IRA Beneficiary Trusts

                 Fort Funston, San Francisco, California

                 Fort Funston, San Francisco, California

In the past, the combination of an individual retirement account and a trust were like dynamite.  In the hands of well trained professional, dynamite literally can be used to move a mountain.  In the wrong hands, the potential for a large-scale disaster is almost a certainty.  

In 2005, the Internal Revenue Service issued Private Letter Ruling 200537044.  A private letter ruling, or PLR, is a written statement issued to a taxpayer that interprets and applies tax laws to the taxpayer's represented set of facts. A PLR is issued in response to a written request submitted by a taxpayer. This PLR approves the creation of a revocable stand-alone trust which will be the beneficiary of your IRA.

 

What Can be Gained by Using a Stand-Alone IRA Trust?

A properly designed IRA Trust is an extremely powerful wealth accumulation tool.  After your death, an individual beneficiary of your IRA has the ability to make many different and somewhat confusing tax elections.  Too often, individuals who are named as the beneficiary make uninformed and short-sighted elections.

If a beneficiary is not familiar with tax laws, it may seem easiest to elect lump sum distribution.  This means that the IRA is liquidated, and the proceeds are given to the beneficiary to spend or invest as he or she wishes.  Often what the beneficiary doesn’t understand is lump sum distribution equals lump sum taxation.  All deferred tax on the IRA must be paid in that tax year.  In addition, the beneficiary loses the potential for further tax deferral.  Lump sum distribution is usually the worst possible choice.

Naming a stand-alone IRA Trust, with a trustee who is knowledgeable or at least trainable, is the key in this situation.  After the death of the owner of an IRA, the IRS allows for the recalculation of the life-expectancy of the beneficiary/new owner (see IRS Publication 590 for more information.)  This recalculation changes the Required Minimum Distribution to match the life expectancy of the beneficiary.  The combination of utilizing a “stretch-out” of distributions and compounding growth create amazing results.   To illustrate the importance of recalculation, consider the following:

 

Lump sum distribution – regardless of age, assuming the beneficiary is in the 33% tax bracket 

Value of the IRA at the time of death                    $100,000.00

Less tax at 33%                                                      - $33,000.00

Distribution to beneficiary                                     $  67,000.00  

 

IRA Stand-Alone Trust –  Beneficiary Age 35 years old

Life expectancy under IRS re-calculation rules 49 years

Value of the IRA at the time of death $100,000

Assuming averages of annualized 8% return

 

Required Minimum Distributions paid out          $1,223,584.00

Remainder in account                                                   5,046.00

Total                                                                     $1,228,630.00

 

IRA Stand-Alone Trust –  Beneficiary Age 10 years old

Life expectancy under IRS re-calculation rules 70 years

Value of the IRA at the time death $100,000

Assuming averages of annualized 8% return

 

Required Minimum Distributions paid out          $4,279,898.00

Remainder in account                                          $1,083,614.00

Total                                                                     $5,363,512.00

 

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

 

How Does it Work?

During your lifetime, you create a stand-alone trust which is separate from the rest of your estate planning.  You are the grantor.  The trust is revocable which means the terms can be changed or voided at any time during your life.  The sole purpose of this trust is to act as the beneficiary of your IRA.  You sign a new beneficiary designation with the custodian of your IRA naming the trust as the beneficiary.  You should submit a copy of the trust to the custodian of the IRA, and ask for written verification that the custodian finds the trust an acceptable beneficiary.  

As the grantor, you will appoint the trustee and the successor trustee.  You many act as the trustee while you are alive, but you need to name a person or institution to take over if you become incompetent or upon your death.  You will name the primary beneficiary or beneficiaries of the trust.  You should also appoint a contingent beneficiary or beneficiaries in case the primary beneficiary does not survive you.  The trust beneficiaries can be changed at any time during your life.  

Upon your death, the trust becomes irrevocable.  The stand-alone trust becomes the owner of your IRA.  The successor trustee takes over.  This vests your trustee with the authority to make any necessary tax elections, and ultimately distributions to your beneficiary in accordance with your instructions under the trust. 

 

What are the Benefits of Designating a Trust as the Beneficiary of an IRA?

In addition to being able to stretch-out distributions and the potential for compounding growth, an IRA Trust has other benefits.  Designating a trust as the beneficiary of your IRA allows you to control the distribution of the asset after you are deceased through your trustee.  In the IRA Trust, you can dictate the terms upon which funds will be disbursed.  You also vest your trustee with full authority to make any and all tax elections based upon the facts such as they are at the time of your death.  Under traditional “conduit” language used in many revocable trusts, to satisfy the IRS requirements the trustee was mandated to distribute the required minimum distribution to the beneficiaries each year.  The trustee of the stand-alone IRA trust has the authority to make distributions to beneficiaries as would occur in a standard conduit trust,  or elect to accumulate the income within the IRA Trust.  

 

Are there Additional Benefits of Designating a Trust as the Beneficiary of My IRA?

Many additional problems can be effectively dealt with by using an IRA Trust:  

A spendthrift in the family –-- Unfortunately, some people can’t handle money.  The trustee controls the flow of the money, not the spendthrift.  

Issues with creditors and predators –-- Even if your family members are fiscally responsible, they may still have issues with creditors.  If your beneficiary is an obstetrician or in another high risk profession, chances are occasionally they get sued. The predator problem pertains to your children’s spouses.  If the IRA passes through a trust, it will not be a marital asset should your child later divorce nor is it exposed to judgments from potential creditor judgments.

Special needs beneficiaries –-- If you have a family member with a disability, you definitely want the IRA to pass through a stand-alone trust with special needs provisions so that you do not disqualify the family member from receiving governmental services and benefits.

Family members with issues –-- If you have someone with addiction problems (alcohol, drugs, gambling, etc.,) you definitely need the extra layer of protection the trust provides.

Multiple marriages –-- If you want your current spouse to have the benefit of the IRA, but the IRA to go to your children after your spouse’s death a trust is the best way to accomplish this. 

The beneficiary is a minor –-- If your beneficiary is a minor, under the law they are not eligible to receive the IRA outright.  Trust planning in this situation is a must.  If you fail to plan, the courts will impose a guardianship which will most likely result in immediate lump sum taxation.  

Temptation –-- Even if your family members are otherwise stable, responsible adults, the temptation factor always exists.  It can be very tempting to withdraw the IRA funds to pay educational costs, pay off a mortgage, or otherwise deal with a negative financial issue.  This is often short-term thinking that the beneficiary will regret later typically after they have their income tax returns prepared.  

If the IRA is held in a trust, the trustee gets to decide if the beneficiary should be allowed to remove the money.  If the trustee does agree that the request for withdrawal has merit, he can either make a disbursement of principal, or loan the beneficiary the money.  If principal is loaned to a beneficiary, the trust in essence becomes the bank. As a loan, the disbursement does not become income to the beneficiary. 

 

What if There are Multiple Children or Generations Whom I want to Benefit?

The difference in siblings can be amazing.  In a family of three children, you can have one that is a CPA, one with bad judgment in life-partners, and one who has addiction issues.  The best remedy for this situation is to divide your IRA into separate accounts with separate IRA Trusts.  If this is done properly, you can tailor the individual trusts to meet the specific issues of each child.

In addition, if there is a large age gap between your beneficiaries, you should consider dividing your IRA’s during life into separate accounts.  You then should set up IRA Trusts for each of the accounts.  During recalculation, the IRS will require you to use the life expectancy of the oldest beneficiary of the trust.  Consider the above example where one beneficiary was 35 and the other 10.  If you are using this as a vehicle to plan for children and grandchildren, you should definitely divide the IRA and establish separate IRA Trusts.

   

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

"Stretch IRA" is a marketing term implying the ability of a beneficiary of a Decedent's IRA to withdraw the least amount of money at the latest allowable time in order to maintain the inherited IRA assets for the longest time period possible. Beneficiary distribution options depend on a number of factors such as the type and age of the beneficiary, the relationship of the beneficiary to the decedent and the age of the decedent at death and may result in the inability to "stretch" a decedent's IRA. Illustration values will greatly depend on the assumptions used which may not be predictable such as future tax laws, IRS rules, inflation and constant rates of return. Costs including custodial fees may be incurred on a specified frequency while the account remains open.