NAMING A TRUST AS BENEFICIARY OF YOUR IRA – PROS AND CONS
By: M. Todd Smith, Esq.
Proper planning for an individual retirement account (IRA) is becoming increasingly more important as it has become more common that the average person’s retirement nest egg consists of a large “rollover” IRA. An IRA is a unique asset. Generally, it is best to name an individual as the designated beneficiary because only an individual can be named as a beneficiary of an IRA and receive a “stretch” of distributions over his or her remaining life expectancy. Careful guidance should be sought especially in situations where the IRA owner has reason to believe the beneficiary would not be capable of handling the IRA.
Some examples of when it would be inappropriate to name an individual directly as the beneficiary are:
- If the IRA owner is in a second marriage with children from a prior marriage to whom he or she would like the account to transfer after the death of the surviving spouse.
- If the desired beneficiary has special needs and acquiring the IRA would jeopardize his or her ability to qualify for income disability or social security.
- If the IRA owner has minor children. It is quite common for married IRA owners to name their spouse as the primary beneficiary and their minor children as contingent or secondary beneficiaries. It may not have crossed their minds that their children could inherit the IRA while they are still minors if both spouses were killed at the same time. In such instances the IRA custodian would require the unnecessary expense of a court-appointed, court-supervised conservator to manage the IRA until the beneficiary reaches 18 years of age.
- If the beneficiary is irresponsible and the IRA owner is concerned that the IRA will be cashed out despite the severe income tax consequence of doing so. Continuing from the prior example, once the child reaches 18 years of age there will be no restrictions on the IRA and nothing stopping the child from withdrawing the entire account and simply paying the tax, which may not seem like such a problem to the child since it is all a windfall anyway.
Many IRA owners have set up or at least thought about setting up a revocable living trust. When dealing with non-IRA assets, many of the problems described above can be easily solved. However, there are several hazardous traps to watch out for when naming a trust as a designated beneficiary of an IRA because a trust is a non-individual, which means that generally, it does not have the ability to “stretch” the IRA as discussed above because it has no life expectancy. The Tax Code requires a trust to withdraw the funds from the IRA and pay the income taxes due within five years from the end of the year of the IRA owner’s death (and usually at a higher rate).
The good news is that there is a tool that can provide the best of both worlds, meaning the IRA owner can secure the ability to “stretch” the IRA while at the same time keeping control over the IRA out of the hands of the beneficiary. This tool is often called an “IRA Look-Through Trust”. This specialized trust falls under an exception in the Tax Code to the general rule that the designated beneficiary must be an individual as long as the following four requirements are met:
- The trust must be valid under state law;
- The trust must be irrevocable or become irrevocable upon the IRA owner’s death;
- The trust beneficiaries must be identifiable from the trust instrument; and
- Proper documentation must be provided to the IRA custodian by October 31 of the year following the IRA owner’s death.
Obviously, the fourth requirement is an administrative requirement that has little to do with the drafting of the trust instrument. Moreover, most competent legal drafters can satisfy the first two requirements pretty easily. The requirement that causes the most problems for estate planners is the third requirement. The IRS has made it very clear that if any of the IRA funds could be distributed to a non-individual beneficiary then the trust would not qualify for the “stretch”. For example, if the terms of the trust allow the trustee to disburse trust assets (including the IRA) to the IRA owner’s estate to pay for satisfaction of debts, administration expenses, or taxes, then the third requirement has not been met.
Clearly, while it is certainly possible to name a trust as the designated beneficiary of an IRA, it can be very complex and careful planning is required in order to avoid unintended income tax consequences.