IRA Beneficiary Designations And The Use Of Trusts

In another blog post, the topic addressing who is your IRA’s beneficiary can be important. Leaving an IRA directly to heirs has many pitfalls: any withdrawn money will lose the inherent protections of the IRA, the heirs may exhaust the funds quickly to the detriment of any long-term tax deferral benefits and the money may be vulnerable to divorce settlements or creditors.

Trusts offer a safer option for passing on your IRA to heirs. Just like any assets held in trust, an inherited IRA left to a trust will limit exposure to both creditors and unchecked spending, thus providing greater assurance that long term tax deferral will be achieved. Furthermore, leaving an IRA to a trust with a responsible trustee can increase the likelihood that, along as there’s no imperative need for cash, your heirs’ tax deferral benefits will be maximized.

There is a difference between naming a “living trust” as the beneficiary of an IRA and transferring the funds to the trust’s name. The former action is permissible, often desirable and does not trigger the immediate recognition of the taxable income inherent in the IRA. The latter is a distribution triggering immediate taxable income.

It is common for the spouse who is the IRA account holder to designate the other spouse as the primary beneficiary. The complication arises when it comes to the contingent beneficiary. What if there are funds left in the IRA after both spouses have passed away? Should they name the children as the beneficiaries? At that point, many couples consider naming the “living trust” as the beneficiary.

As nothing in life is perfect, you should be aware that leaving an IRA to a trust has its disadvantages. The IRS interprets the minimum required distribution (MRD) rules strictly for trust beneficiaries, which can result in reduced tax deferral. Consequently, the children will not be able to use their own life expectancies to calculate the required minimum distributions, and may be forced to withdraw the funds over a period of as little as five years.

Take for example that you leave your IRA to a trust, naming your sister Stacey as the trustee. Stacey will have the discretion as to how much she distributes to your son Cary, who is the primary trust beneficiary.

This arrangement serves to protect the assets. Stacey can take minimum distributions from the IRA and hold the funds in trust, if she wants to keep Cary from depleting the money too quickly or losing the money to creditors or divorce.

The IRS considers this example an “accumulation trust” and as a result, the shortest life expectancy of all the possible trust beneficiaries will be used to determine MRDs.

Suppose that the IRA passes to the trust when Cary when he is 58, with a 26-year life expectancy on the IRS table. If his Aunt Glendene, 68 years old with an 18-year life expectancy, is the oldest of the secondary beneficiaries, money must be withdrawn from the IRA on an 18-year schedule. The result is that taking money from the IRA over 18 rather than 26 years will curtail tax deferral and reduce potential wealth building.

The best option is to name a standalone IRA beneficiary trust as the beneficiary as allowed by the 2005 Private Letter Ruling 200537044 approving an “IRA Trust” or a conduit trust. An IRA Trust has a single individual as a primary beneficiary. A standalone trust is designed to meet the requirements of a designated beneficiary trust; give each beneficiary the ability to use that beneficiary’s life expectancy for purposes of “stretching-out” distributions; and make it less likely that the beneficiaries will immediately cash out the IRA or take other actions that may have adverse tax consequences.

Using this new strategy, a benefactor begins by creating either an accumulation trust or conduit trust that will inherit his or her IRA. This trust should be a one-purpose trust. Following death, an independent party can “toggle” from one of these types of trust to the other, depending on the beneficiary’s needs. At the death of the owner of the IRA, this IRA Trust will divide into smaller “subtrusts,” one for each intended beneficiary.

For instance, you intend to divide your IRA among your four children. At your death, the IRA Trust (which becomes irrevocable at your death) will divide into one trust for each child.

Assuming your children can manage their inherited IRAs, each of the subtrusts can be structured as conduit trusts for maximum tax deferral and potential protection of principal. At any time during your life, you can amend the plan if you decide that one or more of your children needs the protection of an accumulation trust.

Letter Ruling 200537044 clarifies what happens after you die. It approves an arrangement in which each subtrust can have a “trust protector.” The person who serves as trust protector must be unrelated by blood to the trust beneficiary, but may have a personal relationship to him or her, such as a CPA, attorney, personal financial adviser or friend.

If adverse conditions come up, such as a beneficiary has creditor or marital problems, the trust protector can change a conduit trust to an accumulation trust by voiding the provision that requires the immediate payout of IRA distributions to the primary trust beneficiary. As a result, the trustee will gain the discretion to accumulate funds, and more significant asset protection is given to the beneficiary.

The Internal Revenue Service’s ruling can be helpful in another way too. If an accumulation trust had been setup for a beneficiary with current financial problems that have since been resolved, the trust protector may switch it to a conduit trust by requiring the full payout of MRDs.

This post-death switch can be done only once, regardless of the direction the switch is made. The decision can be made on a beneficiary-by-beneficiary basis so that some beneficiaries have conduit trusts and some beneficiaries have accumulation trusts.

The IRA Trust has been approved in a Private Letter Ruling which technically applies only to the taxpayer from whom the ruling was requested.

For more information about incorporating IRA Trusts into your estate plan, please call Mitchell A. Port at (310) 559-5259.