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Naming A Trust As Beneficiary Could Mean Trouble for Your Heirs

By: Richard Feldman

By: Richard Feldman, CFP, MBA, AIF

Naming a trust as the beneficiary of your retirement plan or IRA could mean drastically less income for your heirs than first planned and higher taxes. New IRS regulations that govern trust income accounting could leave your loved ones with much less income than they need to survive. Any individual who has named a trust as either a primary or contingent beneficiary should first make sure that the trust is set up properly so the beneficiaries can qualify as a designated beneficiary and then make sure that trust accounting rules do not limit the distributions to the income beneficiary which is typically a spouse.

Qualified Trust

If you choose to name a trust as a beneficiary of your retirement account, the first thing you need to do is make sure that the trust qualifies as a look through trust, otherwise the trust will have been determined to have no beneficiary. A Trust is not an individual and so it cannot be a designated beneficiary. However, if the trust qualifies as a look through trust or see through trust, then the individual beneficiaries can qualify as designated beneficiaries for IRA distribution purposes. A designated beneficiary must be an individual with a birth date. A single nonqualifying beneficiary means there is no designated beneficiary for Required Minimum Distribution purposes. This could be disastrous to your heirs because the IRA would have to be emptied much faster which in turn would accelerate taxes and reduce the total amount of funds distributed. (Attached is a link to an article that provides the steps required).

New Rules for IRA Trusts

The IRS released final regulations that revise the definition of trust income under Section 643(b) of the internal revenue code. The new rules became effective January 2, 2004. These new IRS regulations could substantially decrease the income payout that was originally planned for the trust when it was first created. The reason being that these new regulations clarify a basic tenet in trust accounting of what is income and what is principle. “They say that a state law’s definition of income is valid, if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year”[1]

Trust Accounting

A trust document typically outlines how much income and principle a beneficiary is entitled to. Principle is usually defined as the property that was used to fund the trust or property that was received from a decedent’s estate. Income is typically defined as the receipt of earnings derived from the principle or corpus of the trust.

UPIA (Uniform Principle and Income Act)

Almost all states have adopted one of the versions of the UPIA. The UPIA was first promulgated in 1932, with revisions in 1962 and 1997. However, not all states have adopted the UPIA, and only about three-fourths of the states that have adopted the UPIA have adopted the most recent version. Therefore, a trust document could have a different meaning depending on which state you reside in.

Before the new regulations, if a trust was named beneficiary of an IRA or other retirement account, it was not clear how much of the Required Minimum Distribution (RMD) that was paid to the trust from the IRA would be paid out as income to a trust beneficiary. Prior law was unclear to what constituted income so trustees had more leeway in meeting the needs both the beneficiary and the remainder beneficiaries. Individuals who have named trusts as beneficiaries of their retirement accounts need to now if they are one of the 40 states that have adopted the Uniform Principal and Income Act (UPIA).

The reason is that in many of the states income is defined to be 10% of a required minimum distribution and the remaining 90% is considered to be principle. This could cause a lot of problems for trusts that are set up to pay all of the income out to a beneficiary and had calculated the RMD to be 100% income. The beneficiary could be left with considerably less income than they had figured and no means of getting at the principle of the trust account. This clarification of income, especially for states that have adopted the UPIA, may require trusts to be redone to meet the income needs of the trust beneficiaries.

For example, suppose an IRA pays a $50,000 RMD distribution to the trust for 2004. If the trust document provides that only the income will be paid to the trust beneficiary, than only $5,000 will be distributed to the income beneficiary under the UPAIA in many states (RMD is 10% income and 90% Principle under UPAIA). This leaves the remaining $45,000 trapped in the trust where they may be taxed at the trust level which is very restrictive. Trust tax brackets are very compressed meaning that all trust income over $9,550 is taxed at 35% in 2004 whereas individuals must have taxable income over $319,000 to be in the top tax bracket.

Summary

There are numerous reasons to use a trust in estate planning but you need to know the state trust laws that are going to govern the income distributions of the trust. If you do name a trust as your beneficiary of your retirement account make sure you are dealing with an attorney who specializes in estate and trust tax law and who is up to date on these new regulations, otherwise the beneficiaries of the account might end up receiving a substantially different amount than was originally intended.

[1] Goldberg, Seymour , Ed Slott’s IRA Advisor, May 2004