By: Robert Gordon
By: Robert J. Gordon, MBA, CFP, CRPS, AIFA
While naming a trust as the beneficiary of an IRA can be an effective way to manage the distribution of your IRA after death, it can also cause an inadvertant tax and accounting disaster. Seek competent counsel!
This technique of wealth transference can be very useful particularly when the desired beneficiaries have substance abuse problems, are minors, or for some other reason would not be able to prudently manage the assets for their own benefit. A trust beneficiary is not an ideal solution in every situation. Here are a few points to consider when trying to determine whether or not a trust is the most suitable beneficiary for your IRA.
Practical Reasons for a Trust Beneficiary
A trust may be a suitable beneficiary for an IRA owner who wants to control how the IRA funds are spent by beneficiaries. Here are some examples:
- Expenditure control: A trust can be used to control how much is spent during a given period. This is usually recommended if the IRA owner fears that the trust beneficiary might spend all of the IRA funds too quickly. In this case, a spendthrift trust can be used to dictate how much is spent during a given period.
- Purpose control: A trust can be used to ensure that the funds are used for specific purposes, such as to cover education costs for children and grandchildren.
- Protecting children from previous marriage: A qualified terminable interest property (QTIP) trust can be used to ensure that the surviving spouse of the IRA owner receives income during her lifetime, and the children receive the remainder after her death.
- Financial stability for special needs beneficiary: If the beneficiary has special needs, the IRA can be left to a special needs trust that includes provisions to ensure proper care is provided.
The proper type of trust should be determined by the purpose for which it is intended. Regardless of the type of trust, the annual distribution amount must not be less than the required minimum distribution (RMD) due for the year. Failing to with withdraw the RMD amount could result in steep penalties from the IRS.
Non-Qualified Trusts can Kill the Stretch
One of the benefits available to a designated beneficiary of an IRA is the ability to stretch distributions over his or her life expectancy . This is a powerful benefit. Take the example of a grandparent who, at the time of her death, had $1,000,000 in a traditional IRA. Let’s also assume that at the time of her death, the beneficiary named in the IRA was her previously deceased husband. The IRA would end up in the estate and be taxed at ordinary income rates as high as 35%. If she had named a niece or nephew or non-relative as the beneficiary through a properly-designed trust, those assets would have had a much lower distribution rate over the lifetime of the presumably younger beneficiaries and therefore a greater opportunity to grow over that presumably younger person’s lifetime. In this particular case, the oversight may have cost her heirs more than twice the current value of the IRA. That would pay for quite a few college educations and provide downpayments on a first home or two!
The stretch benefit is severely limited when the IRA owner does not have a “designated beneficiary,” which would be the case if the beneficiary is a non-qualified trust, hence the emphasis on seeking competent counsel. In such cases, the IRA must be distributed within five years of the owner’s death if the owner died before he or she was required to start taking RMDs. If the IRA owner died on or after they were required to start taking RMDs then the distribution takes place over his remaining life expectancy.
To prevent the stretch from being subject to such limitations, steps must be taken to ensure that the trust is a “qualified trust”. A qualified trust would have a “designated” beneficiary, which would allow distributions to be stretched over the life expectancy of the oldest beneficiary identified under the trust. In order to be “qualified” a trust must meet a specific set of requirements which are carefully detailed in IRS Publication 590. This publication is available and searchable online through the IRS website www.irs.gov.
Workaround For Trust Beneficiaries
There are a large number of cases in which trusts beneficiaries have received approval from the IRS, allowing the IRA assets to pass-through the trust and be transferred into inherited IRAs under the beneficiaries’ names and tax identification number (TIN) instead of the names and TIN of the trusts. Some custodians will even accommodate these pass-through transfers without IRS approval. This can be a practical solution for beneficiaries if the trust was not intended for any purpose which cannot be served after the transfer, and in cases where keeping the assets in the trust would result in higher income tax.
It’s always better and far cheaper to do it right the first time rather than fix a problem that never should have occured. Our lives are complicated enough without having to enlist the services of attorneys, accountants and incur IRS fees that a bit of planning could have avoided. Appeals and Private Letter Rulings from the IRS are expensive!
Please contact your tax professional or financial advisor if you have questions about the rules that apply when naming a trust as the beneficiary for an IRA and/or the issues that should be considered.
 If the IRA owner dies after the RBD, the distributions stretch over the longer of the beneficiary or decedent’s life.