By: Mark L. Dodds, Esq., Partner at Grant Morris Dodds
There is considerable confusion concerning the effects of naming a trust as the beneficiary of an IRA. What is most remarkable about this subject is that it seems to me that most professionals who should know better, i.e. CPA’s, investment professionals and lawyers, have as many misconceptions and gaps in their knowledge as the general public. As an attorney who has assisted in hundreds of estate administrations, I would say that in most cases where a trust was named as the IRA beneficiary, upon the death of the IRA owner I found it necessary to school the CPA’s and investment companies on the rules concerning the options available to the beneficiaries of the trust named as beneficiary of the IRA.
The response I get most often is that, because the trust was named as beneficiary, it will be necessary for the trustee of the trust to terminate the IRA and pay all the income taxes due on the termination within five years of the IRA owner’s death. While this result is possible, in most cases the law will support the beneficiaries if they choose to take the IRA as an inherited stretch IRA, which will normally allow the beneficiaries to either take the distributions ratably over the life expectancy of the oldest beneficiary or over the period of time the IRA owner would have taken the balance of the IRA had he or she not died prior to full distribution.
A complete discussion of all the rules concerning IRA distributions from trusts is beyond the scope of this blog. This is the case for two reasons, being 1) I don’t know all the rules and 2) I don’t want to take the time to discuss them all. But the following will give you a good understanding of the basics which will arm you against the onslaught of naysayers if and when you ever inherit an IRA due to your status as a trust beneficiary.
Most of us understand that we can start taking IRA withdrawals at age 59 ½ without incurring the 10% penalty for early withdrawal. You can also elect at any time to take withdrawals without penalty if you take withdrawals in substantially equal annual payments which must continue for at least five years and until you reach age 59 ½. If you don’t need the money from your IRA, you must, nevertheless, begin taking your Minimum Required Distribution in the year in which you reach age 70 ½. (What other body than the U.S. Congress would come up with the ½ year deal? Were they debating and got to where one side said ”70” and the other side said “71,” so they compromised at 70 ½? Unbelievable. As Germany’s Otto von Bismarck reputedly said, “Two things you don’t want to see being made are sausages and legislation.” Considering both processes, I think he should have apologized to the sausage makers.)
When the IRA owner dies, the beneficiaries, if they are “qualified beneficiaries” have the following options: 1) take the entire IRA immediately and report it all in the beneficiaries income tax return as ordinary income; 2) elect to take any or all of it over a five year period, but in all events it must be withdrawn and taxes paid by the end of the fifth year following the owner’s death; or 3) elect to stretch the IRA and take minimum required distributions over the applicable life expectancy of the beneficiary. Obviously option 3 allows for maximum tax deferral.
Of course, with anything based on federal law, it’s not quite as simple as I have described, particularly with the stretch option. When you determine what the life expectancy of the beneficiary is, you have to determine which beneficiary’s age and, hence, life expectancy, must be used. Thus, the treasury regulations at 1.401 state that if there are multiple beneficiaries of an IRA, whether a trust is named as beneficiary or the beneficiaries are named individually, then the life expectancy of the oldest beneficiary must be utilized, with the result that the distributions are accelerated, being based on an older life and, thus, shorter life expectancy. Thus, if the IRA goes 50% to someone age 60 and 50% to someone age 20, the life expectancy of the 60-year old must be used in determining annual distributions, resulting in a faster drawdown of the IRA and negatively impacting the opportunity for continued tax deferral for the 20 year old. This negative result can be avoided by actually splitting the IRA into separate IRA’s, with each IRA having one primary beneficiary. Even if the oldest beneficiary receives only a small fraction of the IRA, that beneficiary’s age is the measuring life.
Where the beneficiaries are adults and can handle the account, I recommend bypassing the trust as beneficiary and naming the individual(s) as beneficiary(ies). It just simplifies the process and means that I won’t have to write an expensive tax opinion letter for the custodial institution of the IRA explaining to them why the Trustee of the trust does not need to withdraw the whole IRA and pay all the taxes on it up front.
But sometimes you may want the IRA to be held in trust, e.g. you want your spouse to enjoy the benefits of it, but when he/she dies, you want any remainder to go to your heirs, not his/her friends, just as an example. (True to what would have been perceived as my sexist ways, I almost wrote “she” and “her” in that prior sentence instead of “he/she” and “him/her.” Thanks to my editor I am spared an apology to every woman who has lived and who will ever live.) So you can name a Marital Trust, often known as a “QTIP” trust (standing for “Qualified Terminal Interest Property Trust” and therefore having nothing to do with the health device which is the cause of more punctured eardrums than all other other implements, diseases and accidents.) The benefit of the Marital Trust is that it will allow the surviving spouse to inherit the assets held in this trust, enjoy the income (and principal if the creator of the trust so desires) and allow deferral of the estate tax on the assets of the Marital Trust until following the death of the surviving spouse, letting the later heirs pick up the liability for the estate tax. In order for the Marital Trust to qualify as a “Designated Beneficiary” and therefore allow for stretching the withdrawals from the IRA over the surviving spouse’s life expectancy, the trust must meet the following tests: 1) it must be valid under state law; 2) the trust must become irrevocable before or upon the death of the IRA owner; 3) the trust beneficiary(ies) must be identifiable (in a Marital Trust it can be the spouse and only the spouse); and 4) certain documentation must be provided to the IRA custodian by September 30 of the year following the taxpayer’s, i.e. the IRA owner’s, death.
This all seems quite easy. But there are some potential pitfalls. First, since a Marital Trust must require annually the distribution of all trust income to the spouse who is the beneficiary of the trust, the Marital Trust must state that with regard to any IRA, the income must be determined using the greater of (i) the actual Minimum Required Distribution (MRD) and (ii) the actual income of the assets of the IRA. So let’s say the MRD is $5,000 but the IRA has accounting income of $10,000. In determining the income of the Marital Trust, the $10,000 of actual income attributable to the IRS assets must be used and distributed to the surviving spouse. If the MRD is $5,000 but the actual income of the IRA assets is only $3,000, then the $5,000 must be used in determining the income of the Marital Trust. Then, after determining the income amount to use for the IRA, if there are other assets in the Marital Trust, the income of those assets must be determined as well and added to the greater of the amounts described above and that total must be distributed to the surviving spouse. If these provisions are not included, then the Marital bequest of the IRA will fail, in fact the entire Marital Trust might fail, and the estate tax will be due, thus reducing the size of the bequest from the Marital Trust passing to the surviving spouse. Attorney drafting errors in this area are frequent and have caused considerable grief to attorneys and their clients as a result of these mistakes.
Another problem will result if the remainder beneficiaries of the Marital Trust are not clearly designated, or if the remainder beneficiary is a charity. Thus, if the beneficiary of the IRA after the surviving spouse dies is somebody’s “estate” or if the beneficiary is a charity, then this means there is no identifiable beneficiary with an identifiable life expectancy and the designation of the trust will fail as a “designated beneficiary” and the beneficiary will be required to withdraw the IRA within five years.
Where the trust designated as the IRA beneficiary is not a Marital Trust, there is NO requirement for distribution of the greater of the RMD or the actual IRA income, and all that is required is that the RMD be distributed annually. Thus, if for example the trust is for your three children, ages 42, 38 and 33, and if the trust meets the tests, i.e. it is valid under state law, becomes irrevocable by the death of the IRA owner, has clearly designated beneficiaries, and then the information is timely provided to the IRA custodian, then it is likely the trust will qualify to allow the beneficiaries to take the withdrawals over the life expectancy, which will be based, again, upon the life expectancy of the oldest child. Where the children are close in age, this is not much to worry about; however, if the beneficiaries are spread out in age, then the younger ones suffer with a faster required distribution rate because of the use of the oldest beneficiary’s life expectancy. And you still have to watch out for contingent beneficiaries. It’s not clear how deep you must go in looking at contingent beneficiaries, but if there is a chance a charity could take the IRA, I would draft the trust to prevent such a possibility. The trust forms at Grant Morris Dodds have a “fail-safe” clause which addresses many of these contingencies so that there will be no chance that a marital trust will fail as a designated beneficiary and that there will be no chance that the trust will fail due to the chance a portion of the IRA could go to a charity.
Another nice thing about a non-Marital trust as a beneficiary is that, although the RMD must be taken every year, there is no requirement that the RMD be paid to the beneficiary, thus allowing the trustee discretion in making all trust distributions, even where the trust is the beneficiary. But in these cases, special attention must be paid to the contingent beneficiaries to be sure they are identifiable and do not cause the trust to be disqualified as a designated beneficiary.
There is a lot more that can be, and has been, written on this subject. I hope this gives you some resolve in dealing with those advisors, who should know better, but continue to provide inaccurate or incomplete advice concerning IRA withdrawals.
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