A complete liquidation of a person's retirement account can trigger a huge income tax liability, significantly diminishing assets available for investment. For example, a person who withdraws $100,000 from a 401(k) plan will have to report $100,000 of taxable income, producing combined federal and state income taxes of roughly $40,000 and leaving only $60,000 to invest. Had the $100,000 stayed in the plan, the $40,000 would have generated significant investment income, but the taxation of the distribution permanently deprived the individual of that revenue. Over 16 million people have received lump sum distributions and less than half rolled over the entire distribution to defer taxation.1

There are many opportunities for employees to defer paying taxes on lump sum distributions from their own account2 — the most important of which is the rollover. But opportunities are extremely restricted for beneficiaries after an employee's death. Distributions from an inherited retirement account are taxable as income in respect of a decedent (IRD).3 Only a surviving spouse can rollover a distribution from an inherited retirement account4 — nobody else can.5 The laws permit payments from a decedent's retirement account to be made over a beneficiary's remaining life expectancy;6 but as a practical matter, very few companies make that opportunity available to beneficiaries. Businesses do not want the burden of keeping track of the whereabouts of every beneficiary of every employee who ever worked for them. Consequently, many plan documents require a deceased employee's retirement account to be liquidated within one year of death. How can the beneficiaries of unmarried employees at such companies defer paying income taxes on lump sum distributions?

One solution that comes close to a post-death rollover of an unmarried employee's retirement account is if the employee names a charitable remainder trust (CRT) as the beneficiary of the account. A CRT typically pays a fixed dollar amount or a fixed percentage of the trust's assets to an individual for life and then distributes the trust's assets to a charity upon the individual's death. The income tax advantage is that a CRT, like an individual retirement account (IRA), is exempt from the income tax.7 A lump sum distribution from a deceased employee's retirement account to a CRT triggers neither an income tax liability8 nor the 20 percent withholding requirement9 that can apply to other retirement plan distributions. Because the CRT is tax-exempt, it can reinvest the entire distribution and provide an income stream to an individual that will last a lifetime. For companies that do not offer the option of an annuity payout (many plans do not),10 it's the closest thing possible to a rollover of a distribution from an unmarried employee's retirement account. The CRT option will be of greatest benefit to an unmarried individual with total wealth under $2 million who has a large retirement balance and wants to provide an income stream after death to a beneficiary, but who works at a company that insists on lump sum distributions at death

The CRT offers several non-tax advantages as well. For individuals who have charitable intent, it's a great way to provide an increased income stream to their beneficiaries while supporting their favorite charitable organizations. For a parent who is concerned that shortly after his death children might squander an inheritance, the CRT offers assurance that they will receive income for life. It can also work well for an individual who wants to provide a relatively stable source of income to a life partner.

The arrangement can be accomplished by having an unmarried employee name a CRT as the beneficiary on the company retirement plan's beneficiary designation form. A married employee might consider naming a CRT as a contingent beneficiary in the event of a simultaneous or early death of a spouse.11 As a practical matter, naming a CRT as a beneficiary should be done only in situations in which there are sufficiently large retirement balances that can justify a trust's administration costs. Many charities are willing to administer a charitable remainder trust with a minimum contribution of $100,000, but some bank trust departments may set a higher minimum. It will, of course, also require the drafting and execution of a CRT trust instrument so that the CRT will be in place in the event of the employee's death. For smaller balances, similar results might be obtained by naming as the beneficiary a financially sound charity that will issue a charitable gift annuity (CGA) to an individual. Many charities will issue a charitable gift annuity for as little as $10,000.

In most cases, the retirement assets will never actually be transferred to a CRT. Most people don't die while they are employed; they usually die after they've retired. When a person terminates employment, he can transfer the assets from the company retirement account into an IRA, which renders meaningless the beneficiary that was named on his company retirement plan form. Once the assets are in an IRA, an unmarried individual usually has no need for a CRT to accomplish income tax deferral to beneficiaries after his death. IRAs are very flexible, and beneficiaries can easily defer distributions from inherited IRAs over their own life expectancies (the “stretch IRA”). Thus, in most cases a CRT strategy should be viewed principally as a contingent plan to defer income taxes in the event that an unmarried employee with a large retirement balance dies while working at a company that has an inflexible policy for liquidating retirement accounts.

TECHNICAL RULES

So how do you select the right type of CRT? There are several different types: A charitable remainder annuity trust (CRAT) pays a fixed dollar amount (at least 5 percent and no more than 50 percent of the value of the property contributed to the trust) each year to one or more income beneficiaries for life (or for a fixed term of years, a maximum of 20) and then distributes the remaining proceeds to one or more charitable organizations. This may be appealing for older beneficiaries who would like a steady source of income that's not subject to market fluctuations. Younger beneficiaries would find that inflation would reduce the value of the fixed payments over a long period of time. A CRAT can receive only one contribution, so the trust should be funded only after death.12

A charitable remainder unitrust (CRUT) pays a fixed percentage (at least 5 percent and no more than 50 percent) of the value of the trust's assets each year (redetermined annually) to one or more income beneficiaries for life (or for a fixed term of years, maximum 20), then distributes the remaining proceeds to one or more charitable organizations.13 A CRUT would be better for a younger beneficiary, as it offers the chance of growing investments and, hence, larger distributions in the future. A CRUT can receive additional contributions, which could provide greater flexibility than a CRAT. There are several variations of the standard CRUT — the Net Income with Makeup Unitrust (NIMCRUT) and the Flip CRUT — that a beneficiary might find attractive.14

The charitable remainder interest of the CRT must be at least 10 percent of the value of the property contributed to the CRT.15 As a practical matter, this means that the stated payout cannot be too high and the beneficiaries of a lifetime CRT cannot be too young.16 (See “Youngest Permissible Ages,” this page.) for the outer limits of payouts and ages under current interest rates.)

If the beneficiaries are too young, the administratively simplest solution is to establish a CRT for a term of years. The legal maximum is 20 years.17 Another solution may be to establish multiple CRTs if there are several beneficiaries. As the number of beneficiaries of a CRT increases, the minimum age necessary to pass the 10 percent test also increases, since the joint life expectancy of several people who are the same age will always be greater than the life expectancy of any one of them. Thus, it may be possible for an individual with five children to pass the 10 percent test by establishing one CRT for the three oldest children and another for the two youngest. The disadvantage of multiple trusts, of course, is higher administrative costs.

CGA ALTERNATIVE?

A charitable gift annuity is not subject to the minimum 10 percent charitable deduction. Many charities are unwilling to issue a CGA on behalf of someone under the age of 50, so in most cases a CGA will not be a workable solution to the problem of young beneficiaries.

For those who can take advantage of a CGA, they may get comparable benefits to a CRT at a much lower administrative cost. A CGA is a contract between a donor and a charity to pay income over one life or a maximum of two lives. Most charities follow the investment and payout guidelines recommended by the American Council on Gift Annuities.18 Whether a charity follows those guidelines or not, the tax law imposes four restrictions on CGAs: (1) the value of the annuity must be less than 90 percent of the value of the property contributed by the donor; (2) the annuity can be paid over a maximum of two lives; (3) the contract cannot guarantee a minimum or maximum amount of payments; and (4) the contract cannot change the amount of payments based on the income produced by the property contributed by the donor (or based on any other property for that matter).19

Obviously, the employee needs to establish a separate agreement with the charity whereby the charity agrees to issue a CGA when it receives the retirement plan distribution. Not all charities issue CGAs20 and, as with commercial annuities, selecting an organization with solid financial resources is of paramount importance. The Internal Revenue Service has issued a private letter ruling (PLR) that approved the issuance of a CGA from an inherited retirement plan distribution.21

TAX BREAKS

There are two special tax breaks that may apply to a lump sum distribution received from a Section 401(a) qualified retirement plan (but not from an IRA or a 403(b) plan). Estate planners should examine the impact that a CRT might have on these opportunities.

First, appreciated employer stock that is received as part of a lump sum distribution can be sold with the built-in gain taxed at long-term capital gain rates rather than ordinary income rates. IRS private letter rulings have concluded that if a CRT receives a contribution of such stock, the CRT will classify the gain on the sale of such stock as long-term capital gain and may be able to distribute such gains to the trust's beneficiaries under the four-tier accounting system that applies to CRTs.22

Second, a lump sum distribution of the retirement plan account of an individual who was born before 1936 can be taxed at a special low tax rate: the “10-year tax option.” The rates can be very low for smaller distributions (see ‘Lump Sums,’ this page). The computation of the tax and the eligibility criteria are described on IRS Form 4972. If this tax result is desired, it would probably be better to name an individual or the estate as the beneficiary of the retirement account rather than a CRT. As a tax-exempt trust, a CRT probably could not take advantage of the tax rate savings.

WEALTHY ENOUGH?

If a person is so wealthy that his estate will be subject to the federal estate tax (the threshold in 2006 is $2 million), a CRT will strip away an important income tax benefit. Normally in the same year that a person reports the receipt of taxable IRD from a retirement plan distribution, he can claim an offsetting itemized income tax deduction for the 45 percent or 46 percent federal estate tax — but not for any state inheritance tax or state estate tax — that was attributable to the IRD.23 What happens if instead of paying these amounts directly to an individual, the retirement plan makes a distribution to a CRT and the CRT over time makes distributions to an individual? In a PLR, the Service concluded that the CRT effectively strips away this income tax deduction.24 The loss of an income tax deduction equal to 45 percent or 46 percent of the assets that were transferred to a CRT is a stiff price to pay for the income tax deferral that the CRT might offer. Indeed, people who are wealthy enough to pay the estate tax should explore simply leaving their retirement assets as outright bequests to charities since the combination of federal estate and income taxes can produce an effective tax rate of 64 percent on retirement assets and the addition of state income and estate taxes could bring the overall effective tax rate to over 80 percent!

BOTTOM LINE

Although there are many options for employees who retire or change jobs to defer taxes on distributions from their company retirement plans, the opportunities for the beneficiaries of a deceased employee are limited. A surviving spouse can rollover an inherited distribution, but no other beneficiary can. Unmarried employees with large retirement balances who are concerned about the potentially harsh tax results that could apply upon their death should consider naming a CRT as a beneficiary of their company retirement account.

Endnotes

  1. Patrick Purcell, ”Pension Issues: Lump-Sum Distributions and Retirement Income Security,” Congressional Research Service Report, Order Code RL 30496, Library of Congress (August 2005) and James Moore and Leslie Muller, ”Lump-Sum Pension Distribution: An analysis of lump-sum pension distribution recipients,” Monthly Labor Review, pp. 29-46 (May 2002). The trend has increased. In 2003, 47 percent reported that they rolled over the entire amount compared to just 40 percent in 1998.
  2. Congress recognized the problem of early taxation and enacted laws to encourage and sometimes even require the deferral of income taxes when employees terminate employment. In 2002, Congress amended Internal Revenue Code Section 401(a)(31) to generally require plan administrators to transfer large retirement balances to individual retirement plans. There are also laws that can require an employer to retain the assets in the company plan if an account balance is over $5,000 (a company retirement plan may not make a distribution to an employee before his or her normal retirement age or age 62 without the employee's written consent). IRC Section 411(a)(11); Treasury Regulations Section 1.411(a)-11(c)(3). There is no corresponding consent requirement for a beneficiary after an employee's death that would require the plan to retain the assets. Treas. Reg. Section 1.411(a)-11(c)(5).
  3. IRC Section 691; Treas. Reg. Section 1.691(a)-2(b)(1); Revenue Ruling 73-327, 1973-2 C.B. 214.
  4. IRC Section 402(c)(9) for inherited qualified retirement plan accounts and Sec. 408(d)(3)(C)(ii)(II) for inherited IRAs. The general prohibition against rolling over an inherited IRA is described in IRC Section 408(d)(3)(C).
  5. Ibid and Private Letter Ruling 200513032 (Jan. 4, 2005), in which the Internal Revenue Service rejected a request made by the decedent's children and a trust to rollover a distribution made from the decedent's retirement account.
  6. Treas. Reg. Section 1.401(a)(9)-5, Q&A 5(c)(1).
  7. IRC Section 664(c).
  8. In PLRs 199901023 (Oct. 8, 1998), 9634019 (May 24, 1996), 9253038 (Oct. 5, 1992) and 9237020 (June 12, 1992), the Service concluded that neither the decedent's estate nor any beneficiaries of either the estate or of the charitable remainder trust would have taxable income in the year that amounts were transferred from a retirement plan account into a CRT. Instead, beneficiaries of the CRT would report taxable income under the CRT four-tier system in the year that they received distributions from the CRT. The income in respect of decedent from the retirement plan distribution was classified as first-tier ordinary income rather than as fourth-tier corpus.
  9. There is mandatory 20 percent income tax withholding if a qualified retirement plans makes a distribution that is eligible to be rolled over. IRC Section 3405(c)(3). Because distributions after death to anyone except a surviving spouse cannot be rolled over, the 20 percent withholding tax should not apply to a distribution to a CRT after death.
  10. Among other reasons, many profit sharing plans and 401(k) plans will not offer annuities in order to avoid the complex joint and survivor annuity requirements in IRC Section 417. Treas. Reg. Section 401(a)(11)(B)(iii).
  11. Congress enacted legislation that requires the surviving spouse to receive the entire account balance of a married employee's IRC Section 401(a) qualified plan unless the spouse waives this right in a specific written consent. Section 401(a)(11)(B)(iii). The consent must acknowledge the effect of the waiver and must be witnessed by a plan representative or by a notary public. Section 417(a)(2)(A). The net result is that regardless of who a married employee may have named as the beneficiary of the account, the entire account balance will be transferred to the surviving spouse as a matter of law unless there is a written consent from the spouse. IRAs are not subject to this waiver requirement.
  12. Treas. Reg. Section 1.664-2(b). That regulation also makes an exception that all property that passes to a trust by reason of death shall be treated as a single contribution, even if there are several such transfers, but the exception does not apply where a contribution had been made during a person's lifetime.
  13. IRC Section 664(d)(3) and Treas. Reg. Section 1.664-3(a)(1)(i)(b).
  14. A NIMCRUT (Net-Income with Makeup Unitrust) and a Flip CRUT usually pay smaller amounts in earlier years but larger amounts in later years. A NIMCRUT is like a standard CRUT except that over the entire life of the trust it pays the lesser of each year's net income or the stated fixed percentage. If a beneficiary was short-changed in an earlier year, the trust can pay a larger amount in a future year when the income for that year exceeds the stated percentage (the “make-up”). Treas. Reg. Sec. 1.664-3(a)(1)(i)(b)(2). A Flip CRUT usually begins as a NIMCRUT but the trust instrument states that it will lose both the make-up and net income limitation provisions and convert into a standard CRUT in the year that follows a specified date or that follows a “triggering event” described in the trust instrument. Treas. Reg. Section 1.664-3(c).
  15. IRC Section 664(d)(1)(D) for CRATs and Section 664(d)(2)(D) for CRUTs. The computation is made based on the interest rate in effect when the trust is funded.
  16. To increase flexibility, it can be advantageous to have a testamentary CRUT's payout determined by a self-adjusting clause. For example, the stated yield of the trust could be drafted to be something along the lines of “the highest percentage permitted by law for this trust to qualify as a charitable remainder trust, but in no event above [stated percentage].” That way, the payout would not have to be determined until the client's death and it also would not exceed an amount that the client thought was excessive.
  17. IRC Section 664(d)(1)(A) for CRATs and Section 664(d)(2)(A) for CRUTs. A CRT for a term of years could use the same formula for the stated payout that is described in the preceding endnote.
  18. The suggested rates of The American Council on Gift Annuities can be found at www.acgaweb.org/giftrates.html.
  19. IRC Section 514(c)(5). See also IRC Section 501(m)(5) and Technical Advice Memorandum 8045010 (July 20, 1980).
  20. Many colleges, religious organizations, community foundations and major national charities issue charitable gift annuities. Many of these charities can be identified by contacting The American Council on Gift Annuities. www.acga-web.org
  21. PLR 200230018 (Apr. 22, 2002). In that ruling, an individual named a charity as the beneficiary of an individual retirement account and left instructions with the charity to use the IRA proceeds to issue a CGA on behalf of another individual. The Service ruled that the full value of the IRA must be reported on the estate tax return but that there would be a partially offsetting charitable estate tax deduction of the CGA. The estate would not recognize taxable income on the transfer. The ruling did not explain the income tax consequences to the beneficiary of the CGA.
  22. The IRS reached this conclusion when living donors contributed such stock to CRTs. PLRs 200335017 (May 27, 2003), 200302048 (Oct. 15, 2002), 200215032 (Jan. 10, 2002), 200202078 (Oct. 19, 2001), 200038050 (June 26, 2000) and 199919039 (Feb. 16, 1999). There is no ruling on the tax treatment of a transfer of such stock directly from a qualified plan to a CRT after death, but the outcome should be similar. A person who receives employer stock as part of a “lump sum distribution” only has to recognize as income the purchase price that the QRP paid for the stock rather than the full value of the stock. IRC Section 402(e)(4)(B); Treas. Reg. Section 1.402(a)-1(b)(2)(i). The net unrealized appreciation (NUA) is not taxed in the year that the stock is received. Instead, NUA is taxable when the stock is sold. NUA qualifies for long-term capital gain treatment even if the recipient held the stock for less than one year. Notice 98-24, 1998-17 I.R.B. 5. Under the four-tier accounting system that applies to CRTs, a beneficiary will not have long-term capital gain income until all of the ordinary income that the trust has ever had has been fully distributed. Section 664(b). As a practical matter this means that if the retirement plan distribution had large amounts of ordinary income and only small amounts of appreciated employer stock, the CRT beneficiary will likely never receive long-term capital gain income.
  23. IRC Section 691(c)(1)(A); Treas. Reg. Section 1.691(c)-1(a); Rev. Rul. 92-47, 1992-1 C.B. 198 (Holding 2). Rev. Rul. 78-203, 1978-1 C.B. 199 provides the rules for claiming an itemized deduction. The deduction is claimed on the last line of Schedule A (“other miscellaneous deductions”). It is not subject to the 2 percent-of-adjusted-gross-income (AGI) limitation that most miscellaneous deductions are subject to. IRC Section 67(b)(7). For extensive analysis of the rules governing the IRC Section 691(c) deduction, see Christopher Hoyt, “Inherited IRAs: When Deferring Distributions Doesn't Make Sense,” Trusts and Estates (June 1998).
  24. PLR 199901023 (Oct. 8, 1998) basically prevents a person who receives an IRD distribution from a charitable remainder trust from ever deducting the estate tax. It does this by categorizing the federal estate tax as fourth-tier corpus and categorizing the remaining portion of the IRD as first-tier ordinary income. The only way that a person could receive a tax benefit from the fourth-tier corpus would be if the CRT drastically shrank in size after liquidating the income from all of the other tiers, which is a result that nobody wants.

YOUNGEST PERMISSIBLE AGES

Payouts of a charitable remainder trust, necessary to pass the 10 percent test, depend on the age and number of beneficiaries

PAYOUT* 5% 6% 7% 8% 9% 10%
GOING TO: YOUNGEST AGE (YEARS)
A SINGLE LIFE BENEFICIARY 24 33 38 43 46 49
TWO LIFE BENEFICIARIES WHO ARE THE SAME AGE 37 45 50 55 58 61
* Payout rates are less for a younger beneficiary, who has a longer life expectancy than an older beneficiary, so that the remainder interest stays at least 10 percent of the value of the property contributed to the CRT.
Christopher R. Hoyt

LUMP SUMS

This type of distribution may be taxed differently

A beneficiary who receives a lump sum distribution from the retirement account of a decedent who was born before 1936 may be able to pay a lower alternate tax rate. Here are some examples of taxes imposed, regardless of the amount of the taxpayer's other income:

Distribution Tax Percentage
$20,000 $ 1,100 5.5
100,000 14,471 14.5
200,000 36,922 18.5
300,000 66,330 22.1
400,000 102,602 25.7
500,000 143,682 28.7
600,000 187,368 31.2
700,000 235,368 33.6
Christopher R. Hoyt

Collectors' Spotlight

American Masters: “Burlesque,” a 1909 oil was painted by Russian-born American Expressionist painter, writer and poet Max Weber, a key figure in introducing avant-garde art to America. The painting sold for $1 million at Christie's “Important American Paintings, Drawings & Sculpture Sale” in New York on Dec. 1, 2005.