As a participant in a qualified plan or the owner of an IRA you have many options in naming a beneficiary upon your death. Most often we think of our families – our spouses and/or children as the natural beneficiaries of our retirement assets. And much can be said in favor of naming your spouse as beneficiary, and perhaps your children. But is it the only way to leave your retirement assets for your family? Is it the best way? Many advisors suggest naming a trust as beneficiary. Others suggest to the contrary. Who is “right”?
Many participants in qualified retirement plans and owners of Individual Retirement Accounts (IRAs) have these thoughts in mind when designating a beneficiary – “how can the distribution be ‘stretched’ over the longest period of time, with minimum tax consequences and maximum benefit to my loved ones?” In most family situations, naming a spouse as the primary beneficiary and the children as secondary or contingent beneficiaries can accomplish those goals. A spouse, for example, may roll over the assets into his/her own IRA and possibly defer taxes and distributions for many more years, naming children beneficiaries so that on the death of the spouse, distributions are stretched over the life expectancies of the children.
I am married and want to name a trust as beneficiary of my retirement plan. May I?
Whenever a married individual wants to name someone other than his or her spouse as beneficiary of the employer sponsored retirement plan, the plan participant, in many cases, must obtain written spousal consent, signed and notarized. That consent is usually not required for IRAs. Defined benefit plans always require spousal consent and in the case of IRAs, although not required, financial institutions as custodians, may require consent.
When might naming a trust as beneficiary be recommended?
Significant amounts of wealth are invested in retirement plans and IRAs. Since distributions from these accounts may occur over the lives of several generations, some of whom may be minors, immature adults or financially unsophisticated individuals, a trust may provide the management expertise and discretion required. The trust plays the same role as it does in many other estate planning applications – to establish a trust as a protective vehicle for minor beneficiaries, spendthrifts, and to ensure inheritances to children from a previous marriage. In the latter case, leaving the IRA or qualified plan to a trust can provide income for the spouse, and continue for the children without having to be concerned that your spouse, if he or she received the money directly, might name someone else as beneficiary (e.g., a new spouse) to the detriment of your children.
For example, Susan is Paul’s second wife. Paul has a son John from his first marriage, If Paul names Susan the beneficiary of his IRA account, she can do a spousal rollover and name her own beneficiaries, to the exclusion of John. On the other hand, if Paul names a trust that meets IRS qualifying criteria, distributing required minimum distribution (RMD) income to Susan during her life, with the remainder to John, Paul can be sure that John will inherit the balance of his retirement account after Susan has passed away or remarried.
Some advisors express concern that using a trust may expose your retirement assets to immediate income taxation. Is that a legitimate concern?
It is a concern but adverse tax consequences can be avoided provided great care is given to drafting the trust to ensure that it is a “qualified” trust.
How does one name a trust as beneficiary yet qualify the IRA or retirement plan for IRA rollover treatment?
A trust is not considered a “designated beneficiary.” Only individuals may be a designated beneficiary. However, beneficiaries of a qualified trust may qualify as designated beneficiaries. The IRS has spelled out the criteria for a trust beneficiary to be treated as a designated beneficiary:
- The trust must be valid under state law.
- The trust must be irrevocable or will, by its terms, become irrevocable on the death of the plan participant or IRA owner.
- The trust’s beneficiary (ies) must be identifiable by the trust or the will terms.
- The IRA owner or plan participant must provide the trustee or custodian, whichever the case, with a copy of the trust instrument or will, or the beneficiaries must provide it upon demand.
These requirements must be satisfied by October 31st of the year following the year of the death of the owner/participant.
Must the trust be created during my lifetime or can it be in my will?
You can create a qualifying trust that meets the above criteria during life, known as a living or inter vivos trust, or you can create a qualifying trust in your will, known as a testamentary trust. As long as the trust satisfies the IRS criteria, it does not matter when it was created.
My minor children would be the beneficiaries of a trust that would be the beneficiary of my IRA or qualified retirement plan. I want income accumulated for them until they reach the age of majority. Can I do that?
This type of trust design can result in unforeseen consequences. In order to qualify the trust for distributions based on the children’s ages, it must be a “conduit” trust – all income received by the trust must be distributed by the trust to its named beneficiaries. If minor children are involved, the distribution can be made to their guardian or a custodial account and accumulated outside the trust for distribution to them when they attain the age of majority.
I have an IRA and want to leave it to a trust for my three children. How will it be “stretched”? Assuming the trust meets all the other qualifications, the age of the oldest beneficiary is used to calculate the time over which Required Minimum Distributions are calculated, meaning the RMDs will be highest and the children taxed on them quicker. For example, if you have three children ages 20, 15, and 10, the distribution would be based on the life expectancy of the 20-year old.
How can I ensure that each child is distributed their share based on their age?
If the account is a qualified retirement plan, you should create separate trusts for each child and name each trust as beneficiary for each respective child. If the account is an IRA, you should split the IRA into three separate IRA’s and, again, have three separate trusts, one for each child. Then each child’ life expectancy will be used to calculate their RMDs.
I have an IRA and want to leave half to a charity and the other half to my children. Can I name a trust as beneficiary, with half for the benefit of a charity and half for the benefit of my children?
A beneficiary of a trust that is other than an individual person (such as a charitable organization) will cause an IRA or qualified retirement plan to be treated as having no designated beneficiary. The lack of a designated beneficiary requires full distribution of the IRA or qualified retirement plan within 5 years of the date of death of the participant/owner, or over the remaining life expectancy of the participant/owner if the participant/owner is over age 70 ½ at death. For example, if the trust provided 30% each to your three children and 10% to a charity, the distributions could not be stretched over the life expectancies of the children.
Okay, I understand. So how would I accomplish my goal?
During life, if you were to split the IRA 50/50 and leave the children’s 50% portion to a qualifying trust, and the other 50% to the charity, then the children’s interest would not be tainted by the non-designated beneficiary charity, and would be distributed to them based on the oldest child’s age.
I understand that my IRA is protected from my creditors. When I die and my children inherit my IRA, will it still be protected from their creditors?
On June 12, 2014, the Supreme Court of the United States issued a decision in the case of Clark v. Rameker. The Court held that Inherited IRA’s were not “retirement funds” and therefore, inherited IRA’s are not protected assets in the case of a bankruptcy proceeding.
The Court defined “retirement funds” as sums of money set aside for the day an individual stops working. In support of its position, the Court said there are three legal characteristics of an Inherited IRA that provide evidence that these funds are not retirement funds.
- The holder of an inherited IRA may never invest/add additional money to the account.
- The holder of an inherited IRA is required to withdraw money from the account(s), no matter how far they are from retirement.
- The holder of an inherited IRA may withdraw money at any time, for any reason, without penalty.
What added protection would a trust provide?
A spendthrift trust, one which prohibits the beneficiary from any access to the principal, prevents the beneficiary’s creditors from accessing trust assets under state law. In addition, under Federal Bankruptcy Code Section 541(c)(2), assets in a spendthrift trust are exempt from creditors. Since a qualifying trust must be a conduit trust, once any distributions are made to your heirs, those distributions would be reachable by creditors.
From these questions and answers it should be clear why naming a trust as beneficiary of your qualified retirement plan or IRA, can be an effective planning tool for the long term benefit of your family. However, doing so involves careful planning and drafting of a trust document, whether in a living trust or in your Will. In the end, though perhaps legally challenging, naming a trust can provide your loved ones not only the security of required minimum distributions for life, but important protections that would not otherwise be available to them if they were named outright beneficiaries.
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