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Planning for Tax-Qualified Plans

Planning for tax-qualified plans, which
includes IRAs, 401(k)s and qualified retirement plans, requires a careful
examination of the potential taxes that impact these assets. Unlike most other
assets that receive a "basis step-up" to current fair market value upon the
owner’s death, IRAs, 401(k)s and other qualified retirement plans do not step-up
to the date-of-death value.


Therefore, beneficiaries who receive these
assets do so subject to income tax. If the estate is subject to estate tax, the
value of these assets may be further reduced by federal and perhaps state estate
tax. And if your clients name grandchildren or younger generations as
beneficiaries, these assets may additionally be reduced by the
generation-skipping transfer tax at the highest federal estate tax rate. All
told, these assets may be subject to 70% tax or more.

There are several
strategies available to your clients to help reduce the impact of these taxes
and to ensure that these assets meet each client’s unique planning objectives.
This article examines some of the more common planning
alternatives for tax-qualified plans, as well as the advantages and
disadvantages of each.

Structure Accounts to Provide the Longest
Term Payout Possible

Structuring tax-qualified plans to provide the
longest term payout possible is the most common option. With this strategy your
clients name beneficiaries in a way that requires the beneficiaries to withdraw
the least amount possible as required minimum distributions (those distributions
that the beneficiaries must take in order to avoid a 50%

Frequently, married clients name the surviving spouse as the
primary beneficiary so that the survivor may roll over the account into his or
her name and treat the account as his or her own. The surviving spouse then
names younger beneficiaries for stretch-out purposes.

To achieve the maximum
"stretch-out," your clients should name beneficiaries who are young (e.g.,
children or grandchildren, although there are special considerations when naming
grandchildren or younger generations). The younger the beneficiary, the smaller
the required minimum distributions. To achieve maximum income tax deferral,
beneficiaries should take only their required minimum distributions.

clients can accomplish this strategy by naming the beneficiaries individually.
Alternatively, if your clients are concerned about the loss of creditor or
divorce protection that occurs when they name beneficiaries outright, they can
name a beneficiary’s share of a trust as the designated beneficiary of their
tax-qualified plans.

Structuring tax-qualified accounts for maximum "stretch-out" makes
sense from an income tax perspective. However, naming a beneficiary outright may
subject the account to the beneficiary’s creditors or former spouse upon
divorce. Consider naming a trust as designated beneficiary to ensure that the
account passes to the client’s intended beneficiaries and in the manner intended
by the client.

Name a Retirement Trust as Beneficiary to
Ensure the Longest Term Payout Possible

Naming a beneficiary
outright to accomplish tax deferral with a tax-qualified plan has several
disadvantages. First, if the beneficiary is very young, the distributions must
be paid to a guardian; if the beneficiary has no guardian, a court must appoint
one. Another disadvantage is the potential loss of creditor protection or
bloodline protection, particularly where the named beneficiary is the surviving

A third, practical disadvantage is that many beneficiaries take
distributions much larger than the required minimum distributions. In fact,
studies show that beneficiaries consistently consume this "found money" in only
a couple of years regardless of the amount in the account or the age of the

However, by naming a trust as the beneficiary of
tax-qualified plans, your client can ensure that the beneficiary defers the
income and that these assets remain protected from creditors or a former son- or
daughter-in-law. A stand-alone retirement trust (separate from a revocable
living trust and other trusts) can further help ensure that it accomplishes your
client’s objectives while also ensuring the maximum tax deferral permitted under
the law. This trust can either pay out the required minimum distribution to the
beneficiary or it can accumulate these distributions and pay out trust assets
pursuant to the standards your clients set in advance (e.g., for higher
education, to start a business, etc.)

Consider naming a stand-alone retirement trust as beneficiary of
tax-qualified plans to ensure that the account passes not only in the manner
intended by the client, but while achieving maximum stretch-out if that is the
client’s objective.

Naming a trust as beneficiary also ensures consistent account
management – in the manner desired by the client, using the client’s advisors –
oftentimes over generations.

Give the Accounts to Charity
at Death

Another relatively simple option is for your clients to
name a charity as a designated beneficiary at their death or at the death of
their survivor, if married. This strategy is particularly attractive for those
clients who intend to make gifts to charity at death and the question is simply
what assets should they select. As a tax exempt entity, a qualified charity does
not pay income tax and therefore receives the full value of tax-qualified plans.

In other words, if the client’s beneficiary is in a 35% tax bracket, a
$100,000 IRA is worth only $65,000 in his or her hands, but is worth the full
$100,000 if given to charity. Therefore, it makes economic sense for clients to
give these assets to charity and give to their beneficiaries assets that are not
subject to income tax after death.

Naming a charity as beneficiary of a tax-qualified plan is
particularly attractive for clients who intend to make gifts to charity at death
and the question is simply what assets should they select.

By purchasing life insurance owned by a Wealth Replacement Trust,
clients can give beneficiaries the full value of a tax-qualified plan in a
manner that is free from income and estate tax, and protected from creditors and

Take Lifetime Withdrawals, Buy an Immediate
Annuity (plus Wealth Replacement Insurance)

Another option is for
your clients to withdraw their IRA or qualified plan and purchase an immediate
annuity, which will generate a guaranteed income stream during their lives (or
during their joint lives if married). Your clients can use this income stream to
pay the income tax caused by the withdrawal, and also pay the premiums on life
insurance owned by a Wealth Replacement Trust.

This strategy makes the
most sense if your clients are in good health and are able to obtain life
insurance at reasonable rates. Unlike with an IRA or retirement plan, the
beneficiaries will receive the life insurance proceeds from the Wealth
Replacement Trust free of income and estate tax and, under certain
circumstances, free of generation-skipping transfer tax.

it may make sense to use other assets to purchase the immediate annuity, saving
the IRA for family members. This alternative strategy makes the most sense when
your clients can name a very young beneficiary, thereby deferring the income tax
on the IRA or qualified plan for many years.

For clients who desire a steady and known income stream, an
annuity purchased with a lump-sum withdrawal from a tax-qualified plan can meet
those objectives.

In many instances, the annuity income will provide additional cash
flow sufficient to purchase life insurance that can replace or increase what
would have passed to the beneficiaries.

Take Lifetime
Withdrawals, Gift Remaining Cash through Life Insurance

Another option for your clients is to take the money out
during their lifetime and pay the income tax, then gift the remaining cash
either outright via lifetime giving or, better yet, through an Irrevocable Life
Insurance Trust. If your clients desire to make the gifts through an Irrevocable
Life Insurance Trust, this strategy makes the most sense when they are in good
health and able to obtain life insurance at reasonable rates. Unlike the IRA or
retirement plan, the beneficiaries will receive the life insurance proceeds free
of income and estate tax and, under certain circumstances, free of
generation-skipping transfer tax.

By using withdrawals from a tax-qualified plan to purchase life
insurance owned by a Wealth Replacement Trust, clients can pass the full value
of the assets to their beneficiaries in a protected manner undiminished by
income tax.

Name a Charitable Remainder Trust as

Yet another option is for your clients to name as
beneficiary of the accounts a Charitable Remainder Trust, a type of trust
specifically authorized by the IRS. These irrevocable trusts permit your clients
to transfer ownership of assets to the charitable trust in exchange for an
income stream to the person or persons of their choice, typically the client’s
spouse with tax-qualified plans. The term can be for life or for a specified
term of up to 20 years.

The survivor receives income that will help
maintain his or her lifestyle should the income stream from other assets be
insufficient. At the survivor’s death, the property passes to

This strategy defers income tax until the survivor receives each
income payment; there is no tax at the initial transfer to the trust. This
strategy can also help reduce estate taxes for those clients subject to the
estate tax.

With this option, your clients fund the Charitable Remainder
Trust upon death. Therefore, it is only at death or incompetency that this
aspect of the estate plan becomes irrevocable, giving clients the option to make
changes in the future if their circumstances change.

Naming a Charitable Remainder Trust as beneficiary of a
tax-qualified plan can provide a steady income stream to a surviving spouse in a
tax-deferred manner. Since the assets ultimately transfer to charity, this
strategy also provides a charitable deduction for those clients subject to
estate tax.

Give Up to $100,000 from IRAs Directly to
Charity in 2007

For clients who are at least 70 1/2 years of age, it
may also make sense for them to transfer up to $100,000 from IRAs to charity in
2007 to satisfy their charitable contributions. If the contribution is made by
direct transfer from the IRA custodian to a public charity (for example,
religious organizations, colleges and universities, etc.), the client need not
report the distribution as taxable income. In other words, unlike a typical IRA
distribution, the distribution will not appear as taxable income on the client’s
income tax return. However, because the distribution does not appear as income,
the client will not get an offsetting charitable income tax deduction to reduce
the income created by the IRA distribution.

Giving up to $100,000 from IRAs directly to charity is
particularly attractive for clients who intend to make gifts to charity in 2007
and the question is simply what assets should they

These are only a few of the
more common planning solutions for tax-qualified plans. The right solution for
your clients will depend upon their particular goals and objectives as well as
their particular circumstances.

To comply with the U.S. Treasury regulations, we must inform you that
(i) any U.S. federal tax advice contained in this newsletter was not intended or
written to be used, and cannot be used, by any person for the purpose of
avoiding U.S. federal tax penalties that may be imposed on such person and (ii)
each taxpayer should seek advice from their tax advisor based on the taxpayer’s
particular circumstances.

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