Multigenerational Trust Planning With Qualified Retirement Plans
The math that drives the stretch.
April 17, 2008
by Joseph Welch, JD
In my last column, I explained the phenomenal growth potential of a multigenerational qualified retirement plan ("QRP") account and the desirability of keeping the largest amount of dollars tax-deferred for the longest possible time to achieve this exponential growth basic of multigenerational qualified retirement plan ("Stretch QRP"). In this column I will reveal the mathematics that drive QRPs, as well as the problem of "Stretch Blowout," the tendency of beneficiaries to withdraw QRP funds before they achieve full tax‑deferred growth.
READER NOTE: See related story on Stretch IRAs.
The Plan Owner's Math
Excellent planning for QRPs begins with the Plan Owner. Remembering the principle that assets kept in a tax-deferred column over a longer period of time grow exponentially greater than their shorter-term counterparts, the Plan should be initiated as early as possible in the Owner's lifetime. The following chart illustrates the effect of a three-year delay in opening an IRA:
The same principles (compound interest coupled with tax deferral over the longest possible time period) also dictate that the Plan Owner defer distributions until age 70½, if possible, and then only withdraw those funds at the annual Required Minimum Distribution ("RMD") rate. The following Uniform Table, used by the Plan Owner to determine RMDs, indicates that an account averaging seven percent will continue to generate growth each year in excess of the RMD until the Owner turns age 86, in which year he will be required to divide the previous year-end account balance by the 14.1 divisor shown on the chart, and withdraw 7.09 percent of the account. In each prior year, his RMD will be less than the seven percent rate of growth on the account, and the account balance will continue to increase in spite of the RMD.
Even assuming a mere five percent rate of return, the account balance will continue to increase until the beneficiary's 79th year of age!
The Beneficiary's Math
Next, consider a client who dies at age 77 with a 50-year-old child beneficiary. The Plan Owner's RMD must be paid out for the year of death. During the following year the child must, pursuant to the RMD rules, withdraw 2.92 percent of the account (the previous year-end account balance divided by 34.2) pursuant to the following IRS Single Life Table (the table used by beneficiaries):
If the account averages a seven percent rate of return, the balance will continue to increase in value despite withdrawals of each annual RMD until the child is 74, when the Life Expectancy column of the Single Life Table requires withdrawal of the previous year-end account balance divided by 14.1 (7.09%), an amount just slightly greater than the seven percent rate of return.
If the account averages an eight percent rate of return, the balance will continue to increase in value despite withdrawals of each annual RMD until the child is 77, when the Life Expectancy column of the Single Life Table requires withdrawal of the previous year-end account balance divided by 12.1 (8.26%), an amount just slightly greater than the eight percent rate of return.
If, however, the account beneficiary is a grandchild rather than a child, additional tax deferral and asset growth will occur, generating even higher RMDs. Assuming the grandchild is 25 years old, and using the same table, we see that the grandchild beneficiary will be required to withdraw only 1.72 percent of the account (the previous year-end account balance divided by 58.2). Again assuming a seven percent rate of return, that account will continue to grow until the grandchild is 74 years old, when the Life Expectancy column of the Single Life Table requires withdrawal of the previous year-end account balance divided by 14.1 (7.09%), an amount just slightly greater than seven percent of the account balance. By that time, the account will have doubled approximately four times, although the lion's share of this growth will have already been paid out to the grandchild by way of RMDs. (Unless the grandchild's parent is deceased when the Owner dies, the Owner's Trustee or Personal Representative will need to allocate GST Exemption to the account passing to the grandchild in order to avoid Generation‑Skipping Tax.)
The Problem: "Stretch Blowout"
The "Stretch QRP" does not work to full capacity if the next-generation beneficiaries withdraw more than their RMDs in any calendar year. Even if the multigenerational tax-deferred "Stretch" has been enabled through excellent planning, many beneficiaries simply withdraw the money from the tax-deferred account, often oblivious to the tax consequences of doing so, thereby losing the benefits of the "Stretch QRP" in a disaster which I call "Stretch Blowout." Many beneficiaries simply report the Owner's death and accept a check. Evidence suggests that, 10 years after the advent of "Stretch QRP" planning, most accounts result in "Stretch Blowout" as the assets pass from the Owner's generation to that of the beneficiaries, and are then dissipated by poor money management skills and spending habits of the next-generation beneficiary and his or her spouse and children.
Very few beneficiaries have the sense, willpower, or understanding of the tremendous growth potential of the tax deferral feature to limit themselves to RMD withdrawals. In addition, inherited retirement funds may be lost by the beneficiary's divorce or may disqualify a "Special Needs" beneficiary from government benefits until they are "spent down" to below the beneficiary's Individual Needs Allowance (usually $999.99). Inherited assets are subject to the claims of creditors and the ruses of predators. Finally, any amounts remaining unspent will be taxable in the estate of the beneficiary upon the beneficiary's death. All of these negative results can be eliminated by proper trust planning.
The Solution: Trust Planning
"Stretch QRP" planning in conjunction with trust design is complex and may only be successfully accomplished by a practitioner with a high level of expertise. However, the rewards are great (for client or advisor???). A trust can ensure that the "Stretch QRP" will continue to build to very large proportions (and defer income taxes on the account growth as it builds) by coupling the "Stretch QRP" with special trust provisions designed for QRP beneficiaries. The Owner might provide, for instance, that only the RMD may be paid out each year. A "safety valve" can be designed into the trust distribution standards to allow the beneficiary to withdraw more than the RMD if the Plan Owner wishes to give the beneficiary that latitude, or to access greater amounts in cases of actual need, or for emergencies, or situations when the beneficiary's own resources are not sufficient to maintain the beneficiary's lifestyle, or virtually any other scenario which is important to the Plan Owner.
Trusts can also ensure that the inherited IRA is not subject to claims by the beneficiary's divorcing spouse, lawsuit creditors, business predators, and bankruptcy claimants. A well-designed trust can also prevent the asset from being subject to spend-down requirements if the beneficiary suddenly joins the ranks of the disabled and becomes eligible for governmental assistance.
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Joseph D. Welch, J.D., is the managing partner of Cary, Welch and Hickman, L.L.P. and the founder and manager of The Estate Planning Center, L.L.C. His practice is limited to estate planning, trust administration, asset protection and business succession planning. He is a frequent author and lecturer on estate planning topics. You can reach him at 866-566-0088.
IMPORTANT: This brief summary of planning ideas is for discussion purposes only. It does not contain legal, tax, investment or insurance advice and cannot be relied upon for implementation and/or protection from penalties. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.
Unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein..