Naming a Trust as IRA Beneficiary: Key Considerations
From: www.wealthmanagement.com
In many, but not all, instances, a trust is a better option than naming an individual.
Trusts are terrific estate planning vehicles that allow individuals to protect and preserve wealth and to pass assets to the next generation. Individual retirement accounts (IRAs) are also useful vehicles that are often used to grow assets free from current income tax and to transfer those assets to the next generation. IRAs, introduced in the 1970s, have become an increasingly popular structure both for funding retirement and for accumulating wealth. These tax-advantaged accounts now collectively hold over $11 trillion of assets, which is more than a third of all retirement assets in the United States. As the significance of IRAs has grown, it has become more common to name trusts as IRA beneficiaries, thus combining the tax-advantaged growth of an IRA with all of the advantages that trusts have to offer.
When a client reaches age 72, they must start taking required minimum distributions (RMDs) each year from a traditional IRA. The RMDs are based on age and a life expectancy factor listed in tables published by the IRS. Roth IRAs are not subject to RMDs during the owner’s life.
Given the way the IRS tables are structured, if a client withdraws only the RMDs from his or her IRA, there will be assets left in the IRA at death. And, if the IRA has a high rate of investment return, it is possible for the IRA to have greater value at death than when the client started taking RMDs.
The IRA, with its remaining assets, does not pass under the terms of the client’s will or trust, but instead passes to whomever he or she has named in the IRA beneficiary designation. The most common designations are to individuals, for example, all to a spouse or in equal shares to children. However, a trust also can be named as an IRA beneficiary, and in many instances, a trust is a better option than naming an individual.
Reasons to Name a Trust
When a trust is named as the beneficiary of an IRA, the trust inherits the IRA when the IRA owner dies. The IRA then is maintained as a separate account that is an asset of the trust. Some good reasons a client may wish to consider naming a trust as an IRA beneficiary instead of an individual include:
- Working around beneficiary ownership limitations. Perhaps the intended beneficiary is a minor who is legally unable to own the IRA. Or perhaps the IRA owner wants to support an individual with special needs who will lose access to government benefits if he or she owns assets in his or her own name. A solution in both cases could be to name a trust as the IRA beneficiary, which will then become the legal owner in place of the minor or individual with special needs.
- Solving for second marriage or other family structures. An IRA owner may wish for RMDs to benefit his second spouse during the spouse’s lifetime, and then have the remainder of the IRA pass to his own children. If the IRA owner leaves the IRA outright to his spouse, he can be certain that his spouse will benefit, but he can’t guarantee that his children will receive anything. If he instead leaves the IRA to a properly structured trust, his desire to benefit both sets of beneficiaries can be carried out.
- Limiting a beneficiary’s access. Clients often think of IRA beneficiaries as taking only the required minimum distributions, but an individual who has inherited an IRA has the right to take larger distributions, or even withdraw the entire balance of the IRA. On the other hand, the access of a beneficiary of an inherited IRA owned by a trust will be subject to the terms of the trust.
- Naming successive beneficiaries. When an individual IRA beneficiary inherits an IRA, she can name her own initial successor beneficiaries. If the IRA owner wishes to control the successor beneficiary beyond the initial beneficiary, the owner will need to set forth the succession terms in a trust and name the trust as the IRA beneficiary.
- Providing creditor protection. A person’s own IRA has some level of protection from creditors, but this does not always carry through to the inherited IRA. The U.S. Supreme Court ruled in Clark v. Rameker, 134 S. Ct. 2242 (2014) that inherited IRAs do not qualify under the Federal Bankruptcy Code as exempt from the claims of creditors as “retirement funds.” An inherited IRA held instead in a properly structured trust will not be an asset of the beneficiary and will have some protection from creditors.
- Funding estate plans structured to minimize estate tax. Most estate plans for wealthy individuals include trusts designed to minimize and postpone the payment of federal and state estate tax. For such estate plans to work as intended, the portion of these trusts that shelters an individual’s federal or state estate tax exemption amounts needs to be funded upon the individual’s death. Often, the only asset available to do this funding is an IRA.
Pulling Back on the Stretch IRA
Just as there are rules about RMDs during the IRA owner’s life, there also are rules about distributing an inherited IRA after the owner dies. The preferred payout has long been the “stretch IRA,” where the post-death RMDs are stretched out, with annual distributions, over the life expectancy of the new IRA beneficiary. In this case, the IRA could continue to grow tax-deferred, often for many decades after the owner’s death.
The SECURE Act, passed in December 2019, has significantly reduced the ability to create a stretch IRA. The prior stretch rule has been replaced, for most beneficiaries, with a 10-year rule that requires the IRA to be distributed out completely by the end of the 10th year following the year of the IRA owner’s death. The 10-year rule does not require annual distributions, so long as the full amount is distributed by the end of the 10th year. The new 10-year rule does not apply to the following beneficiaries (known as “eligible designated beneficiaries”): the IRA owner’s surviving spouse, the owner’s children while they are minors, certain individuals who are chronically ill or disabled and any person who is not more than 10 years younger than the IRA owner. The stretch IRA is still available for these beneficiaries.
RMD Rules for Trusts Inheriting IRAs
The post-death RMDs for a trust named as an IRA beneficiary will be calculated under either the stretch payout rule, the 10-year rule, or the five-year rule, depending on certain attributes of the trust and the trust beneficiaries. It matters whether the trust qualifies as a see-through trust, whether it is a conduit trust or an accumulation trust, and whether the trust beneficiaries are nonindividuals, “regular” beneficiaries or part of the new class of “eligible designated beneficiaries.”
The analysis of which RMD rule applies is not always clear, and there are aspects of the SECURE Act that will require clarification through IRS regulations. For these reasons, among others, it is important for clients to involve their estate planning advisor in any decision to name a trust as an IRA beneficiary. They will want to confirm that their reasons for naming a trust as their IRA beneficiary are reflected in the trust terms and will not be negated by the RMD payout rules. It is also important to review beneficiary designations to be sure that any trust beneficiaries are appropriately named.
It is important to note that the RMD payout rules are different from the payout rules of the trust. Even if an IRA must pay out under the five-year rule to a trust named as the IRA beneficiary, it does not necessarily mean that the IRA assets will distribute out to the trust beneficiaries within five years. Instead, the terms of the trust regarding distribution to trust beneficiaries will apply. For example, if the trust is completely discretionary, then once the IRA assets are distributed out of the IRA to the trust itself, the after-tax proceeds of the IRA will remain invested with other assets of the trust until the trustee exercises its discretion to make a distribution to one or more of the beneficiaries.
