  • A conduit see-through marital trust allows the trustee to withdraw from the deceased spouse’s IRA distributions using the surviving spouse’s life expectancy, which period is recalculated annually. Normally that life expectancy will be longer than the SECURE Act’s 10-year distribution rule. However, as a conduit see-through trust, the distributions must be taken annually by the trustee and then must be distributed to the surviving spouse. Withdrawals from the IRA may not be permitted to remain in the deceased spouse’s IRA untouched until the 10th anniversary of the deceased spouse’s death; annual distributions are required under the conduit see-through trust rules. Annual withdrawals and distributions to the surviving spouse are therefore required.
  • An accumulation see-through marital trust which benefits a surviving spouse, even if the surviving spouse is the sole lifetime beneficiary of that accumulation trust, will not allow for life expectancy distributions based upon the surviving spouse’s life expectancy. Rather, the accumulation see-trhough trust will be subject to the SECURE Act’s 10-year distribution rule with regard to withdrawals from the deceased spouse’s IRA that is made payable to the accumulation trust. While the IRA must be emptied over that 10-year period, or at the end of that 10-year period, there is no further requirement to distribute those IRA withdrawals to the surviving spouse beneficiary.

Conclusion: Obviously, there are a lot of confusing distribution rules when a deceased spouse’s IRA is left either outright, or in trust for the benefit of their surviving spouse. It will take some time to become familiar with the pros and cons of each of the different distribution options.