Such a strategy can be beneficial, but be sure to consult an experienced attorney and tax professional to navigate the maze of rules.
In the first of a two-part series, money manager Lord Abbett tackles some of the complexities of designating a trust as an IRA beneficiary.
Increasingly, clients are relying on their advisors for advanced beneficiary-planning strategies, such as naming a trust as the beneficiary of a retirement account. Designating a "look-through" trust as an IRA beneficiary can be tricky and complicated, with potentially serious tax consequences if done incorrectly. Advisors and their clients need to be aware of the nuances and appropriateness of these arrangements.
Typically, qualified retirement plans and IRAs are not subject to probate. Instead, retirement assets are distributed according to account owners’ current beneficiary designation. Naming rules are very liberal, thus offering IRA owners a number of options in designating a beneficiary; in fact, any individual and/or non-individual (charity, estate, or trust) can be a named beneficiary. But if IRA assets are moved into the trust, either while the account owner is alive or at death, a distribution subject to income tax has occurred.
Tip: Never move IRA assets into the trust. Doing so will result in a taxable event on the entire IRA balance. Instead, name a trust as beneficiary on the IRA beneficiary form.
Why would the owner of an IRA want or need to name a trust, rather than a person, as his or her beneficiary?
The primary reason is to exert control over post-death distributions, thus limiting access to an inheritance. You do not save on taxes by naming a trust. In fact, it’s quite possible to pay more in taxes even if the trust is designed properly. Therefore, you would only use trusts for personal (non-tax) reasons.
Assuming that naming a trust fits a client’s overall objective, advisors should verify (with an attorney) that the trust qualifies as a “look-through” or “see-through” trust. In other words, the IRS will “look through” the trust and treat the trust’s beneficiary as the IRA’s direct beneficiary, although the trust remains the direct owner of the IRA (actually an inherited IRA). This allows heirs to take advantage of favorable minimum-distribution rules that apply to individual designated beneficiaries (e.g., those beneficiaries that have a life expectancy).
To qualify as a look-through, the trust must meet all of the following requirements:
- Must be a valid trust under state law.
- Must be irrevocable upon death of the account owner or contains language to the effect it becomes irrevocable upon the death of the IRA owner. A revocable trust will not be able to utilize stretch provisions.
- Individual beneficiaries of the trust must be identifiable from the trust document.
- Required trust documentation must have been provided to the IRA custodian no later than October 31 of the year following the IRA owner’s death. The trustee is responsible for providing trust documentation to the IRA custodian.
In addition to the above requirements, only individuals (i.e., those with a life expectancy) may be considered “designated beneficiaries” by the IRS for purposes of taking advantage of the stretch IRA provisions. A person who is not an individual, such as an estate or a charitable organization, may not be a designated beneficiary, and the option to stretch minimum payouts will be forfeited.
Tip: The trustee also is responsible for determining that the trust is a look-through trust. However, most likely, the trustee will need to hire a professional (e.g., attorney) for assistance.
Tip: Although naming a trust as an IRA beneficiary is permissible, not all IRA custodians permit trusts to be a named beneficiary. It is imperative that you receive confirmation from an IRA custodian that will allowing you to name a trust beneficiary.
A properly designed look-through trust is deemed a non-spouse beneficiary and thus must follow post-death required minimum distribution (RMD) rules. This is true even if the spouse is the sole beneficiary of the trust. Why? The trust inherited the IRA. After the owner dies, the IRA balance should not be distributed to a trust. Instead, after the IRA owner’s death, only the RMD has to be paid from the (inherited) IRA to the trust.
In other words, when a trust is named beneficiary, then minimum distributions are required to be made from the IRA to the trust. Bypassing (the trust) is not allowed. Instead, distributions are then made to trust beneficiaries, following the rules set forth in the trust.
Want to know whose life expectancy is used to determine minimum distributions if there are multiple trust beneficiaries? Download the complete article from Lord Abbett now.