W
hen it comes to the intri-cacies of tax and estate planning for retirement benefits, few people will argue there is a more revered expert than Natalie Choate. Choate practices law in Boston with the firm Nutter McClennen & Fish LLP, where she consults on estate plan-ning and retirement benefits matters. Her book, Life and Death Planning for Retirement Benefits, now in its seventh edition, has been dubbed the practitio-ner’s “bible” for understanding clients’ IRAs and other retirement plans. She is a frequent contributor to industry publications, and a regular speaker at conferences, including local and national FPA meetings. Those who have heard her speak about retirement benefits appreciate her quick wit, candor, and extensive knowledge of IRS rules and regulations, as well as estate planning laws regarding IRAs and 401(k)s.A Boston native, Choate is a graduate of Radcliffe College and Harvard Law School.
The Journal caught up with Choate in late 2013 to ask her about the latest developments in retirement benefits planning and what planners need to know about required minimum distributions (RMDs), beneficiary forms, and more.
1. When it comes to tax and estate
plan-ning for retirement benefits, what are the most common mistakes people make, and how can financial planners help prevent or avoid those mistakes?This is an area where financial planners can provide valuable help, and it’s noth-ing glamorous, sexy, or sophisticated. The three mistakes people make most frequently are the bread-and-butter fundamentals. The first is failure to take a required minimum distribution. The second is failure to name a beneficiary for their IRA or other retirement plan, and the third is rollover mistakes. And this is where having a financial planner is going to make all the difference to make sure these things get done right.
Who: Natalie B. Choate
What: Expert in tax and estate planning
for retirement benefits
What’s on her mind: “For couples whose
assets are heavy in retirement plans, portability is the angel from heaven.”
Quest
ions
1o
Natalie Choate on RMDs, Smart
Tax Strategies, and Prohibited
Transactions
If there’s no financial planner involved, the person may not even know they’re supposed to take mini-mum distributions, or they may not get the right amount or may skip a year or skip an account. To have a planner to calculate it for you or remind you to take it is just invaluable.
Naming a beneficiary—this is something that nobody gets around to doing it, and the financial planner can make sure it gets done.
And finally, the rollover mistakes— mistakes happen when money is moved from one account to another, but the financial planner can and must take charge of the transfer or rollover process and watch it like a hawk. Do not give it to the summer intern, or else I’ll get a sad call about how it blew up because somebody put the money in the wrong account. People make mistakes on that all the time, and financial planners perform a great service when they take charge of the rollover and transfer process and make sure the right amount goes to the right account. This isn’t some sophisticated investment or tax idea. It’s just where people goof and where help is really valuable.
2. What is the most recent
develop-ment in retiredevelop-ment benefits planning that financial planners may not be aware of yet?There are two pending developments out there that are not good. One is that the IRS has stepped up enforce-ment of prohibited transactions (PT). Prohibited transactions on IRAs have been part of the law since 1974, yet the IRS has never run a big campaign on prohibited transactions because every five years or so they would come out and attack somebody on a PT ground, and they would lose and get their head handed to them. They would retreat in shame. But they’re trying again, and
this time they’re having success. They’re going after self-directed IRAs, where there’s a business in the IRA. When you have a business in the IRA, that’s very likely to get you involved in prohibited transactions. The IRS is winning those cases, giving penalties as well as disqualifying IRAs. So that is a big buzzer area.
Let me expand on that. In one of the most recent cases, called the Ellis case, the IRA owned a business, and the IRA owner was the manager of the business, and he paid himself a salary out of the business that was owned by the IRA. This has been questionable for a long time, but this time the IRS went after it, disqualified the whole IRA, and he owed penalties.
If you want to run a business inside a retirement plan, that’s probably something to stay away from. But if the client insists on doing it, the path to explore—and I’m not saying it always works—is to start a corpora-tion with the business, have it adopt a qualified plan, roll the IRA money into the qualified plan, and make the plan an ESOP that then buys the stock of the employer company. You’ve got a fighting chance that way, but not with an IRA.
The other ominous development out there is a proposal to kill the stretch IRA and replace it with a five-year payout rule that would apply to most retirement benefits, with about seven exceptions to that five-year payout. This was part of the president’s budget proposal, and Senator Baucus (D-Mont.) is very interested in it. It’s not something that’s in any current legislation, but it’s not going away either. It keeps being tacked onto laws that haven’t happened to get passed yet, but there’s a danger that it could get passed.
I’m not sure exactly what you can do about it, but it means that you’ve got to step back if your client’s estate plan
is very closely married to the stretch payout, to be aware of the vulnerabil-ity there.
3. What are the most important things
planners need to know about beneficiary forms for IRAs, 401(k)s, and other retire-ment plans?My hobby horse is that the lawyer who does the estate plan also should do the beneficiary designation form; it’s part of the estate planning documents. I often see cases where the lawyer says, “I’ve drafted the trust. I’ve drafted the will. I’ve drafted thousands of docu-ments.” And then they say to the client, “You go complete your own beneficiary designation form.” Clients aren’t equipped to do that. Basically, they’re not going to do it. They’re sick of the whole process by the time they finish signing the will. Then you get the sad situation that nobody does it. So the message is for financial planners to ride the client and the estate planning attorney to get this done.
4. What happens if a plan provider
loses a beneficiary form?I keep hearing about cases of that. If it does happen, you’re really screwed because they won’t pay the benefits except to the default beneficiary. So the big thing is to make sure it doesn’t happen in the first place. The way to do that is, every two or three years and/or every time the bank goes through any kind of merger or reorganization, to require them to certify who is the beneficiary and to make sure they have the form, but they may not be willing to constantly respond to requests like that.
And, if possible, get the IRA provider to sign a receipt for the thing in the first place. When you file a beneficiary form, have them sign a copy of what they’ve gotten, admitting that they
received it. That way, if they lose it, you may be able to browbeat them into honoring the one they received, which I hope they would do.
5. If a financial planner has a client with
a large amount of company stock in his or her retirement plan, what may be the most tax-efficient options for that client? The big possibility is if you have employer stock in your retirement plan, you potentially get a special deal that the rest of us don’t get, and that is a lump sum distribution of your retirement plan. Say you’re 65, you retire; a lump sum distribution means that the whole plan is cleaned out and distributed to you in the year you’re retiring. You can’t do it over a couple of years or gradually, because then you lose this treatment. There has to be 100 percent distribution of everything from that plan and possibly some related plans within one calendar year. If you carry that step out correctly, the deal you get is that you only pay tax on the plan’s basis in the stock, which is the value of that stock when it originally went into the plan. So an employee might receive $1 million worth of stock in a lump sum distribu-tion, and only have to pay tax on $300,000 worth of it because the com-pany says it was only worth $300,000 when they put it into the plan. The rest of the value, the $700,000, is called net unrealized appreciation, NUA, and that is not taxed at the time of receipt. It’s not taxed until the employee sells the stock, which could be right away or later, whenever he wants to. And it’s taxed at long-term capital gains rates, so that’s much more favorable than the income tax rate.And it gets better. Because he had to take a lump sum distribution, he had to take out everything, so there might have been other assets in there besides the stock, like mutual funds.
The employee can roll that over to an IRA tax-free and not lose the deal he’s getting on the stock. And here’s the final, and fairly recent development: remember I said he got $1 million worth of stock, of which $300,000 was currently taxable, and the rest is NUA, tax-deferred until he sells it. He can roll over 30 percent of the stock he got. There’s a recent letter ruling that indicates he’s now rolled over all of the currently taxable portion, so he doesn’t have to pay any current tax.
My advice is, this should be on your checklist. Does your client have employer stock in his retirement plan? If so, you’ve got to either be or hire an expert on net unrealized appreciation to help guide you to get the best deal for this client.
6. You speak and write often about
issues surrounding naming trusts as beneficiaries of retirement benefits. Can a trust be written or administered in a way that reduces the new net investment income tax for beneficiaries?Theoretically, it can be drafted to reduce the net investment income tax, but this is going to be very difficult. I think it’s going to be unusual for a trust to be drafted like that. It’s going to be tough to avoid this tax. Here is what the story is: say the trust receives net investment income, and maybe it also receives some IRA distributions. Well, IRA distributions are exempt from the net investment income tax. They’re subject to regular income tax, of course, but not this 3.8 percent extra tax that applies to investment income.
If an individual receives net invest-ment income and he or she is over the threshold amount, that’s the end of the story. You’re stuck with it. You can’t give it to charity. You can’t invest in something that’s deductible. You just pay the tax. But a trust is a little different. The trust is only taxed on undistributed
net investment income. So theoretically, the trust can shovel the net investment income out to the beneficiaries and let them worry about this tax.
But let’s back up. The trust is at a much lower threshold than humans. The trust’s threshold is $11,950, so if a trust has retained income over that amount and has net investment income, the trust is going to pay the 3.8 percent tax; whereas individuals have a higher threshold of $200,000 or $250,000. So you’re probably going to have a lot of families where the beneficiaries of the trust are not subject to the net investment income tax (NIIT), because their income is under $200,000 or $250,000. But if money is going to be accumulated for them in a trust, the trust is going to be subject to the tax because it has a much lower threshold. So administratively, trustees now have an added incentive to distribute income out because they’re probably at a much higher tax bracket than the beneficiaries. But not all trusts are going to permit them to distribute all that income, and if the trust has both retirement plan distribution income and investment income, what you might like to be able to do is pass out the investment income to the family beneficiaries, because that will make it free of tax if they’re in a low bracket or if they’re under the threshold amount, and keep the retirement plan distributions in the trust; they’re not subject to the NIIT. The trustee simply cannot do that, administratively, because all distributions are going to carry out proportionate amounts of both kinds of income. So unless the trustee distributes every penny of income to get rid of all of it, he’s going to get stuck with some NIIT.
Looking forward, the Holy Grail is going to be, “Maybe I can write my trust so that the trustee will be able to some-how shift the net investment income tax to the beneficiaries without distributing all of the income.” Can it be done? I’m
not sure it can be. Or, if you figured out how you could do it, it’s not going to be clear that you’d want to do it.
7. It’s not uncommon for someone to
name a trust for a spouse as beneficiary of his or her retirement benefits. What are some issues surrounding this that financial planners should be aware of? The biggest issue to be aware of when naming a trust for the spouse is the price that you’re paying by giving up the spousal rollover. When you name a trust for the spouse as beneficiary of any retirement plan, the very best deal that that trust can get is to take out gradual distributions from the plan over the life expectancy of the surviv-ing spouse, assumsurviv-ing she’s the oldest trust beneficiary. That guarantees that the IRA is going to be totally liquidated by the time the surviving spouse reaches her mid-80s, or would have reached her mid-80s, because that’s when her life expectancy runs out on the IRS table.If you make the benefits payable to the spouse, individually, and he or she rolls them over to their own IRA, the money can stay in the deferral environ-ment much longer, because the spouse doesn’t have to take any distributions until reaching age 70½. Or, in the case of a Roth IRA, [the spouse] doesn’t have to take any distributions ever during their lifetime.
With the traditional IRA, when the spouse reaches 70½ and she starts to take minimum distributions from her own rollover IRA, the distributions are smaller than would be paid to a trust and they’ll probably still be plenty of money left in the rollover IRA when the spouse dies, which she can then leave to the younger generation for a stretch payout.
Sometimes, you’re going to name the trust for the spouse because it’s
a second marriage, so you need to quantify. How much are you giving up to protect the children? Would it be better to protect them in some other way, such as by buying life insurance? If you’re doing it because the surviving spouse is a spendthrift or just cannot handle money, well, you’re still paying a very high price, but in that case, it may be worth it if the alternative is losing everything.
8. What are some things that planners
should keep in mind when it comes to required minimum distributions from IRAs?The thing I want to let people know about is how to get a waiver of the penalty for minimum distributions. It has several steps, but if you follow
these steps very carefully, you should get a penalty waiver from the IRS. What you need to do is find the year that the client missed a minimum distribution. Let’s say it was 2012, and the client was sick or for some other reason didn’t take their minimum distribution. Let’s say it was $10,000. So you file Form 5329 for the year that you missed the distribution. You’re not going to go back and amend the return for 2012 to add that income, because you didn’t take the distribution, so there’s no income to be added in. So you’re not amending the return for the year that was missed, but you file Form 5329 as a standalone return for the year of the missed distribution. Form 5329 has three lines. The first line is, what was the amount you were supposed to take? You write the
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amount, $10,000. The second line asks how much did you actually take? In this example, zero. The third line—and this is the most important one—is, what is the amount of the shortfall? Now logically, you would think the shortfall was $10,000, but that’s not what you put on that line. You have to put zero, so you’re reporting that your missed distribution was zero, and you write in the margin “RC.” That stands for reasonable cause.
What you’re saying is, I don’t have any missed distribution because I had reasonable cause. Now I know this doesn’t make any sense and it’s ridiculous, but this is what the form instructions say.
Then you attach a statement. The statement explains what your reason-able cause was, such as illness or an error by the IRA provider—those would be typical examples. The final step is to show that you remedied the shortfall. So now it’s 2013. You found the mistake. You take out $10,000 right now from the IRA in addition to this year’s minimum distribution. Take it as a separate check. Make a copy of the check, attach it to your 5329, and the IRS agent can see, “OK, there’s the check. They took the $10,000 as soon as they found out about the mistake.”
9. Since the U.S. Supreme Court
overturned DOMA last year, what has changed for same-sex couples when it comes to retirement plans?What the Supreme Court said, very simply, is if your marriage is recognized by your state, the federal government also has to recognize it for tax purposes. Therefore, if your mar-riage was not recognized previously by the IRS, but now it is because it’s recognized by your state, planning is just the same as for any other married couple.
The only thing I can think of that’s
a little bit out there, is under qualified retirement plans, surviving spouses have rights to the deceased spouse’s retirement benefit. I admit, I haven’t studied this, but it could be that if your spouse died in the last few years and you did not get their death benefit under their qualified plan because of DOMA, and now the Supreme Court said that was unconstitutional, you may have a claim against the plan going back a few years for spousal benefits.
10. We’ve heard a lot about the
implications of the American Taxpayer Relief Act and portability for married couples. What can you tell us about how the new laws impact a married couple’s assets when those assets are heavy in retirement benefits?The new landscape for federal estate tax planning divides the world of married couples into three groups: the poor, the rich, and the middle. If the husband and wife together have assets of $5 million or less, federal estate tax planning is just off the table. Some would say they should plan because the exemption might get reduced in the future, but you can’t write a hypo-thetical estate plan based on things that haven’t happened. So they don’t care about portability.
Super rich people also don’t care about portability, because they should
not be leaving their exemptions to each other. People with $100 million, $200 million, or $1 billion should use their exemption as soon as possible to transfer money to the next generation. That brings us to the middle, let’s say a couple with $10 million. Should they adopt a traditional credit shelter or should they rely on portability? I can see a good case being made that they should use the traditional credit shelter approach, anyway, which means split-ting up the assets, so no matter which spouse dies first, he or she has assets equal to the exemption amount in his or her name. Then the first spouse to die leaves the assets to a trust for the surviving spouse instead of outright. So I can see a case being made for not relying on portability. Portability is not a slam dunk. Somebody has to file an estate tax return on the first death. They might forget to do that, and then you don’t have any portability. Or, the surviving spouse could remarry and inadvertently lose their exemption, because you only get the exemption of your last deceased spouse.
But if their assets are heavy in retire-ment plans—say they have $10 million, but it’s all in the wife’s IRA—there’s no argument for using the credit shelter trust, because to equalize their assets, they’d have to cash out their retirement plan and pay income taxes. That would be insane. And then the first spouse to die would have to leave assets in trust for the surviving spouse or a credit shelter trust.
So, for couples whose assets are heavy in retirement plans, portability is the angel from heaven. It means that they can get the full deferral of using the spousal rollover, leaving the retirement plans totally to each other, and still not pay any price in terms of lost estate tax opportunities.
Carly Schulaka is editor of the Journal. Contact her at CSchulaka@OneFPA.org.
