Retirement Accounts and Funding a Bypass Trust

Q. Our entire estate except for a small checking account, and a house worth about $150,000 is in my IRA account. My IRA is now worth about $1.6 million. Can my IRA be used to fund a bypass trust? What happens if we do not fund the trust and I name my wife as the beneficiary of the IRA?

A. Yes, with proper planning, an IRA can be used to fund a bypass trust.

By way of background, bypass trusts are sometimes needed because people are allowed to leave only $1,500,000 estate tax-free at death. While it is true that the $1,500,000 amount will be increasing over the next few years, it is also likely that your IRA will increase in value too. At least you hope so.

If you name your wife as the beneficiary of your IRA and you give her the rest of your estate, she will immediately be worth in excess of $1,500,000 upon your death. That dollar amount is much larger than the amount she can leave estate tax-free upon her death. If your wife dies first, you would likewise then be worth in excess of $1,500,000, and upon your death, the estate tax would be the same. Certainly, you would like to do whatever you can to reduce or eliminate the estate tax.

That is why bypass trusts can be useful.

Rather than give your entire estate to each other, the first spouse to die would instead place as much property as possible into a bypass trust. Typically, the surviving spouse would be in charge of the trust as trustee and would be able to distribute property as needed for health, support and maintenance. So there is no real loss of control or access to the property in the trust.

Placing real estate, cash, stocks and bonds into a bypass trust is easy, as there are generally no tax consequences when setting up the trust. However, the IRS has complicated and restrictive rules when it comes to IRAs.

The typical plan involves setting up your estate so that a portion of your IRA could be placed in the bypass trust following your death. Estate taxes would be eliminated because your wife's estate would be less than the $1,500,000 threshold upon her death. Even if your wife dies first, her one-half community property interest in your IRA can be sheltered within the bypass trust created in her Will, thereby saving estate taxes upon your subsequent death.

Getting the IRA into the bypass trust does have a few downsides.

Number One: In your quest to save estate taxes, your wife may get stuck paying extra income taxes. For instance, if you die first and your IRA is paid to the bypass trust, your wife may not be able to roll the entire IRA over to her own new IRA and defer income taxes until she reaches age 70 Ѕ. Instead, with the bypass trust named as the beneficiary, distributions may need to start soon after your death, and then continue over your wife's life expectancy. If your wife is 55 years old upon your death, that means she may need to start taking distributions 15 years earlier than if she had opted for the IRA rollover.

Number Two: Your wife may not be able to name your children as beneficiaries and thereby extend the income tax deferral for their lifetimes. This option would be available if she rolled your IRA over to her own IRA.

Number Three: You may not completely eliminate estate taxes. The reason stems from the fact that you have never paid income taxes on your IRA. When the IRA is owned by a bypass trust, each time a distribution is made to the trust, income taxes must be paid. If the IRA distribution is left in the bypass trust, the tax rate will generally be equal to the highest marginal income tax bracket (that figure is now 35%). Your wife can avoid this high rate of tax by giving the IRA distributions to herself (which is allowable, and possibly even required depending on the terms of your will or revocable trust, as she controls how much she can get from the trust). When the distributions end up in her hands, rather than the trust paying a high income tax, she pays income taxes at her own income tax rate, which may be far lower. The result over time is that the bypass trust keeps getting smaller and smaller each time your wife gives the IRA distributions to herself directly. That makes her worth more and the bypass trust worth less. And if she is worth too much at her death, then estate taxes will still be owed.

As you can see, the laws associated with IRAs and bypass trusts are extremely complicated. This answer is designed to give you a general overview of the planning options which are available, and there are exceptions to some of the statements in this answer.

Q. My retirement plan at work has grown to a little over $1,000,000, and it's going to get bigger because I still have about ten years before I retire. My wife and I have some other investments, but the retirement plan is the bulk of our estate. If I die first, I want to let my wife use the income from the retirement plan for the rest of her life, but after she dies, I want the balance to pass to my two daughters, not to my wife's next husband or anyone else. What should I do?

A. You have a very complicated problem with no simple solution. Here are five approaches you can take.

Option One: You could name your wife as the primary beneficiary and make her promise to name your daughters as her sole beneficiaries after her death. This approach is simple, but risky, as it leaves your wife in total control. After your death, your wife will have the ability to roll your plan over to her own IRA and name her own beneficiaries. With you out of the picture, your wife may break her promise and leave your daughters no part of your retirement money. Your wife would also have the ability to liquidate the plan at any time by making a distribution of the entire amount to herself.

Option Two: Rather than naming your wife as the beneficiary, you could provide for the plan to pass to a trust for her benefit. As the beneficiary of the trust, your wife could receive the income from the retirement plan while she is alive, and then after her death, the remaining assets could pass to your daughters as provided in the trust instrument. As you can see, a trust may be a good solution to your problem, but there are a number of potential drawbacks.

For starters, many company retirement plans cannot be paid to irrevocable trusts without income taxes being due on the plan's entire value. Even though tax laws allow your employer to administer your retirement plan following your death with continued income tax deferral, it is probably your employer's policy to make a lump sum distribution of the entire plan to the trust at your death. Most employers don't want to be bothered with years of bookkeeping following the deaths of their employees. You should check with the benefits department at your company to see what types of payout schedules are possible with your plan. If continued income tax deferral is available, you may have found the best answer to your question.

If you go forward with the idea of a trust, you may want to name someone other than your wife as trustee. Naming your wife leaves her in total control of how the trust property is invested and distributed. She would have the power to negate your intentions by making large distributions to herself, even to the point of using up all the trust property. If you name one of your daughters as trustee (or both of them as co-trustees), then a potential family conflict arises because your wife would need to seek approval from your daughters whenever she needs money. You could name a trust company as trustee, but your wife may not be too happy having to ask a trust officer for money. Also, trust companies charge fees for their services. Trust companies are right for some people and not for others.

Option Three: If you are fortunate enough to retire before your death, you can roll over your company retirement plan to an IRA and achieve all your goals. With an IRA, you can name one or more trusts as the beneficiary, and still continue most of the income tax deferral. Whatever is left in the IRA when your wife dies can pass to your daughters with the possibility of further income tax deferral if they choose. These issues relating to an IRA rollover are good for you to know, but they are not yet relevant because your retirement money is still in a qualified plan at work.

Option Four: You can designate your daughters as partial beneficiaries of your retirement account, with the balance passing to your wife. This way, everyone is guaranteed to get something. After your death, your wife can roll her portion over to an IRA without current income taxation. Your daughters will likely be able to defer income taxes over their life expectancies as well.

Option Five: Another approach is to buy a life insurance policy which names your daughters as beneficiaries. Your wife could be named as the primary beneficiary of your retirement plan. For instance, if you think $400,000 is enough for each daughter, then you could buy an $800,000 policy. Structured properly, the insurance can pass to your daughters (or to trusts for their benefit) without income or estate taxes. Everyone would get enough money, and there would be no conflicts following your death. If you consider that the combined income and estate taxes on your retirement plan could reach as high as 50 - 70% of the entire plan, then spending a few thousand dollars per year on life insurance makes a lot of sense.

Please note, this answer contains some generalities, and many exceptions apply.