This advanced beneficiary-planning strategy has many rules that you need to know.
An owner of an IRA can name anyone they desire to be the designated beneficiary of their retirement account. Designating a trust as an IRA beneficiary is tricky and complicated, with potentially significant tax consequences if not implemented and executed according to the myriad of IRA rules and regulations. For those who are considering naming a trust beneficiary, it’s crucial to hire a seasoned attorney who is familiar with drafting a qualifying trust and has knowledge of retirement plan distribution rules.
Typically, qualified retirement plans and IRAs are not subject to probate and instead, retirement assets are distributed according to account owners’ current beneficiary designation. Naming rules are liberal, thus offering IRA owners a number of options in designating a beneficiary; in fact, any individual (spouse, sibling, children, grandchildren, etc.) and/or non-individual (charity, estate, or trust) can be a named beneficiary. However, the regulations require post-death required minimum distributions (RMDs), forcing the account beneficiary to liquidate the account over the course of time.
Post-death rules allow Required Minimum Distributions (RMDs) to be distributed gradually over the life expectancy of beneficiary—known as a “stretch" IRA or payout. However, receiving this payout option requires the named beneficiary to be a “designated” beneficiary—defined as a human being with a life expectancy. This inevitably leads to the question: Can a retirement account be left to a trust beneficiary (e.g. non-living entity without a life expectancy) “stretch” post-death RMDs? The answer is: Yes, in certain circumstances. IRS rules permit a qualifying IRA trust to be treated as a “designated” (human) beneficiary, thus allowing stretch post-death RMDs by “looking through” the trust to the underlying beneficiaries and therefore using their beneficiaries instead.
Tip: Naming a trust as an IRA beneficiary is allowed. However, if IRA assets are moved or distributed into a trust while the account owner is alive, the distribution is subject to immediate taxation. In addition, the “stretch” payout option has been eliminated. To avoid this, simply name the trust as beneficiary on the IRA beneficiary paperwork.
Why would the owner of an IRA want or need to name a trust, rather than a person, as his or her beneficiary?
The primary reason is to exert control over post-death distributions (sometimes referred to as “control from the grave”), thus limiting or restricting access to an inheritance.
Reasons to Name a Trust Beneficiary
An owner of a retirement plan/account has a lot of latitude in naming a beneficiary. He/she could name a spouse, child, grandchild, friend, charity, estate, trust, or some combination. When, then, should someone consider naming a trust beneficiary? Although each families situation is particular to them, fairly common reasons for naming a trust beneficiary include: the beneficiary is a minor; a disabled (“special needs”) individual; second marriages; creditor protection; estate taxes; or a beneficiary doesn’t have the financial acumen to manage his or her inheritance effectively. In addition, consider naming a trust when the client has beneficiary “trust” concerns—a trust can protect a beneficiary from rapidly depleting an inheritance by including a spendthrift provision. Keep in mind, trusts do not save on taxes; instead, the primary reason to name a trust as beneficiary is to control (post-death) distributions to beneficiaries.
Assuming that naming a trust fits a client’s overall objective, you must verify (with an attorney) that the trust qualifies as a “look-through” or “see-through” trust. In other words, the IRS will look through the trust and treat the trust’s beneficiary as the IRA’s direct beneficiary, although the trust remains the direct owner of the IRA. A qualifying “look-through” trust therefore becomes eligible to receive designated beneficiary treatment where post-death calculated minimum distributions are determined based on the life expectancy of the oldest of the trust’s underlying beneficiaries. This allows heirs to take advantage of favorable minimum-distribution rules that apply to individual designated beneficiaries (e.g., those beneficiaries that have a life expectancy).
To qualify as a “look-through,” the trust must meet all of the following requirements
- Must be a valid trust under state law.
- Must be irrevocable upon death of the account owner or contains language to that effect. A revocable trust will not be able to utilize stretch provisions.
- Individual beneficiaries of the trust must be identifiable from the trust document. This generally means that beneficiaries should be identified by name, or as members of a class (e.g. my children).
In addition, only individuals (i.e., those with a life expectancy) may be considered “designated beneficiaries” by the IRS for purposes of taking advantage of the stretch IRA provisions. A beneficiary that is not an individual, such as an estate or a charitable organization, may not be a designated beneficiary, and the option to stretch minimum payouts will be forfeited.
- Required trust documentation must have been provided to the IRA custodian no later than October 31 of the year following the IRA owner’s death. The trustee is responsible for providing trust documentation to the IRA custodian. The trustee also is responsible for determining that the trust is a look-through trust. However, most likely, the trustee will need to hire a professional (e.g., attorney) for assistance.
Tip: Although naming a trust as an IRA beneficiary is permissible, not all IRA custodians permit trusts to be a named beneficiary. It is imperative that you receive confirmation from an IRA custodian that will allow you to name a trust as a beneficiary.
Importantly, you do not save on taxes by naming a trust. In fact, it’s quite possible to pay more in taxes even if the trust is designed properly. Therefore, you would only use trusts for personal (non-tax) reasons.
A properly designed “look-through” trust is deemed a non-spouse beneficiary and thus must follow post-death RMD rules. This is true even if the spouse is the sole beneficiary of the trust. Why? The trust inherited the IRA. After the owner dies, the IRA balance should not be distributed to a trust. Instead, after the IRA owner’s death, only the RMD has to be paid from the (inherited) IRA to the trust.
In other words, when a trust is named beneficiary, minimum distributions are required to be made from the IRA to the trust. Bypassing (the trust) is not allowed. Instead, distributions are then made to trust beneficiaries, following the rules set forth in the trust.
Suppose there are multiple trust beneficiaries. Whose life expectancy is used to determine minimum distributions? Separate accounts, also known as “splitting,” generally cannot be created when a trust is named as an IRA beneficiary. Why? The trust itself is considered the beneficiary rather than the underlying individual trust beneficiaries.
Generally, unless separate trusts are established for each beneficiary, the oldest beneficiary—the one with the shortest life expectancy among the beneficiaries—will be used to determine the amount of the required withdrawal, which is then divided among the beneficiaries. This is why the IRA owner should name beneficiaries that are relatively close in age. Why? Because the life expectancy of the oldest beneficiary determines the “stretch” payout following inherited IRA RMD rules. Naming a trust as beneficiary generally eliminates the ability for each trust beneficiary to use his or her own life expectancy when determining annual distributions. Notably, it may be possible to “split” beneficiary accounts if the trust created separate “subtrusts” for each trust beneficiary named on the beneficiary form.
What happens if the trust fails to qualify as a “look-through”? Generally, only a living person can “stretch” inherited IRA distributions; an exception would be a “look-through” trust, whereby the trust can “stretch” using the life expectancy of the oldest trust beneficiary. If the trust fails to qualify as a “look-through,” the trust then has no life expectancy, thus the IRA distributions must be paid generally in five years after death.
If you have questions about this months topic or would like to review the beneficiaries you have on your accounts, please call IIS Financial Services and ask for your advisor or schedule a 30 minute call or email us and we would love to help you.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisors LLC nor any of its representatives may give legal or tax advice.