Other IRA Issues with Estate Planning

On Tuesday, I discussed funding retirement benefits to a Living Trust and some of the issues that may come about because of the funding. In response to that post I received a few comments and questions on related issues and thought it a good idea to expand on the topic in today's post.

The first comment talked about the opportunity of using a direct IRA beneficiary trust as well, to mandate a "stretch-out" of distributions and protect non-spouse beneficiaries from creditor claims. We discussed the IRA Trust in our post on November 20, 2012, but it is worthwhile discussing it again.  

The “IRA Trust”, is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement other benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of their inherited benefits over their lifetime. Using the IRA Trust allows the client to design a special trust specifically for the IRA assets and perhaps even for different beneficiaries then for the majority of the estate under the client's Living Trust. Except for the required minimum distributions (RMDs), the IRA assets can continue to grow tax-deferred and protect beneficiaries against their own bad habits of this spending in mismanagement of money. Additionally, if an IRA trust provides for more than one beneficiary, if the IRA beneficiary designation form specifies the percentage of the account that will go to a specific sub trust for each of the beneficiaries, each beneficiary can then use their own life expectancy in calculating the RMDs for a particular year.
     A second comment asked how one meets the "see-through" trust requirements when one of the trust beneficiaries is a charity or other non-individual beneficiary. When a client names non-individual trust beneficiaries, those beneficiaries can be "removed" as a beneficiary for the purposes of determining the “see through” status of the trust. To “remove” the non-individual beneficiary the trustee must either make a distribution of the amount allocated to that beneficiary or arrange for the beneficiary to disclaim their interest. The deadline for this “removal” is September 30 of the calendar year following the calendar year of the account owner's death (the "Beneficiary Finalization Date"). If this is accomplished, the regulations exempt the non-individual trust beneficiaries for purposes of determining individual beneficiaries.
One might ask why anyone would disclaim his or her interest in a Living Trust. In some cases an older beneficiary will disclaim their interest in the IRA assets of the trust, because it will allow the younger beneficiaries (perhaps grandchildren in their 20s) to extend the IRA distributions over the lifetime of the oldest life expectancy of that group. This is important because unless you eliminate the elder beneficiary, all of the beneficiaries must use the oldest beneficiary's life expectancy in calculating the RMDs. Alternatively, a charitable beneficiary may disclaim an interest in IRA assets in exchange for a larger immediate gift that it can invest or put to use immediately.

On a final note, if there are sufficient assets in addition to the IRA to protect loved ones, and the client is charitably inclined, client may want to consider designating one or more charities as the beneficiary of the IRA. This will satisfy their charitable inclinations will save significant income taxes because the IRA will not be subject to income tax when paid to the charity. This can save a large amount of tax, especially where the estate is taxable for estate tax purposes and then the IRA is taxed for income tax purposes as it is distributed to individual beneficiaries. Naming a charity as the IRA beneficiary excludes it from taxation for federal estate tax purposes and income tax purposes.

Again, it is important that a client discusses their desires with experience counsel prior to designating beneficiaries in order to protection of beneficiaries and minimize taxation of the account.

Funding Retirement Benefits to a Living Trust

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:

1. The trust is a valid trust under state law, or would be but for the fact that there is no corpus.
2. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the account owner.
3. The beneficiaries of the trust with respect to the trust's interest in the employee's benefit are identifiable from the trust instrument
4. 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.