Designating a Trust as Beneficiary of Individual Retirement Account Benefits

The most commonly asked question we encounter is whether or not to designate your Revocable Living Trust as the beneficiary of a retirement account and what the tax consequences of doing so are.

In the overwhelming majority of cases, it is our recommendation to our clients that they name their spouse as the primary beneficiary of their retirement account and name the Trust as the secondary 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 6 years.

The advantages of naming the trust as 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 or spendthrift heirs. (Note that the taxable distribution occurs when the payment of the IRA is made to the trust, not when the trustee makes a distribution of the proceeds of the IRA to the beneficiary.);
• The trust can define where any beneficiary’s share will go if the beneficiary dies before receiving their entire share;
• Keeping a beneficiary’s share in the trust can preserve its status as their sole and separate property;
• Keeping a beneficiary’s share in the trust can protect it from creditors; and,
• To solve the underfunded Bypass Trust we encounter increasingly often (see below).

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 or any other person as a beneficiary to receive the account balance on the death of the owner. The rules relating to trusts as “Designated Beneficiaries” changed substantially a few years ago. Until recently, 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. That is because the general rule is that a trust does 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. 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 30, of the year after the year of the participant’s death.

The requirements are as follows:

1. The trust must be valid under State law;
2. The trust must either be irrevocable, or become irrevocable upon the participant’s death;
3. The trust beneficiaries who are beneficiaries with respect to the trust’s interest in the plan must be identifiable from the trust instrument; and
4. Either a copy of the trust instrument or a special affidavit must be filed with the Plan Administrator by December 31 of the year after the year of the participant’s death.

Note that for tax purposes, because the trust is being 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. However, under the Final Regulations, the beneficiaries are determined as of September 30 of the calendar year following the calendar year of the participant’s death.

Just as when a participant names multiple individuals as plan beneficiaries, if there is more than one trust beneficiary, and if requirements are met, then the beneficiary with the shortest life expectancy (the oldest beneficiary) will be 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.

The fact that a trust has been named as a 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, that were first changed in January of 1998, and clarified under the 2001 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 required beginning date (at 70½) with his trust designated as beneficiary, and there are non-spouse beneficiaries of the Trust, then the remaining amount in the IRA must be distributed, either by December 31 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 by December 31 of the year after the date of death (Rule 2). Minimum distributions are calculated by taking the account balance on December 31 of the prior year, divided by the remaining life expectancy of the oldest beneficiary. If the owner dies after his 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 required beginning date (age 70½) with a trust as designated beneficiary, and his spouse is the sole beneficiary of the trust, the account balance may be distributed by December 31 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 31 of the calendar year following the death of the IRA owner, or 2) December 31 of the calendar year in which the IRA owner would have attained age 70½ (Rule 2). If the owner dies after the required beginning date, with the Trust as designated beneficiary and his 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.

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