One of the most commonly asked questions we encounter is whether or not to designate your Revocable Living Trust as the beneficiary of a retirement account and what are the tax consequences of doing so.
In the overwhelming majority of cases, it is our recommendation to our married clients that they name their spouse as the primary beneficiary of their retirement account and name the Trust as the second or alternate or contingent beneficiary. Financial Advisors frequently inform our clients that by doing so the entire balance in the retirement account will be taxable upon the participant’s death. This is not the law, and it has not been the law for over ten (10) years.
The advantages of naming the Trust as a beneficiary, as opposed to naming your children directly as IRA beneficiaries, include:
- The Trustee can control the age of distribution to the beneficiaries. This is especially important with minor children, young adults, spendthrift heirs or beneficiaries with special needs;
- The Trust can define where any beneficiary’s share will go if the beneficiary dies before receiving his or her entire share;
- Keeping a beneficiary’s share in the Trust can preserve its status as his or her sole and separate property; and,
- A recent case provided that while creditors cannot attach a participant’s IRA or a spousal Rollover IRA, they can attach an inherited IRA.
A participant in a retirement account, whether it is an IRA, 401(k), 457, 403b, Profit Sharing Plan, Defined Benefit Plan, or any other Profit Sharing / Pension Plan may designate an individual, Trust, estate as beneficiary to receive the annual distributions on the death of the participant owner. The rules relating to Trusts as “Designated Beneficiaries” changed substantially several years ago. Previously, if a Trust was named as beneficiary of a retirement account, the entire balance would be taxable in the year of the plan participant’s death or within five (5) years of the participant’s death. This was because the general rule was that a Trust did not qualify as a designated beneficiary for the minimum distribution purposes.
That portion of the 1997 Internal Revenue Service’s Regulations dealing with Trusts as “Designated Beneficiaries” was revised significantly in January of 1998, and these revised requirements were carried over largely intact into the final Regulations issued by the Internal Revenue Service on April 16, 2002.
If satisfied, these provisions allow the beneficiaries of a Living Trust that has been named as a plan beneficiary to be treated as “Designated Beneficiaries” and defer the taxability of their distribution in exactly the same manner as if they were named as beneficiaries individually (so called “stretch provisions”). Under the 1997 Regulations, these requirements had to be met as of the participant’s Required Beginning Date (RBD) and for all periods thereafter during which the Trust is a plan beneficiary. Now, the final Regulations make clear that they need not be met until September 30th of the year after the year of the participant’s death.
The requirements are as follows:
- The Trust must be valid under state law;
- The Trust must either be irrevocable or become irrevocable upon the participant’s death;
- The Trust beneficiaries who are beneficiaries with respect to the Trust’s interest in the plan must be identifiable from the Trust instrument; and,
- Either a copy of the Trust instrument or special Affidavit must be filed with the Plan Administrator by December 31st of the year after the year of the participant’s death.
Note that for tax purposes, because the Trust is essentially ignored and the Trust beneficiaries are being considered when determining whether they are the Designated Beneficiaries, all of the Trust beneficiaries must be individuals, as opposed to charities, businesses, etc. This had led to the terms “look through trusts,” “see through trusts” and similar “nicknames.” However, under the Final Regulations, the beneficiaries are determined as of September 30th of the calendar year following the calendar year of the participant’s death.
If there is more than one (1) Trust beneficiary, and if requirements are met, then the beneficiary with the shortest life expectancy (the oldest beneficiary) will be considered the Designated Beneficiary for purposes of determining the minimum distributions. The Final Regulations make clear that the “separate account” rules are not available for Trust beneficiaries. This has led many commentators and financial advisors to suggest that naming each child as a beneficiary directly as opposed to indirectly through a trust as a way to insure each child can ‘stretch’ to their life expectancy. The downside of this includes:
- Most children don’t ‘stretch’ but cash in the inherited IRA far before they turn 70 or die.
- Minor or irresponsible beneficiaries may need the structure of a trust to manage their inheritance.
- Disabled heirs may need the trust to prevent fraud and insure their SSI and/or medical benefits are not lost by inheriting.
- A child’s creditors can attach an inherited IRA but not a trust IRA.
- A soon to be ex-spouse can attach an inherited IRA but not a trust IRA.
The fact that a Trust has been named as beneficiary does not result in the entire account being taxable upon the death of the participant. That would have been true under the old rules, which were first changed in January of 1998 and clarified under the 2002 rules.
Accordingly, the Trust beneficiaries shall be considered plan beneficiaries upon the death of the participant, and the withdrawals from the Trust shall be consistent with the legal requirements of withdrawals as if the Trust beneficiary with the shortest life expectancy was the Designated Beneficiary for purposes of determining minimum distributions.
If the owner dies prior to his or her required beginning date (age 70.5) with his or her Trust designated as beneficiary, and there are non-spouse beneficiaries of the Trust, then either the remaining amount in the IRA must be distributed by December 31st of the fifth year following the owner’s death (Rule 1) or distributions may be made over the remaining life or life expectancy of the designated beneficiary commencing on December 31st of the year after the date of death (Rule 2). Minimum distributions are calculated by taking the account balance on December 31st of the prior year, divided by the remaining life expectancy of the oldest beneficiary. If the owner dies after his or her required beginning date, the five year rule does not apply. The maximum payout period is the longer of: 1) the remaining life expectancy of the designated beneficiary; or 2) the remaining life expectancy of the deceased IRA owner.
If the owner dies before his or her required beginning date (age 70.5) with a Trust as designated beneficiary, and his or her spouse is the sole beneficiary of the Trust, the account balance may be distributed by December 31st of the fifth year following the owner’s death (Rule 1) or distributions may be made over the life expectancy of the beneficiary/spouse. Distributions to a spouse beneficiary under the life expectancy method must commence by the later of: 1) December 31st of the calendar year following the death of the IRA owner; or, 2) December 31st of the calendar year in which the IRA owner would have attained age 70.5 (Rule 2). If the owner dies after the required beginning date with the Trust as designated beneficiary and his or her spouse is the sole beneficiary, the spouse must receive minimum distributions over the longer of: 1) the remaining life expectancy of the designated beneficiary/spouse; or, 2) the remaining life expectancy of the deceased IRA owner. The five year rule does not apply.
Note that if there is no designated beneficiary and the owner dies prior to the required beginning date, the balance must be distributed by December 31st of the fifth year following the death of the IRA owner. If the owner died after the required beginning date, the account balance must be distributed over a period of no longer than the remaining life expectancy of the IRA owner (rather than the life expectancy of the oldest beneficiary).
DROBNY LAW OFFICES, INC. does not normally recommend naming a Trust as the primary beneficiary if an IRA owner has a living spouse. The surviving spouse should almost always be named the primary beneficiary, with the Trust designated as contingent or secondary beneficiary because of the surviving spouse’s opportunity to elect a Spousal Rollover and treat the distributions as an owner rather than a beneficiary. Exceptions typically involve IRA being funded prior to a second marriage.
A spouse/beneficiary frequently elects to receive post-death distributions from the deceased spouse’s IRA as owner rather than as beneficiary because the surviving spouse may delay receiving Required Minimum Distributions until April 1st of the year following his or her attaining age 70.5 (Taking as beneficiary, the surviving spouse must commence receiving distributions by: 1) December 31st of the year following the death of the IRA owner; or, 2) December 31st of the calendar year in which the IRA owner would have attained age 70.5).
The surviving spouse can also designate a new beneficiary for the IRA after the death of the spouse owner.
If this is a second marriage and the participant wishes for the retirement account proceeds to be payable to their children as opposed to the subsequent spouse, then we may advise naming the Trust as the primary beneficiary.
A surviving spouse may not elect to treat the IRA of the IRA owner as the surviving spouse’s IRA if a Trust is the designated beneficiary. This rule applies even if the surviving spouse is the sole beneficiary of the Trust and receives distributions directly from the IRA.
Note, that if a primary beneficiary disclaims his or her benefits and the IRA passes to a Trust as a result of either: 1) state law; or, 2) provisions in the deceased IRA owner’s Will, then the Trust (or its beneficiaries) is not considered a designated beneficiary for purposes of the Required Minimum Distributions. The lesson here is that one should never name the Estate (as opposed to the Trust) as the contingent beneficiary because that will cause the account balance to be distributed as if the IRA owner had no designated beneficiary.
In conclusion, DROBNY LAW OFFICES, INC. normally recommends that IRA participants designate the spouse as the primary beneficiary and designate the Trust as a secondary or contingent beneficiary for the best results. On the other hand, there are many unique circumstances in each case, and the IRA participant should consult with their financial advisor, attorney, CPA and (perhaps) family before making this important decision. If you have any questions concerning beneficiary designation, please contact our office.