Trust as IRA beneficiary

Trusts have been around since the 1500’s when English landowners used them to get free of creditors and feudal obligations.  Today, of course, trusts are more comprehensive and complex, but used correctly, they provide the flexibility and control you want over your assets when you die. 

Choosing a Trust as a Beneficiary

If you choose to name a trust as the beneficiary of an IRA there are some important considerations.  If the trust qualifies as a “see-through trust”, the IRS permits the use of the oldest trust beneficiary’s life expectancy for purposes of required minimum distributions.  This is especially beneficial when the trust is for minor children. Since they most likely are significantly younger than you they can benefit from a much longer applicable distribution period.  Indeed, they have the potential for decades of tax-free growth of your assets.

Risks of using Trust as a Beneficiary

However, using a trust to inherit an IRA poses several risks.  First, the trust could wind up paying higher taxes than your heirs would, because trust tax rates are higher than most individuals' rates.  (The 35 percent tax rate kicks in on a trust when income exceeds $9,750, compared with $326,450 for individuals.) Second, the trust must qualify as a “see-through” trust.  It is called a see-through (or look-through) trust because one is able to look through the trust to the beneficiaries named under the trust. The trust will not qualify if you have named beneficiaries that are not people, such as a charity, your estate or another trust.  Since those entities do not have life expectancies, the IRS will not allow any of the beneficiaries involved to stretch out the withdrawals—even though that was your intention in setting up the trust. 

Keep in mind when setting up the trust that if you are leaving IRA assets to a trust for a child, you need to determine who will receive the remaining trust assets when the child dies.  If you designate a charity as the remainder beneficiary when the child dies the trust does not qualify as a see-through trust. A charity is not a person. If you name a person as the remainder beneficiary, the trust qualifies as a “see-through trust” but it is important to remember that the applicable distribution period is based on the life of the oldest beneficiary, including the remainder beneficiary.

Certain beneficiaries, however, may be disregarded when determining who the oldest beneficiary is, and if all beneficiaries are persons.  For instance, you may disregard any beneficiary whose has taken full distribution of his share by September 30 of the year following the year of the IRA owner’s death.

Another major consideration is the retirement plan you have.  It must specifically offer the life expectancy payout. Because most 401(k) plans do not offer this payout, one of your first steps would be to roll 401(k) assets into an IRA that does.

Note that your will is irrelevant when it comes to your IRA.  What matters is the IRA beneficiary form, which you are supposed to fill out when you open the IRA account.  It, not your will, governs the way an IRA passes along to your heirs. If you do not name a beneficiary, or you name your estate, your heirs lose the ability to stretch their withdrawals over their lifetimes.  In some cases, naming the estate as the beneficiary could even prevent your spouse from being able to roll assets into his or her own IRA. It is a good idea to review those forms periodically

• Additional requirements of a see-through trust are:
• The trust must be valid under state law.
• The trust is irrevocable, or will be, upon the death of the IRA owner
• Beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the IRA are identifiable from the trust instruments.
• The IRA custodian must be in possession of the trust document and informed of any amendments.

If you have considered using a trust but have concerns about the cost or that it might not meet the test for stretched withdrawals, a possible alternative is a Trusteed IRA.  This method uses a combination of a trust and IRA in which the trustee can have responsibility for withholding payments from the beneficiary or making payments to a disabled beneficiary.  Because of the greater flexibility in controlling distributions, this may be a viable alternative in many planning situations.

Inherited IRAs do not work like regular IRAs.  So do not assume that any of the rules governing the IRAs you own would apply to any that you inherit. For example, if you inherit an IRA from anyone other than your husband or wife, you cannot roll it into your own IRA under any circumstance.  You also cannot withdraw the assets from an inherited account and then deposit them into a new IRA and you cannot consolidate IRAs you inherit from different people into one account.

Conclusion

The good news is that traditional IRAs and Roths you inherit have one important thing in common with the ones you hold yourself:  You can stretch out the withdrawals across your lifetime rather than taking them as a lump sum.  Like the trust scenario above, this gives you a chance to postpone the tax bite and lengthen the time that tax-free earnings can accrue, possibly increasing your inheritance by thousands of dollars.

Provided by courtesy of Herb White, MBA, CFP,  Principal and Managing Director of Life Certain Wealth Strategies in Greenwood Village, Colorado, www.lifecertain.com.  Securities and investment advisory services offered through Woodbury Financial Services, Inc. Member NASD, SIPC.