Ah, well, whatever…or saving a Special Needs Trust From a Tax Disaster
Introduction: Just because they pass a law, don’t make it so. Recent legislation allowing nonspouse beneficiaries to request a direct rollover of funds in a qualified retirement plan to an IRA opens up tremendous planning flexibility. Nonspouse beneficiaries now have the same ability as spousal beneficiaries to “stretch” distributions from the IRA and extend the tax deferral benefits over many years (even over many decades, depending on the age of the beneficiary). But we have found that many employers have not updated their distribution forms offering the rollover. As described below, this can lead to a tax disaster especially if the beneficiary is a Special Needs Trust (SNT).
Discussion: Beginning in 2007, nonspouse beneficiaries of qualified retirement plans are allowed to request a direct rollover of the funds to a beneficiary (inherited) IRA. This legislation opened up significant planning opportunities for unmarried couples and other nonspouse beneficiaries (such as children and grandchildren). Under prior law nonspouse beneficiaries were limited in their ability to delay taxation of the account. Without the ability to rollover the funds their choices were dictated by the plan provisions. Plans usually provided for either an immediate, taxable distribution or a payout over a five year period following the death of the account owner. Contrast this with the beneficiary of an IRA (whether a spouse or not) who is allowed to “stretch” distributions over a much longer time period if they so choose – such as over the beneficiary’s life expectancy.
Some employers, however, while aware of the law change, have not updated their distribution forms. The unwary nonspouse beneficiary may see only two choices on these outdated forms - an immediate lump sum or a payout over five years. In one client’s case, the beneficiary was a SNT. Her mother died in 2007. The SNT was established for her brother who had sustained significant brain damage in an accident and is unable to care for himself. Our client was named the sole trustee. Her brother has been receiving state and Federal assistance. Based on the form she received, she thought her only two distribution options were an immediate payout of the $150,000 account or a payout over five years. Fortunately, she sent it to us for review.
In our first conversation with the plan administrator, the person answering the phone insisted that only the two distribution options on the form were available. When asked about the law change and the possibility of a direct rollover request, she replied “Ah, well, whatever. Just fill in one of the boxes and send it back.” It was only after a discussion with the person in charge of plan administration that we confirmed that the plan did allow for a nonspouse to request a direct rollover to an IRA (beginning in 2008, all plans must allow for direct rollover requests from nonspouse beneficiaries). Had the trustee not asked us to review the forms the distribution would have been subject to taxation much sooner than otherwise necessary at the much higher trust tax rates. Alternatively, government benefits could have been lost if the SNT paid out income to the beneficiary (the disabled adult child is only 40 years old, has a life expectancy of over 40 years; the trust constitutes a “see through” trust for purposes of having a designated beneficiary and is an accumulation trust so the trustee has discretion over payment from the trust to avoid loss of government benefits). We requested the direct rollover to an inherited IRA. Required minimum distributions based on the life expectancy of the beneficiary will be made to the trust beginning in 2008.
What to do: Qualified retirement plan forms are frequently incorrect or out of date. Encourage your clients to seek assistance from a knowledgeable advisor when considering their distribution options.
If you have any questions, please call David Fluett or Jim Sullivan.
|