Naming Your Trust as Beneficiary of an IRA?

Beware of These Potential Issues

Estate planning can be a complicated and tricky business, yet you can accomplished a great deal by simply preparing the basics.  Naming the right beneficiary of your IRA is a simple, crucial, yet often misunderstood first step in planning your legacy.

According to the Investment Company Institute (ICI), at the end of 2017 US investors owned more than $9.2 trillion in Individual Retirement Account (IRA) assets, more than the amount held in Defined Benefit (pension) accounts.  With so much at stake, the IRA beneficiary form is not an afterthought to be taken lightly.  For many investors, it represents the most important piece of a proper estate plan.

It is a common desire to name a Trust for a spouse as the IRA beneficiary.  After all, Trusts offer control over distributions to beneficiaries and protections against creditors, often fulfilling very legitimate goals.   Before naming a Trust as IRA beneficiary, however, you must understand the repercussions.

By naming a Trust as IRA beneficiary you lose the spousal rollover and the ability to “stretch” the tax-deferment advantages across generations.  When you name a spouse as your IRA beneficiary, he or she rolls the assets into their own IRA at death.  Assets are not required to be taken out of the IRA until the surviving spouse turns 70 1/2, and at that point the annual required minimum distributions (RMDs) are calculated based on the spouse’s life-expectancy (or in the case of Roth IRAs, distributions are not required). The result here is that distributions are smaller, less tax is paid, and law of compound returns enables your IRA to grow by a larger amount than it may have otherwise.

If you have children, the IRA can be further passed on to the next generation, and distribution requirements are again re-calculated based on the child’s life-expectancy.  This completes the “stretch” and provides a potential longevity to your assets and payout to heirs.  It should be noted that the “stretch” technique has previously come under fire by lawmakers.  Ex-Finance Committee Chairmen Max Baucus (D- Mont.) proposed a requirement (voted down in 2012) that all inherited IRAs to be distributed within 5 years of the original owner’s death.  Like any tax or investment issue, we can only plan based on the laws as they are currently known, but this issue needs to be watched closely.

“By naming a Trust as IRA beneficiary you lose the spousal rollover and the ability to ‘stretch’ the tax-deferment advantages across generations.”

The strategy of naming a spouse as beneficiary of your IRA allows your assets to grow tax-deferred for much longer than if the IRA had been left to a Trust.  Under IRS rules, when you name a Trust as beneficiary, the best deal you can get is that assets will be fully taxed over the life of the oldest beneficiary of trust.  Required distributions from an IRA left to a Trust are based on the life expectancy of the trust beneficiary. If there are multiple individuals who will receive assets from the Trust, the RMDs are based on the life expectancy of the oldest beneficiary.  Distributions that are retained in the Trust (which Trust terms will often require) will also be taxed at high trust tax rates should they result in future gains and/or income.

Even the “best case” outcome above is not guaranteed, as Trusts need to be written to pass a strict “look through” rule for the Trust beneficiaries to be considered “designated beneficiaries” and have RMDs based on their life expectancy.   Trusts that fail to pass this test must have IRA assets fully distributed within five years (if the IRA owner dies before 70 ½) or over the original owners’ life expectancy, which can be quite a short time frame (if the IRA owner dies after age 70 ½).  The “look through” rules require that:

  1.  The trust must be valid under state law
  2.  The trust is irrevocable by will or become irrevocable upon death of the account owner
  3.  The beneficiaries of the trust must be “identifiable from the trust instrument” and
  4.  Certain documentation must be provided to the plan administrator “within a reasonable time”

If you do decide to name a Trust as the beneficiary of your IRA, it is absolutely crucial that you speak with the professional who drafted the Trust to ensure that it will pass this “look through” test.

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Also ensure that you name a contingent beneficiary so that you are protected in the event that your primary beneficiary predeceases you.  This is of course another reason to review your IRA beneficiaries to make sure that they are up to date with living primary beneficiaries listed.

“Retirement benefits left to Trust could be taxed sooner and at a higher rate than if the benefits had been paid directly to spouse or children.”

Naming a beneficiary of your IRA that accomplishes your goals is a crucial piece in estate planning, yet it is often taken lightly because it is deemed as being so simple.  However, the consequences of this decision can be significant.  By naming a Trust as your IRA beneficiary you will lose the stretch payout to spouse and children over their life expectancies.  Retirement benefits left to Trust will be taxed sooner and at a higher rate (most likely) than if the benefits had been paid directly to wife or children.  This could likely result in fewer assets for the widow to live on and the children to inherit.   There are many good reasons to leave retirement assets in Trust to beneficiaries.  Just be sure that you understand the implications.


Pros Cons 1Q14 Newsletter for

Perritt Capital Management, Inc. is the Registered Investment Advisor for Windgate Wealth Management accounts.  Windgate does not provide tax advice.  Consult your professional tax advisor for questions concerning your personal tax or financial situation.

Data here is obtained from what are considered reliable sources as 3/31/2018; however, its accuracy, completeness, or reliability cannot be guaranteed.

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