TRUSTS AS BENEFICIARY OF AN IRA
Estate Planning Considerations
We find clients often do not understand or realize the implications of who they name as beneficiary of an IRA or other retirement plan.
Naming a minor as beneficiary of an IRA means that the IRA assets will pass directly to the minor children or grandchildren. This is a situation most parents and grandparents can avoid by setting up testamentary trusts in their wills. The use of a testamentary trust allows one to control and limit the minor child’s access to his or her inheritance until an appropriate age.
Similarly, parents often specify in their Wills that if one of their children shall predecease them, that child’s share shall pass to that child’s children. If that child should die without any heirs, the Will may specify that said child’s share will pass to his or her surviving siblings. An IRA beneficiary designation form may not provide the owner with such flexibility. That is, if one designated as beneficiary of the IRA predeceases the owner, the assets pass to the next named, or secondary beneficiary, rather than to the primary beneficiary’s children.
Individuals sometimes create revocable living trusts to avoid the need to open an estate. However, if an individual has named his or her estate as the beneficiary of an IRA a probate proceeding will be necessary in order to distribute the IRA assets from the estate.
The need for opening a probate estate also arises if an IRA owner has failed to name any beneficiaries. In such a situation the IRA has no designated beneficiary, and again the assets would be payable to the estate of the owner, and an estate must be opened to distribute those assets to the owner’s heirs.
In order to avoid these situations, a person can designate a trust as the beneficiary of his or her IRA.
A trust as a beneficiary of an IRA may best be utilized if you have minor children or grandchildren for whom you want to determine how and when they will receive the assets of the IRA.
In order for a trust to be named as a designated beneficiary of an IRA it must meet four tests:
1. The trust must be a valid trust under state law;
2. The trust must be irrevocable or become so upon the death of the owner of the IRA (such as a testamentary trust set up in a will)
3. The trust beneficiaries must be readily determinable from the trust instrument; and
4. The trust document must be provided to the IRA plan administrator.
The trust document must set out that the IRA funds are not to be used to pay trust, burial, or funeral expenses, as this may result in the trust’s failure to qualify as a designated beneficiary. Establishing a charity as a beneficiary of the trust may also disqualify the trust from being a designated beneficiary.
There is a method of distributing the IRA which would allow the beneficiaries of the trust to receive the most benefit from the IRA. This method is called the "lifetime expectancy method." The lifetime expectancy method is beneficial because it defers the income tax on the IRA distributions to be spread over the life of the beneficiaries of the trust while at the same time the assets in the trust are producing income and probably increasing in value, therefore allowing for more money to ultimately pass to the beneficiaries, than would have been the case if all of the assets were paid in a lump sum.
If the trust is eligible to use the lifetime expectancy method, distributions from the IRA will be made over the lifetime of the oldest beneficiary. However, if an IRA owner establishes separate accounts for each beneficiary during his or her lifetime, each beneficiary’s life expectancy will be used to calculate the distribution amounts.
A conduit trust, which is a trust that simply receives the distributions from the IRA and then passes the income out to the beneficiaries, is the most appropriate form of trust for the life expectancy method, because it is easier to determine all of the beneficiaries of the trust and which beneficiary’s life expectancy rate must be used to determine the distribution amounts from the IRA. However, there is a drawback to the conduit trust. As mentioned above, a trust is often used by a person so that he or she may control when and how much a beneficiary is to receive from the trust assets, especially if the beneficiaries are minors. A conduit trust does not allow for such control, since all distributions must be paid out immediately to the beneficiaries when received.
In an accumulation trust, a trust which receives the distributions from the IRA but can accumulate the distributions or pay them out to the beneficiaries, it is more difficult to determine which beneficiary’s life expectancy to use.
Of course the simplest way to have your IRA distributed is to designate an individual, typically your spouse, as the beneficiary. If the IRA is distributed outright to an individual rather than a trust, the distributions the individual receives from the IRA are taxed as income to that individual. In most circumstances the tax on the distributions will be much less if paid by an individual rather than a trust, because an individual’s income tax bracket is usually lower than the income tax bracket of a trust.
There are advantages to naming your spouse as the beneficiary of your IRA as well. If a spouse is the beneficiary of an IRA, he or she may defer the distributions and tax by rolling over the decedent’s IRA into his or her own IRA.
Disclaimers can also be used effectively by naming a trust as a secondary beneficiary if the spouse is named as the primary beneficiary of the IRA. At the time the owner establishes the beneficiaries of the IRA, it may be the best planning alternative to have the surviving spouse roll over the IRA into his or her own IRA. However, the situation could change by the time the owner passes away, and the spouse may not want or need the IRA assets, in which case the spouse would disclaim the IRA and the IRA would pass to the designated trust.
Using a trust as an IRA beneficiary can be a useful estate planning tool if it is your desire to control how your assets will be distributed to your beneficiaries after your death.
Information from: Andrew R. Lee, Guidelines for Naming a Trust as the Beneficiary of an IRA, 30 EST. Plan. 502 (2003).
Natalie B. Choate, Life and Death Planning for Retirement Benefits, (3rd ed., Ataxplan 2003).