Naming a Trust as the Beneficiary of an IRA? Proceed with Caution

This article was first published in the June 2019 issue of Planned Giving Today.

Beneficiary designations to charity from an Individual Retirement Arrangement, commonly known as an IRA, are part of the bread and butter of any planned giving program. As philanthropic planning professionals, we are aware of the ease in explaining these kinds of gifts to donors and the ease in which a beneficiary designation can be established, not to mention the tax benefits of naming charity to receive IRA assets.

But what happens when a trust is named the beneficiary of an IRA? Things can get complicated, as a recent experience reminded me.

I was working with the trustee of a living trust on behalf of an elderly grantor. The trustee also had power of attorney over the grantor’s IRA. Our firm was managing the investments in both the trust and the IRA, totaling approximately $2 million.

The trust document provided for the grantor’s sibling to receive 50% of the estate at the grantor’s death, with the remaining 50% divided through a series of specific and percentage bequests to relatives, including some minors whose shares are to be held in trust. In addition, the trust provided for one bequest to charity of $10,000.

Shortly after our firm began managing the grantor’s assets, the grantor passed away.

As I was reviewing the decedent’s documents, I noticed one potential red flag: the IRA’s designated beneficiary was the grantor’s living trust.

Depending on the language in the trust, this could present a problem. If a non-person is named the beneficiary of an IRA, the beneficiary is deemed to not have a life expectancy, and the IRA must distribute its assets within five years from the original IRA owner’s date of death. If the IRA is large, this could result in very negative income tax consequences.

Fortunately, there is an exception to the five-year IRA distribution rule: the “see-through” retirement trust. Before discussing that trust, let’s review what happens when individuals inherit IRAs — and how to make those IRAs last for a long time.

RMDs, Inherited IRAs, and “Stretching” Distributions

When individuals are named as beneficiaries of an IRA, those individuals generally will be subject to required minimum distributions (RMDs) beginning in the year after the death of the account owner[1]. The beneficiary of an IRA will not be subject to the 10% early withdrawal penalty if he or she is under age 59.5.

An individual receiving an IRA as an inheritance can choose to take the RMDs over his or her life expectancy — a strategy known as the “stretch” IRA, because the distributions from the inherited IRA are stretched for as long a period as possible, thereby minimizing taxes and enabling the corpus of the IRA to continue growing tax-deferred. Of course, the heir can choose to take larger distributions over and above the annual RMD, but doing so would defeat the stretch strategy, not to mention subject all distributions to ordinary income tax.

Remember the rules about RMDs: once an IRA owner reaches age 70.5, he or she generally is required to take distributions annually beginning that year[2]. The amount of the RMD is based on the IRA account value on December 31 of the prior year, divided by a life expectancy factor found in IRS Publication 590-B.

For instance, let’s say that Mary Smith has an IRA with an account value of $500,000 on December 31, 2018. She turns 70 in February, which means she is turning 70.5 in 2019 and therefore must take her first RMD in 2019. Per the IRS Uniform Life Table, the life expectancy factor at age 70 is 27.4. Divide $500,000/27.4 = $18,248.18, which is Mary’s first year’s RMD.

If Mary dies in 2018 and has named her nephew John as the sole beneficiary, Mary’s IRA would be retitled into an Inherited IRA “for the benefit” of John. If John is 30 years old and inherits that same $500,000 IRA, his first year’s RMD would be just $9,380.86, based on his life expectancy. If John is smart (or has good advisors), John can continue taking just his RMD every year, preserving the IRA for a longer period and deferring taxes along the way.

Enter The “See-Through” Retirement Trust

A see-through retirement trust[3] can be named the beneficiary of an IRA and still permit the underlying trust beneficiaries to stretch RMDs, avoiding the five-year distribution. There are specific requirements to qualify as a see-through trust[4]:

1. The trust must be valid under state law;
2. The trust must be irrevocable or become irrevocable upon the death of the original IRA owner;
3. The underlying beneficiaries must all be identifiable as being eligible designated beneficiaries; and
4. The IRA custodian must receive trust documentation by October 31 of the year following the IRA owner’s death.

If the trust meets the requirements above, the rules permit the trustee to “see through” the trust to the life expectancy of the underlying beneficiary. If there are multiple beneficiaries of the IRA trust, then generally, unless separate trusts are established for each beneficiary, the oldest beneficiary’s life expectancy is used for purposes of the RMDs for all beneficiaries.

If the trust does not meet the requirements, the five-year IRA distribution schedule applies.

Returning to my client, recall that the deceased grantor’s IRA named his trust as beneficiary, and the trust provided for multiple beneficiaries, including a specific charitable bequest.

Therein was the problem. One of the requirements of the see-through trust (#3) is that the underlying beneficiaries must be “eligible designated beneficiaries” — which means the beneficiaries must all have a life expectancy. Since charities do not have life expectancies, naming a trust as beneficiary of an IRA in which the trust provides a bequest to charity — even a small bequest as in this case — disqualifies the trust as a see-through trust, thereby forcing the five-year distribution schedule.

This is one instance where a charitable bequest in a trust could have resulted in a negative financial outcome for the heirs! Fortunately, there was a solution we could still use, thanks to the attorney’s knowledge of the IRA rules.

The “eligible designated beneficiaries” of a see-through trust are determined on September 30 of the calendar year following the year of death of the IRA owner. Thus, if the charity can be “cashed out” before September 30 and its bequest fulfilled, the issue is resolved, since the remaining beneficiaries are all individuals and therefore “eligible designated beneficiaries.”

Needless to say, the grantor’s sibling was relieved to hear that, by paying the charitable bequest before September 30, he could still stretch the IRA distributions over his life expectancy, which is what he wanted.

Case Study Takeaways

The takeaways from this case study are:

• Always try to get a holistic picture of your donor’s net worth by gathering data – think like a financial planner. How much of your donor’s assets are in retirement accounts?
• Confirm the beneficiaries of the retirement accounts. Does the donor have a primary and a contingent beneficiary named? Is a living trust the beneficiary of any IRA?
• If a trust is the beneficiary, does the trust meet the requirements of a see-through retirement trust?
• Is there a charity named as a beneficiary of the trust along with individuals? If so, can the trust be cured by cashing out the charity before September 30 of the year following the IRA owner’s death?

As you can see, this is a complex area of tax and estate planning, and the rules are confusing. Working collaboratively with the donor’s estate planning attorney, CPA, and financial advisor, you can identify potential tax traps like this one and work to avoid them before it is too late.

Thank you to Heather Glick-Atalla, attorney with Glick Atalla, a Professional Law Corporation, for her review of this article.

Footnotes

[1] The exception being if the beneficiary is the account owner’s spouse and the spouse is younger than age 70.5. In that case, the spouse can defer RMDs on the inherited IRA assets until he or she reaches 70.5.

[2] An IRA account owner may delay the first year’s RMD until April 1 of the following calendar year, but then must also take the second year’s RMD by December 31 of the second year.

[3] “See-through” is not a technical or legal term but used here descriptively to describe any trust drafted to provide stretch IRA distributions to named trust beneficiaries.

[4] "Publication 590-B: Distributions from Individual Retirement Arrangements (IRAs)" IRS.gov. https://www.irs.gov/pub/irs-pdf/p590b.pdf. Accessed March 14, 2019.