April 30, 2014
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Is your IRA trust beneficiary a tax trap?

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From Ken Rudzinski, Five-Star Wealth Manager, comes valuable insights and practical, timely strategies on a wide range of financial planning topics, including investments, retirement, insurance, taxes and estate planning.

It is not unusual for one or more IRAs to be the largest asset in a person’s retirement portfolio. Is this you? It is also commonplace for people to name a revocable trust as the primary beneficiary of the IRA. If this is you, then you need to make sure your trust is a properly-established “see-through” trust. Otherwise, you will be dooming your IRA to accelerated federal income taxation when you die.

People name trusts as beneficiaries of their estate assets — including their IRAs — for many reasons, including where a minor is a beneficiary or for health or other reasons a “special needs” trust is deemed appropriate rather than leaving IRA assets outright. Further, troublesome or complicated marriage situations, or cases where spendthrift provisions are important may result in naming a trust as an IRA beneficiary.

There is, however, one major income tax savings provision that an improperly drafted trust named as an IRA beneficiary may unintentionally void, and that drafting error may amount to significant federal income taxes due immediately at your death or within 5 years of your death. This tax advantage is known as the “stretch” provision.

The stretch refers to the ability of your IRA beneficiaries to spread out the income taxes due on your IRA when you die throughout their lifetimes. The taxes thus deferred can provide later retirement security for your children or other heirs. However, to take advantage of the stretch payout, the beneficiary must be a specifically named person, otherwise defined in Internal Revenue Code (IRC) as “designated beneficiaries.” Since a trust is not a person, it cannot serve as a designated beneficiary for stretch purposes. The result then would normally be that the IRA proceeds at your death would be taxed immediately or within 5 years. That would be an unfortunate outcome for your heirs, but is a totally avoidable one. How?

The IRS allows a trust to be properly designated as IRA beneficiary — and thus eligible for the stretch — if it passes assets on to named beneficiaries of the trust all of whom are living persons. This is often referred to as a see-through or “conduit” trust.

However, for a trust to be considered a see-through or conduit trust for income tax purposes, it must contain five specific requirements. These are:

  • the trust must be valid under state law
  • the trust must be irrevocable on or before the death of the original IRA owner
  • the beneficiaries of the trust must be clearly identifiable
  • a copy of the trust must be provided to the plan custodians (all IRAs require a custodian)
  • all of the beneficiaries of the trust must be individuals or another trust that also satisfies all of these obligations

In short, if even one beneficiary of the trust is not a person, or is not identifiable, or is a trust not designated as a see-through trust itself, then the trust will not qualify as a see-through trust. On the other hand, if the trust qualifies, then the life expectancy of the oldest named beneficiary is used to calculate postmortem required mandatory distributions (RMDs). These RMDs to nonspouse IRA beneficiaries are similar to those the IRA owner has to begin taking at age 70½. For the record, a spouse beneficiary may continue the tax deferral the IRA owner enjoys; the stretch, therefore, is not needed for the spouse beneficiary.

Here is an example. You leave your $1 million IRA to a qualifying see-through trust that names as equal beneficiaries your son, John, age 30 years, and your brother, Bill, age 65 years. The RMD distribution, in this case, would be figured over the 25.2-year life expectancy of your brother instead of the 53.5-year life expectancy of your son. So, the qualifying see-through trust permits the stretch. But it does require the age of the oldest beneficiary to determine the amount. In this case, your son’s RMD is accelerated and, therefore, higher distributions are taxed sooner.

Is it possible to avoid this uneven and perhaps unwanted tax result? Yes, one simplistic way to do this would be to split your IRA into two separate equally funded IRAs before you die. You name your son as beneficiary of a see-through trust for one of the IRAs, and your brother, for the second. The result would be each beneficiary using his own life expectancy for RMD distributions. 

So I ask, have you named a trust as your IRA beneficiary? Does it qualify as a see-through trust? When was the last time you checked? If you don’t, who will?

Ken Rudzinski, CFP, CLU, ChFC, CRPC, CASL, CAP, a partner in the financial planning firm Heritage Financial Consultants, LLC, is a registered representative and investment advisor representative with Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor in Wilmington, Del. Rudzinski offers insurance through Lincoln affiliates and other companies. This information should not be construed as legal or tax advice. You may want to consult a legal or tax advisor regarding this material as it relates to your personal circumstances. CRN-887376-032414. If you have questions specific to the article they can be emailed directly to the author at Kenneth.Rudzinski@LFG.com. The author does have the ability to respond in the comment section below. General Healio.com questions should be directed to editor@Healio.com