Here’s the nitty-gritty on naming a trust beneficiary, plus insights on trust mechanics and taxation, and why bequeathing a Roth IRA appeals to many investors.
Owners of a 401(k) plan or IRA account, depending on their estate and legacy-planning goals, have the option to name a trust as a beneficiary instead of an individual (e.g., spouse, child, grandchild, etc.).
In last week’s column, I covered the strict, complicated, and cumbersome IRS rules to be followed so that the oldest trust beneficiary can use his/her own life expectancy to determine post-death payouts, including the requirement that the trust qualify as a “look-through.” So long as the trust qualifies, the “stretch” technique (whereby payments can be “stretched” out over a period of time) can be utilized.
Instead, assuming the trust qualifies as a “look-through,” you must use the life expectancy of the oldest trust beneficiary for required minimum distributions (RMDs). For this reason, anyone naming multiple trust beneficiaries ideally should see that they are close in age. Further, if any of the trust beneficiaries is not an individual (e.g., estate, charity), there would be no designated beneficiary for distribution purposes, even if the trust qualifies as a look-through; thus, trust beneficiaries would not be able to stretch post-death RMDs over the life expectancy of the oldest beneficiary. If the trust fails to qualify as a look-through, then it has no life expectancy. Generally, the entire account must be distributed to the trust within five years.
Trust Mechanics: How Do They Work?
When a trust is named as the beneficiary, these are the steps to follow: First, the account should be retitled as an inherited IRA, 401(k), etc. In addition, the account is not paid out to the trust. Next, RMDs are made from the retirement account to the trust. In other words, the RMD is a distribution from the IRA and paid to the trust. Only the RMD amount must be moved, each year, from the IRA to the trust. Distributions are then made to beneficiaries following trust language. The trustee, assuming trust language permits, can make additional distributions, for example, upon attaining a minimum age, time, and or life event (from the trust) to the beneficiaries of the trust.
Retitling an Inherited IRA
A trust beneficiary should be retitled as follows:
John Smith, IRA (died February 1, 2018)
For the benefit of (FBO) James Smith, Trustee of the Smith Trust, beneficiary
It’s imperative that the account is registered using the trust federal identification number—not the Social Security of the deceased. Retitling an account incorrectly has severe consequences. Instead of having an inherited account, you will have distribution to the trust, subject to immediate taxation.
Reasons to Name a Trust Beneficiary
An owner of a retirement plan/account has a lot of latitude in naming a beneficiary. He/she could name a spouse, child, grandchild, friend, charity, estate, trust, or some combination. Is a trust, though, right for you? When, then, should someone consider naming a trust beneficiary? Although each family situation is particular to them, fairly common reasons for naming a trust beneficiary include: minors as a beneficiary; a disabled (“special needs”) individual; second marriages; creditor protection; estate taxes; or a beneficiary that doesn’t have the financial acumen to manage effectively his or her inheritance. In addition, consider naming a trust when the client has beneficiary “trust” concerns—a trust can protect a beneficiary from rapidly depleting an inheritance by including a spendthrift provision. Once again, trusts do not save on taxes; instead, the primary reason to name a trust as beneficiary is to control (post-death) distributions to beneficiaries.
Trust Beneficiary and Taxes
Virtually every trust has its own unique set of rules, and each family has its own dynamics. So, when assessing a trust, consider taking a team approach to designing and implementing it. Involve all centers of influence, such as a tax professional, an attorney, and the trustee, in addition to the client. Notably, a client can make his or her trust as liberal as they want, or conversely, if they want more post-death control, as rigid as they like. It’s up to the client—with one caveat: the inherited IRA must pay out at least the required minimum amount (to the trust) annually.
Using a trust to inherit an IRA poses several tax risks if not designed properly. First, the trust could wind up paying higher taxes than heirs would. For example, in 2018, the top trust tax rate of 37% applies to income exceeding $12,500 versus income exceeding $600,000 for married individuals filing jointly ($500,000 for single taxpayers). However, heirs can avoid paying the higher trust tax rate, assuming the trustee can pass all distributions to the trust beneficiary, as opposed to retaining income inside the trust.
The 3.8% investment surtax also needs to be addressed. The surtax applies to taxpayers whose modified adjusted gross income (MAGI) exceeds $200,000 or $250,000 (not indexed to inflation) for married couples filing jointly versus a lower income level for trusts. The threshold for trusts in 2018 is $12,500.
Tip: Periodically review language ensuring the trust continues to meet client objectives. A review is especially important now that tax reform has been implemented.
With some advanced planning, a trust can offer the trustee both the needed flexibility and discretion to decide how much income to distribute to beneficiaries based on their needs, along with how much income will remain after taxes.
Want to know more about whether you should consider leaving a Roth to a Trust? Download the complete article from Lord Abbett now.