Using Retirement Funds for Credit Shelter Trusts

If you are like many people, individual retirement accounts (IRAs) and other retirement plans may constitute a significant portion of your estate. In the past, fully using the gift and estate tax applicable exclusion amount (currently $650,000) in such a situation was difficult because participants could not name revocable trusts, such as credit shelter trusts, as beneficiaries. The only trust option -- irrevocable trusts -- often limited flexibility and increased the fees involved in creating an effective estate plan. But under proposed U.S. Treasury regulations, you can now name a revocable trust as beneficiary of your retirement accounts, as long as the trust becomes irrevocable on your death.

How Credit Shelter Trusts Work

Currently, married couples may protect $1.3 million in assets (twice the applicable exclusion amount) from estate tax if both spouses fully use their own applicable exclusion amounts. To take full advantage of the available tax savings, however, each spouse must own assets worth the full amount of the exclusion at death. Married couples may transfer assets from one spouse to the other without gift tax to ensure that none of the applicable exclusion amount is wasted on the death of either.

As a general estate planning technique, on your death assets equal in value to the applicable exclusion amount can be placed in a credit shelter trust to be held for the benefit of your surviving spouse and descendants. The trust then provides income to your spouse during his or her lifetime and can provide principal payments if needed to maintain his or her lifestyle. This trust is not taxable in the surviving spouse’s estate.

The proposed Treasury regulations make it easier to use retirement accounts to fund credit shelter trusts. For example, let’s say you own an IRA with a value of $1 million, and the value of all your other assets, including the residence and liquid assets of you and your spouse, are worth $650,000. Under the proposed regulations, you may use a portion of the IRA to fund the credit shelter trust, so that both you and your spouse can fully use the applicable exclusion amount.

After your death, retirement account distributions may be made to the credit shelter trust as a named beneficiary. Your spouse, and in some cases your descendants, can receive an income interest in the credit shelter trust. In some instances, it is possible to have the payments from the retirement account made to the credit shelter trust over your spouse’s life expectancy. Care should be used in structuring the credit shelter trust so that, if desired, payments and taxes can be deferred as long as possible.

The estate tax savings from naming the credit shelter trust as the beneficiary of a retirement account do have a cost, however. Your spouse loses the ability to further defer income taxes by rolling over the retirement account into his or her own IRA. And the portion of the retirement distribution that remains in the trust as principal is taxed at the highest marginal income tax rate of 39.6%

Qualified Disclaimers Add Flexibility

Determining what portion of the retirement account should pass to the credit shelter trust can be difficult due to such uncertainties as the health and life span of you and your spouse and future cost of living. Rather than predetermining the portion of the retirement account that will pass to the credit shelter trust, your spouse may prefer to make that determination after your death. With planning, this option is available through the use of a qualified disclaimer.

A disclaimer is the refusal to accept all or a portion of a benefit. If your spouse is named as the primary beneficiary of the retirement account and the credit shelter trust is named as the secondary beneficiary, then any portion of the retirement account that is not accepted by your spouse will pass to the credit shelter trust. Your spouse may wish to disclaim that portion of the retirement account that results in the use of your entire applicable exclusion amount after taking into account other assets available for that purpose.

Ensure that a proper disclaimer can be made. A disclaimer is not allowed more than nine months after the date that a surviving spouse is irrevocably named as the beneficiary of the retirement account.

Therefore, an irrevocable beneficiary designation should not be made if a disclaimer is intended to be used, so that your spouse may disclaim after your death within the applicable time period.

When To Use Retirement Funds

Generally, only use retirement accounts to fund credit shelter trusts if other assets are not available. Retirement accounts, which are subject to income tax, are less desirable for funding a credit shelter trust because the amount sheltered from estate tax is reduced by the income tax paid. The effect is that the amount that will eventually pass to your children or other beneficiaries is reduced. Consider other assets before the use of a retirement account, including cash, Roth IRAs and assets that receive a stepped-up basis on your death, such as securities or real estate.

If the retirement account is payable directly to your spouse, then income tax paid on the retirement account reduces the amount that will later be taxable in your spouse’s estate. If other assets are not available, then using retirement accounts to fund credit shelter trusts may be a better option than wasting the applicable exclusion amount.

Planning Considerations