1. Typical Estate Plan for Husband and Wife with over $1,000,000 in Assets: They have a living trust, commonly called an "A-B Trust." Upon the death of the first spouse, an amount of his or her assets up to the estate exemption ($1,000,000 in 2002-3) is placed into the "B" trust (we call it the "Exemption" trust it is also commonly called the "decedent’s" or "bypass" trust). The balance of the assets typically go into the "A" trust (we call it the "Survivor’s" Trust). No estate tax is paid at the death of the first spouse. The Exemption "B" trust is never subject to estate tax. If the Survivor’s "A" trust exceeds the estate tax exemption at the death of the surviving spouse, only the amount in excess of the exemption is subject to estate tax. Thus, the A-B Trust effectively doubles the estate tax exemption to $2.0 million in 2002 and can save up to $435,000 or even more in estate taxes at the death of the surviving spouse.

2. The Problem: Retirement plan benefits, such as an IRA, cannot be owned by a living trust (being the beneficiary, however, we will discuss in a moment). If such benefits were distributed out to the living trust, they would be taxed by the income tax and possibly even penalty excise taxes. On the other hand, retirement benefits are included in your estate subject to estate taxes. Therefore, an IRA may be subject to estate tax upon the passing of the surviving spouse.

3. Example: For example, suppose Husband and Wife have $1,000,000 in assets in their living trust and another $1,000,000 in the IRA of Husband. Assume Husband dies before Wife and Wife is the sole beneficiary of Husband’s IRA, as is the common plan, and so rolls over Husband’s IRA into her own spousal rollover IRA. Wife, therefore, may only put Husband’s half of the living trust assets in the B trust (see paragraph 1 above); Wife cannot include Husband’s share of the IRA because it is not part of the living trust. Therefore, when Wife passes away the unspent IRA is entirely and absolutely controlled by her in her spousal rollover IRA, thus will be included in her taxable estate, and so will be subject to estate taxes. The following diagram illustrates this problem of IRA’s and other retirement plans:

4. Solution: The solution is to position as much as possible of the Husband’s half of the IRA so it is not included in the Wife’s taxable estate when she passes away. We do this by designating the Exemption "B" Trust as the beneficiary of enough of the Husband’s community property half of the IRA so as to use up the balance of the Husband’s estate tax exemption left over after the Husband’s living trust assets go into the Exemption "B" trust.

Until late January, 1998, the IRS required us to set up a separate irrevocable trust now as the beneficiary. However, in late January, 1998, the IRS changed its rules and now allows us to name the Exemption "B" trust as a beneficiary of part of the Husband’s IRA or other retirement plan. (Prop. Reg. § 1.401(a)(9)-1, Q&A D-5, D-6 and D-7; Reg-209463-82.) The IRS further liberalized the rules in January 2001.  The following illustrates the solution:

The Exemption "B" trust escapes estate tax when the Wife dies because she did not create it and cannot change who ends up with its assets when she is gone. The Wife should not want to do any of those things. On the other hand, the Wife can be, and usually is, the trustee and sole beneficiary of the Exemption "B" trust, and so she gives up no real control or enjoyment of the IRA or other retirement benefit.

5. Why is Keeping the Funds in the IRA or Other Retirement Plan so Powerful? The IRA or other retirement plan benefit has a feature of astounding power that we want to preserve. The longer assets remain in the plan, the longer they can continue to grow tax-free. Investments that are otherwise taxable, such as stocks, corporate or U. S. government bonds, and mutual funds of the same, increase with dividends, interest, and capital gains tax-free.

That is why traditionally the Wife is the beneficiary of the IRA or other retirement plan. She can do a tax-free rollover into her own spousal rollover IRA. However, after age 70 ½ she must begin taking minimum distributions of the rollover IRA, but they are taken out over many years. That period of time typically can stretch out over 26.2 years if she names her child(ren) as the IRA beneficiary.

On the other hand, the Exemption "B" trust as IRA beneficiary may take out its part of the IRA over an average of 19.8 years. This occurs because it is treated as if it were the Wife for purposes of avoiding the 50 percent IRS penalty. Hence, we can avoid estate taxes on the IRA going into the irrevocable trust, and the distributions stretch out over a period to time almost as long as with the Wife as beneficiary (19.8 versus 26.2 years).

6. Downside: The only real downside is our fee to advise you and handle the paperwork on properly making the Exemption "B" trust a beneficiary of the retirement plan. However, saving up to at least $435,000 in estate taxes makes the fee look pretty insignificant.

7. Other Details: The IRS requires that certain requirements be met, such as informing the IRA custodian or retirement plan administrator regarding the Exemption "B" trust beneficiaries. We will assist you with such details.

8. Additional Use of Exemption Trust: Another use of the Exemption "B" trust as retirement plan beneficiary is if the Husband has children from a prior marriage or other beneficiaries he would like to receive the retirement benefits after the Wife is gone. Under the traditional planning, if the Husband dies first, the Wife rolls over the entire retirement plan benefit into her rollover IRA. When she dies, her children or her family members usually get the IRA, and the Husband’s family gets nothing. The Exemption "B" trust allows us to achieve two normally disparate goals: first, have the IRA available to support the Wife for her lifetime, and second, get whatever is left over to the Husband’s children or family.

9. Conclusion: The Exemption "B" trust as the IRA or other retirement plan beneficiary can be a great tool. It can reduce or eliminate estate taxes in the case of large ($200,000+) retirement plan benefits. At the same time, it can preserve the powerful tax-free compounding of such benefits.

To learn more about how a good estate plan can positively effect your estate taxes, or if you would like a free consultation, please do not hesitate to contact us at (805) 482-2282, or e-mail us at  KGS@Staker.com.

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