As part of the trust funding process,
I normally suggest that clients change the beneficiary designation of their
IRAs and retirement benefits. Most of the time, I suggest that their spouse be
the primary beneficiary and the Living Trust be the secondary or contingent
beneficiary, because spouses receive better distribution rights under federal
law with respect to retirement benefits. If the spouse predeceases the account
owner, or if it makes sense for other reasons for the spouse to disclaim the
retirement benefits, the benefits then fall to the Living Trust where, in all
probability, the spouse remains the primary beneficiary and if the spouse has
already died, the beneficiaries of the Living Trust become beneficiaries of the
retirement benefit.
After contacting their financial
professional, clients will often call me concerned because their financial
professional warned them against designating the Living Trust as beneficiary of
the retirement benefits because their children will not be able to
"stretch out" the IRA over their lifetime, and the entire benefit
will be taxable immediately. While this advice may be well meaning, it is often
incorrect.
The Internal Revenue Code (the "Code")
and Regulations provide that a "designated beneficiary" can use the
provisions which allow a beneficiary to take minimum required distributions
(MRD's) over their life expectancy. Normally, only an individual can be a
"designated beneficiary", therefore a Living Trust ordinarily is not
a "designated beneficiary" because it is not an individual. There is
an exception to that rule and, if the trust document meets certain
requirements, then the Living Trust is considered a "see-through"
trust and the regulations treat the beneficiaries of the Living Trust as
designated beneficiaries of the decedent's retirement account. To achieve “see
through” status, the Living Trust must meet the following requirements:
- The trust is a valid trust under
state law, or would be but for the fact that there is no corpus.
- The trust is irrevocable or
will, by its terms, become irrevocable upon the death of the account owner.
- The beneficiaries of the trust
with respect to the trust's interest in the employee's benefit are
identifiable from the trust instrument
- Required documentation has been
given to the Plan Administrator. The Plan Administrator must receive a
copy of the trust instrument and a list of all beneficiaries of the trust
with a description of the conditions on their entitlement.
If the trust meets all the
requirements then the Living Trust beneficiaries are deemed “designated
beneficiaries", entitled to receive their MRDs over their life expectancy.
The next issue when a Living Trust is
the beneficiary of IRA benefits usually arises at the account owner's death. At
that point, clients want to know whether the beneficiaries can split the “inherited
IRA” into separate IRAs and make their own decisions about how distributions
are made. Generally, "inherited IRAs" received by beneficiaries other
than a surviving spouse, cannot be rolled over to their own IRA, but the
account can be split into separate IRAs for the trust beneficiaries using the
designation "John Doe IRA for the benefit of Beneficiary A", etc. Beneficiaries
can then decide the manner in which they want their IRA distributed. One
beneficiary may take a lump sum distribution, pay the tax and invest or spend
the rest. Alternatively, a beneficiary can decide to take MRD's over their designated
life expectancy, deferring income tax until future distributions are made.
Along with the question of splitting
an “inherited IRA”, is the question of whether the MRD's are based on each
beneficiary's own life expectancy or on the life expectancy of the oldest
beneficiary.
Regulations §1.401(a) (9)-8, A-2
provides the general rule that if the account owner's benefit is divided into
separate accounts no later than the last day of the year following the calendar
year of death, distributions subsequent to the division are treated as separate
accounts and each beneficiary of each separate account can use his/her own life
expectancy in determining minimum required distributions each year. However,
this rule does not apply to beneficiaries receiving a "separate share"
through a trust that was the beneficiary of an IRA. Therefore, even if
beneficiaries split the IRA into separate accounts for each beneficiary, all
the beneficiaries must use the life expectancy of the oldest beneficiary of the
Living Trust in determining their MRD's.
The law and regulations governing
“inherited IRAs” is both vast and complex, before designating beneficiaries of
retirement benefits, you should consult with a professional expert in that
area. At the death of the account owner, it is important to seek additional advice
as to the best way to retitle the accounts or distribute the assets. These
experts should take the time to understand your unique situation and provide
you with an understanding of the consequences of decisions, not just provide
you with the forms needed to make changes.
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