In 2005 a Private Letter ruling was issued by the Internal Revenue Service approving a specially designed “IRA Trust” that offers maximum protection and flexibility while allowing the beneficiaries to “stretch” their shares of the IRA over their life expectancies. The IRA Trust can also be used for employer provided retirement plans, such as 401(k)s, 403(b)s, 457 Plans, etc.
In most cases, an IRA owner designates a trust as the beneficiary of the IRA in order to have control over the disposition of the assets after he or she dies. The following are some reasons why an IRA owner may designate a trust as beneficiary:
- Spendthrift beneficiary protection – An IRA owner may be aware that a beneficiary is a spendthrift who may squander the inheritance. As such, the IRA owner may want the assets to be disbursed to the beneficiary according to a certain schedule instead of in a lump-sum payment. The IRA owner may also want some of the assets to be used for specific purposes, such as financing the beneficiary’s education. The IRA owner can ensure these conditions are met by designating a trust that includes the desired payment options. The trustee of the trust would then be responsible for complying with the trust provisions.
- Providing for children from a previous marriage – An IRA owner may want to ensure that his or her current spouse receive income from the assets and that the IRA owner’s children from any previous marriages receive their share of the assets. This can be accomplished by designating a trust that meets certain requirements, such as a qualified terminable interest property (QTIP) trust.
The Two Types of IRA Beneficiary Trusts
There are two types of trusts that can be utilized as an IRA beneficiary: the Conduit Trust and the Accumulation Trust. The IRS defines an Accumulation Trust as any type of trust that is not a Conduit Trust. With an Accumulation Trust, the trustee is not required to immediately distribute withdrawals from the IRA; the withdrawals can be held in the trust. The advantages of accumulating the distributions instead of paying them directly are: asset protection, substance or spendthrift issues, incentive distributions and further tax planning. One possible issue with this type of trust is that the life expectancy of the oldest beneficiary is used to calculate the required minimum required distributions (MRDs).
In order to ensure long term tax deferral, a “conduit” trust (rather than an accumulation trust) may be desirable in certain cases. Since a conduit trust has a single individual as a primary beneficiary, the trustee is required to take at least the MRD amount from an inherited IRA each year and pass that amount directly through to the trust beneficiary. With this conduit trust, the primary beneficiary’s life expectancy –not the original owner’s life expectancy – can be used to stretch MRDs over this younger life.
The disadvantage to the conduit trust is that distributions can’t be accumulated in the trust. They must be passed through to the trust beneficiary, who may spend the money or lose it to creditors. However, the IRA principal may still be protected.
The IRS strictly adheres to established regulations when they review and/or audit one’s estate. Therefore, expertise and great care must be exercised when planning for an asset that will be heavily relied upon by your family for future financial needs.
The rule for non-person beneficiaries also applies to trust beneficiaries, unless an exception applies, in which case the oldest underlying beneficiary of the trust is treated as the beneficiary of the IRA – for purposes of determining the distributions options. In general, the exception applies if the following requirements are met:
The trust is a valid trust under state law.
- The trust is irrevocable or will, by its terms, become irrevocable upon the death of the IRA owner.
- The beneficiaries of the trust are identifiable.
- A copy of the trust documents are provided to the IRA custodian by Oct 31 of the year immediately following the year in which the IRA owner died.
Designating a trust as the beneficiary of an IRA should be a solution to the IRA owner’s financial planning needs. However, steps must be taken to ensure that the designation does not create problems for the parties who will inherit the assets. An IRA owner should check with the IRA custodian to ensure that the provisions of the trust are acceptable to the IRA custodian and that they meet regulatory requirements. In addition, the IRA owner should consult with a competent attorney or estate planning professional for assistance in designing the trust. Here are some examples of circumstances that cause the trust to fail to satisfy the needs of the IRA owner:
- A copy of the trust is not provided to the IRA custodian by Oct 31 of the year following the year the IRA owner died, preventing the underlying beneficiary of an otherwise valid trust from using the life expectancy of the oldest identifiable beneficiary in calculating RMD amounts.
- The trust is eligible to disclaim the assets. If this happens, the other primary or contingent beneficiary usually inherits the assets, and the provisions of the trust no longer apply. This can be avoided by including a ‘disclaimer provision’ in the trust. In general, this provision may require that in the event the trust disclaims the assets, the disclaimed assets, instead of going to an individual, must be disposed according to certain provisions of the trust.
- The IRA custodian does not find the provisions of the trust acceptable, or the provisions of the trust conflict with the provisions of the IRA plan document. When designating a trust as the beneficiary of his or her IRA, the IRA owner should check with the IRA custodian to determine whether any provisions are unacceptable.
In short, designating a trust as the beneficiary of an IRA can be an effective estate-planning tool. However, it is effective only if all the parties involved – especially the IRA owner, the IRA custodian, the trustee of the trust and any attorneys representing the beneficiary – agree on the interpretation of the provisions of the trust and applicable laws. Conflicting interpretations could result in a delay of disposition of the assets and can be quite frustrating for those involved. Designing a trust is a complex process. The IRA owner should seek the assistance of a competent attorney and tax professional to determine if and when a trust is appropriate, the type of trust that suits the IRA owner’s needs and to ensure that estate planning needs are met and maximized.
What Sets The IRA Trust Apart From Other Designated Beneficiary Trusts?
The IRA Trust offers some unique post-mortem flexibility, which permits the trust to adapt to
the conditions existing at the time of the IRA owner’s/grantor’s death. If the beneficiary’s share
of the IRA Trust is a “Conduit,” trust, meaning that all of the IRA distributions flow over into the trust and then are immediately distributed out to the beneficiary, the beneficiary’s life expectancy can be used for stretch purposes. On the other hand, there are a number of estate planning reasons why we would prefer an “Accumulation” trust instead, where the IRA distributions that flow into the trust are distributed to the beneficiary only in the discretion of the trustee. Unfortunately, an Accumulation trust may cause the maximum stretch to be lost unless a whole number of requirements are met; if any monies accumulated in that trust could ever, at any time in the future, pass to someone older than the primary beneficiary, that older person’s shorter life expectancy must be used and there are even situations where no life expectancy can be used and the IRA will have to be distributed for and all the tax paid in five years. Since a discretionary trust is often designed for estate planning purposes to benefit individuals other than just the primary beneficiary, such as that beneficiary’s issues or others subject to the beneficiary’s power of appointment, and we want to take advantage of generation skipping for estate tax purposes, it may be very difficult for the estate planner, at the time of drafting the trust, to determine where to cut off future beneficiaries in order to balance the desire for stretch with the desire to fulfill the grantor’s dispositive intent. Also, it is difficult to determine at the outset whether or not a beneficiary’s trust would best be a Conduit or Accumulation trust, not knowing the circumstances of the beneficiary that will exist at the time of death, and the amount of protective features that will be appropriate for that beneficiary.
One of the unique features of the IRA Trust is a “toggle switch” which the Trust Protector can use, following the grantor’s death, to convert between a Conduit and Accumulation Trust, as is appropriate given the circumstances of the beneficiary and their need for protection. The Trust Protector, armed with this toggle switch, can also determine, for any beneficiary who will have an Accumulation trust, which secondary or contingent beneficiaries should be kept in or removed
in a way that best balances the primary beneficiary’s desire for stretch and fulfills the grantor’s
dispositive intent when that primary beneficiary passes away.