Minimizing the government's bonanza in clients' retirement accounts.

In helping clients achieve their financial objectives, practitioner involvement in financial and estate planning is ever increasing. Over the years, new strategies have been implemented in order to reduce income taxes and obtain financial security on retirement through the use of company-sponsored retirement plans and individual retirement accounts. Today, in assisting these same clients with estate planning, practitioners are confronted with some rather intriguing dilemmas when trying to achieve various tax objectives: [] Fully utilizing unified credits.

[] Preserving the minimum payouts from the plan.

[] Maximizing cash flow to the surviving spouse during her lifetime.

Fulfilling these goals may not be easily accomplished in all situations. However, they can often be attained through well-thought-out beneficiary designations.

The following example illustrates these complexities.

Example: Taxpayer H is about to reach age 701/2 H and his wife, W, together have a net worth of $1,000,000. H has a net worth of $500,000, consisting solely of his retirement account, while W's net worth of $500,000 is primarily marketable securities. They have two adult children, both of whom are self-sufficient. H and W have not made any taxable gifts during their lifetimes; therefore, both have retained all of their lifetime exemptions. On the death of the later to die, the entire estate will be left to the children in equal amounts. H and W want to retain their current standard of living and cash flow throughout their lifetimes. They want to accomplish their objectives without accelerating the income tax liability that results when retirement distributions are made, and without incurring any estate taxes on the death of the later to die. The issue to be addressed is the selection of the most appropriate beneficiary designation for the retirement account.

Potential solutions

[] H names W the designated beneficiary of the retirement account plan and the children as contingent beneficiaries. This entitles W to plan distributions during her lifetime if H predeceases her. However, the plan will be included in W's estate, creating an estate tax liability of $153,000 (assuming the value of assets does not change).

[] H names his children as designated beneficiaries with his grandchildren, if any, as contingent beneficiaries. There will be no estate tax at the death of either H or W. In addition, the re ire annual distributions reduced because the joint life expectancy of H and the oldest child can be used (Prop. Regs. Secs. 1.401(a)(9)-1 and 1.408-2(b)). Unfortunately, W will not receive the distributions from the retirement account and this is likely to substantially reduce her standard of living.

[] H names a trust as designated beneficiary. H's estate benefits from his lifetime exemption and eliminates any estate tax liability from W's estate. If the trust is properly drafted, W continues to receive all the distributions from the retirement plan. However, for the trust to qualify as a designated beneficiary, it must exist when H reaches 701/2, be irrevocable, be valid under state law, and the beneficiaries of the trust must be identifiable. Finally, H must name the trust as designated beneficiary and provide the plan administrator with an executed copy of the trust agreement prior to reaching the age of 70 1/2. With so many restrictions, complexities and costs, this may not be the best option (Sec. 401(a)(9)(b)(i) and Prop. Regs. Sec. 1.401(a)(9)-1, Q&A B-4).

The solution

H names W the designated beneficiary, but instead of naming the children contingent beneficiaries, he names a credit trust established by his will or trust. On H's death, W disclaims the retirement account. This allows the plan to fund the credit trust, which accomplishes all of H and W's objectives and minimizes any tax liability. H's lifetime exemption is used to eliminate W's estate tax liability. The credit trust is drafted to require income distributions to W during her lifetime, thereby preserving her standard of living. On W's death, the annuity payments are not accelerated (provided that W's life expectancy is not recalculated), but continue as before to the beneficiaries of the credit trust. By allowing the credit trust to be the contingent beneficiary, all the primary beneficiary's detriments are avoided and some degree of flexibility in the estate plan remains (Secs. 408(d)(1) and 2518).

This technique is valuable in that it maximizes both lifetime exemptions, maintains the desired cash flow, and substantially reduces or eliminates the estate tax liability. Consideration should be given to this type of planning vehicle in the proper circumstances.

From Byron C. Smith, Aidman Piser & Company, Tampa, Fla.