Is naming a trust as beneficiary of your IRA a good idea?
Since noncompliance with the IRA-required minimum distribution (RMD) rules can be costly, and naming a trust as an IRA beneficiary can limit flexibility to the ultimate individual beneficiaries, it’s important to understand the ramifications of naming a trust as an IRA beneficiary. Here are six considerations.
- In search of the designated beneficiary
Naming a trust as an IRA beneficiary does not circumvent the RMD rules. On the contrary, noncompliance with the trust-specific rules could have devastating effects — namely, application of the “no-designated-beneficiary” rules. In general, to achieve the most tax-effective treatment under the RMD rules, there must be a designated beneficiary. A designated beneficiary is an individual with a measurable life expectancy. Ostensibly, a trust is not a designated beneficiary because it’s an entity, not an individual. However, a trust will be considered a designated beneficiary if certain conditions are met. These are known as the “see-through-trust” requirements.
- See-through-trust requirements
When naming a trust as an IRA beneficiary, it’s extremely important to satisfy the see-through-trust requirements. If an IRA is left to a non-see-through trust, the trust will receive benefits under the “no-designated-beneficiary” rules: either (1) by the end of the fifth year after the participant’s death if the participant dies before age 70 ½, or (2) the decedent’s life expectancy if the participant dies after the required beginning date. There are five requirements:
- The trust must be valid under state law.
- The trust must be irrevocable.
- Documentation must be provided to the plan administrator.
- Beneficiaries must be identifiable.
- All trust beneficiaries must be individuals.
- Who is an identifiable individual?
Whether a beneficiary is “identifiable” and an “individual” depends on whether the trust is a conduit or accumulation trust. A conduit trust requires the trustee to distribute all IRA distributions. An accumulation trust is any trust that is not a conduit trust (the trustee may accumulate IRA distributions in the trust). Differentiating between a conduit and accumulation trust is important: a conduit trust is a see-through safe harbor and automatically satisfies the requirements; an accumulation trust may or may not satisfy the requirements.
Whether an accumulation trust distributes to an identifiable individual depends on the successive beneficiaries. You must count all successive beneficiaries who could receive assets under the trust until you come to the beneficiary who would be entitled to the trust property immediately and outright upon the death of the prior beneficiaries. If no beneficiary would receive the assets outright upon the IRA owner’s death and the contingent taker is a non-individual (estate or charity), the trust does not satisfy the see-through requirements.
- Maximizing “the Stretch”
After satisfaction of the see-through-trust requirements, the next step is determining whose life expectancy to use for ascertaining the RMDs. The simple answer: use the life expectancy of the oldest beneficiary. The conduit-versus-accumulation method is used to decide which beneficiaries are countable: for a conduit trust, only the conduit beneficiaries are countable; for an accumulation trust, all potential beneficiaries are countable. The RMD is calculated by dividing the account balance by the life expectancy of the oldest beneficiary based on the Single Life Table.
- Separate accounts and dispelling “bad” beneficiaries
What happens if, say, a charity is a countable beneficiary and, therefore, fails the see-through-trust requirements? To reclaim the “stretch” benefits, the “bad” beneficiary (i.e. the charity) can be removed before September 30 of the year following the year of death by distributing their portion to them. In addition, a beneficiary may use his or her own life expectancy for calculating RMDs if separate accounts are established by December 31 of the year following the date of death
Naming a trust as an IRA beneficiary seems like an attractive idea as long as the trust satisfies the see-through requirements. However, there are certain limitations that need to be considered. For example, if a younger beneficiary of a trust is responsible and financially independent, naming that trust as an IRA beneficiary will prevent that beneficiary from maximizing the “stretch” that would otherwise be offered to him if he was named as a beneficiary individually. This is because the “stretch” is based on the oldest beneficiary’s age. In addition, that same responsible beneficiary of the trust may be restricted from withdrawing funds pursuant to the terms of the trust — even if there’s a legitimate need. These considerations, along with many others, need to be considered prior to naming a trust as an IRA beneficiary.
Should you name your trust as a beneficiary of your IRA? Without more information, we must resort to the quintessential estate-planning response: “it depends.”
Here’s what we do know: Naming a trust as an IRA beneficiary shouldn’t be done out of ease or convenience; rather, the decision should be intentional and based on the totality of the circumstances. For example, the option may be attractive if the beneficiaries are minors, irresponsible, or have creditor-protection issues. Otherwise, because of the complexities and limitations, naming a trust as a beneficiary may fail to adequately express the true intent of the IRA account holder.
As always, please reach out to us to discuss your personal needs and situation. We’re happy to help.