I’ve had several new clients come to me with an existing estate plan that includes IRA beneficiary designations naming their revocable trust as either the primary or contingent beneficiary. On closer review, many did not meet IRS requirements to treat the beneficiaries of the trust as the IRA beneficiaries.
When the IRS requirements aren’t satisfied, IRA distributions following the account holder’s death are accelerated, resulting in taxes due on the remaining balance right away, and of course, the loss of tax deferred growth.
This can be a double whammy for larger estates that also owe estate tax.
The IRS rules require a trust to qualify as a “see through trust” to the beneficiary. Allow me to explain by example: Suppose Father names his Trust as the beneficiary to his IRA account following his death. The trust has one beneficiary, Son. If the IRS “see through” requirements are met, then Son is treated as the beneficiary, and the trustee has 10 years in which to withdraw the entire trust balance for Son.
The trustee of the trust might be Son himself, or it might be a third party, such as a bank or trust company. Why would Father name the trust and not Son as beneficiary? There are several possibilities. Son might be a spendthrift or may have a mental incapacity causing Father to want a third party to manage the money. Father may want to protect the IRA inheritance from Son’s divorcing spouse. Father might want to give Son the ability to distribute the IRA to Son’s children rather than himself.
There are five requirements the trust must satisfy in order to qualify as a “see through trust.” First, the trust must be valid under state law. Second, the trust must be irrevocable, or become irrevocable by its terms upon the death of the original IRA owner. Third, the trust beneficiary(ies) must all be identifiable as being eligible to be designated beneficiaries themselves, and fourth, a copy of the trust must be provided to the IRA custodian by October 31st of the year following the account owner’s death, and fifth, all beneficiaries must be individuals.
Another troublesome issue is when the account owner names the trust instead of a spouse as the beneficiary. This typically occurs in blended families when each spouse has children from a prior marriage. The desire might be to allow a spouse to benefit from the IRA account for his lifetime, then upon his death the balance can be distributed to the original account owner’s children.
The reason the account owner doesn’t want to name her spouse as the primary beneficiary because he can then “rollover” the IRA into his own account, and name whomever he wants (his children) as beneficiaries.
So the trust appears to be a reasonable alternative. Except it’s not.
The reason the trust doesn’t usually work is due to the Required Minimum Distribution rules. Assuming the trust qualifies as “see through” so the surviving spouse is “identifiable,” if that spouse lives out to a full life expectancy, the trustee will be required to withdraw most, if not all, of the IRA account balance anyway. There are other tax issues should the trustee wish to accumulate portions of the distribution inside the trust for the first decedent spouse’s children, but that discussion is beyond the scope of this column.
Income taxation of testamentary and irrevocable trusts are complex. I’ve seen dozens of trusts where the drafter failed to consider these issues, but they can have a real economic effect on the beneficiaries. If you have named your trust as the beneficiary to an IRA, 401(k) or other qualified plan account, make sure that you have it reviewed by a competent attorney.
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